Prices remained almost unchanged after yesterday’s surge that followed the Fed’s surprising announcement that they would continue open market purchases in the same monthly amount.
Both the DJIA and the S&P500 slipped a bit whereas the NASDAQ added a fraction, moving ahead for the third consecutive session. Today’s diagram shows the low frequency of this pattern and its recent relative decline. According to this history, the following day has about an even chance for gains and losses.
While many people know that interest rates and bond prices move in opposite directions, it is useful to describe the action underlying this relationship.
When the U.S. Treasury borrows money, it issues an IOU in the form of a bond that matures, say, in ten years; it of course pays interest for this loan. That rate of interest, as on most loans, remains constant over the life of the bond. Using symbols, this transaction can be stated as
IOU Amount X Rate of interest = Annual income.
When the Fed wants to increase the money supply, it instructs brokers to buy bonds from the stock of existing U.S Treasury IOU’s. This is exactly the same process that we all use to buy securities, and just like those purchases result in higher prices, the Fed’s buying spree increases the going, market price of the existing stock of U. S. Treasury bonds.
Though this results in raising the market price of the IOU, the Treasury continues to pay the same annual income as before, since that payment was contracted when the bond was issued.
Now, returning to the statement above,
IOU Amount X Rate of interest = Annual income,
With the bond’s market price now higher, while the annual income remains unchanged, the effective interest rate has to decline. Further, since all financial securities are related, this increases interest rates across the board.
It’s just like floating on the ocean; any wave that comes causes all things to rise in its wake.
DJIA -.26 percent
NASDAQ .15 percent
S&P500 -.18 percent
