Bond Market during deflation

[Kidlicious]

Ok, assume that there will be a sustained period of deflation in the US. You may or may not believe that that will happen, but just assume it. Will that be good for the bond market or will it cause a bubble to burst? If a bubble does burst in the bond market what will be result?

For those of you who are unfamiliar with the liquidity trap theory. It states that if interest rates continue to fall far they will reach a point where investors demand dollars instead of bonds.

There are a couple of articles at cnn.money on this today.



Bonds: the rally with legs

Money for Nothing

[Sten Sture]

ahhhh, the convexity trade!

[Kidlicious]

Originally posted by Sten Sture
ahhhh, the convexity trade!

What does that mean Sten?

edit: no trick. honest. I would like to know what it means and I'm having trouble.

[Saras]

Fixed income traders are people who can calculate how much tips everyone at a table has to leave without a financial calculator.

[Urban Ranger]

Well, first thing is, with a deflation you end up with a nicely high real interest rate.

[DaShi]

I prefer my interest rates shaken not stirred.

[DAVOUT]

Deflation can be analysed as an addition to the interest rate.

Therefore, when deflation appears, without an equivalent decrease of the interest rate, the price of bonds should decrease.

If interests rates decrease when deflation appears, and in the same proportion, the price of bonds should not move.

If interest rates decrease more than the deflation, the price of bonds may increase.

When interest rates reach zero, bonds are no longer more attractive than notes or bank accounts (liquidity trap). This is particularly worrying for the Treasury which needs to issue huge amounts of bonds every year. To induce subscription, interest rates must remain positive. In other worlds, deflation will not reduce the burden of interests in the federal budget.

[Kidlicious]

Originally posted by Urban Ranger
Well, first thing is, with a deflation you end up with a nicely high real interest rate.

joking? that's where the drag comes in.

[Kidlicious]

Originally posted by DAVOUT
If interests rates decrease when deflation appears, and in the same proportion, the price of bonds should not move.

Is this possible to have negative nominal rates though? The nominal rates in Japan are still positive, but practically zero.

[DAVOUT]

Although I can imagine a negative nominal rate, I cant see it applied in real life simply because the lender is better off in not lending.

[DAVOUT]

Originally posted by Kidicious


joking? that's where the drag comes in.

UR is wright :

real interest rate = nominal rate - inflation or + deflation

With a nominal rate of zero and a deflation rate of 1%, the 100$ you had in the beginning of the year are still 100$ at the end, but meantime, the 100$ item costs now 99$. The remaining $ is equivalent to a real interest.

[Kidlicious]

Originally posted by DAVOUT


UR is wright :

real interest rate = nominal rate - inflation or + deflation

With a nominal rate of zero and a deflation rate of 1%, the 100$ you had in the beginning of the year are still 100$ at the end, but meantime, the 100$ item costs now 99$. The remaining $ is equivalent to a real interest.

I know the rate is higher. That's the problem. The rate where S=I needs to be reached and that optimal rate is difficult to reach during sustained deflation. The only hope is for the central bank to convince investors that deflation will be reversed. The BOJ has given up. So there is no hope there. Hopefully we won't find out what will happen in the US.

[DAVOUT]

You think that lowering the interest rates results infaillibly in improving the economy. The situation assumed in this thread demonstrates the limits of such a policy.

I believe, but I can prove it only in looking at the absence of effects of the last several decreases of the rate, that the monetary policy consisting in decreasing the rates has a range of effectiveness that we have largely exceeded.

[Kidlicious]

Originally posted by DAVOUT
You think that lowering the interest rates results infaillibly in improving the economy. The situation assumed in this thread demonstrates the limits of such a policy.

I believe, but I can prove it only in looking at the absence of effects of the last several decreases of the rate, that the monetary policy consisting in decreasing the rates has a range of effectiveness that we have largely exceeded.

I believe that liquidity traps are possible. In fact, I believe there is one in Japan. I think it would be very difficult to get out of one with monetary policy. However, I think that it is possible to avoid one with monetary policy. The Fed and ECB should act now, before it's too late.

[DAVOUT]

What do you mean by : Fed and ECB should act ?