A Layman's Explanation of Why U.S. Bond Yields and U.S. Bond Prices Move in Inverse Proportion
"First of all, everyone knows what U.S. bonds are, right? If you don't, it's okay; just think of them as stocks.
A student A bought $1,000 worth of U.S. bonds with a 3% interest rate in 2021, so when they mature, they will receive $1,030 in principal and interest.
Now, the Federal Reserve increased the interest rate to 5% in 2023. Student B, who is buying new U.S. bonds, will receive $1,050 upon maturity.
Seeing this, student A felt a bit of FOMO (Fear of Missing Out). They realized that the U.S. bonds they already had had a lower interest rate compared to student B's. So, student A decided they didn't want their low-interest U.S. bonds anymore; they wanted the latest high-interest U.S. bonds. However, they couldn't just buy new bonds because they were already invested, and they couldn't cash them in before maturity. So, student A took their 3% interest rate U.S. bonds to the market, hoping to sell them to someone else to get cash back.
Student C in the market saw that student A was selling these 3% U.S. bonds. They weren't foolish; why would they buy old bonds when the interest rate on the newest U.S. bonds is 5%? So, student C said, "You have to compensate me for the interest rate difference, and then I'll consider taking over your bonds. You need to make up the $20 difference. In other words, I need you to sell them for $980; otherwise, I might as well buy the new ones."
After some thought, student A realized that the Federal Reserve might continue raising interest rates, and the new bonds might go up to 6%, 7%, or even 8%. So, they decided to agree to student C's request and sold their U.S. bonds for $980, getting cash back.
So, as you can see, it's all due to FOMO. If student A had enough funds, they could have simply bought new U.S. bonds while still holding the old ones until they matured. They wouldn't have had to lose $20 to get cash back; it was just their FOMO mentality, thinking that interest rates might surge, which led to this decision. In real-market trading, the price difference may not necessarily equal the interest rate difference. You can think of it like stock trading, considering the buying and selling prices. It all depends on how eager the seller of the old bonds is to get cash back.
On another note, you might wonder why student C didn't just buy the newest U.S. bonds. Well, in reality, the transaction cost might be higher than the $20 interest rate difference. Moreover, it's important to note that the old bonds mature faster, so even if the yield is the same, they are more attractive because they will mature sooner. So, student B naturally acted in their best interest.
In summary, if the new U.S. bonds keep increasing their interest rate, and if there are many students like student A who can't resist FOMO, more and more people will sell their bonds. With more sellers, it becomes a buyers' market, and buyers can negotiate lower purchase prices, thus increasing the yield.
By now, it should be quite clear. If you still have questions, feel free to continue the discussion in the FOMOSTOP group. There's a lot of interesting stuff to talk about!"
"Let's add a practical example to make it even clearer. Comparing the chart of the 20-year U.S. bond ETF, TLT, with the 20-year U.S. bond actual interest rates is quite revealing.
Around March 2020, the interest rate on 20-year U.S. bonds was just below 1%. At that time, the TLT ETF reached an all-time high. This happened because, in the context of the moment, the new bonds (1%) were perceived as having little value, while the old bonds were appreciating significantly."
