What Affects Bond Yield

The single biggest factor affecting bond yield is inflation expectations, which increases bond yield as investors demand higher returns to compensate for expected losses in purchasing power, as seen in the 1970s when US bond yields rose from 6% to 14% in response to soaring inflation.

Main Factors

• Inflation expectations — when inflation expectations rise, bond yields increase to compensate for the expected loss of purchasing power, with a 1% increase in inflation expectations corresponding to a 0.5-1% increase in bond yields, as witnessed in the 1990s when the UK's bond yields rose from 8% to 10% in response to a 2% rise in inflation expectations (Bank of England).
• Economic growth — a strong economy decreases bond yields as investors seek higher returns in the stock market, with a 1% increase in GDP growth corresponding to a 0.2-0.5% decrease in bond yields, as seen in the 1990s when the US economy grew at 4% annually and bond yields fell from 8% to 5% (Bureau of Economic Analysis).
• Monetary policy — expansionary monetary policy, such as quantitative easing, decreases bond yields by increasing the money supply and reducing borrowing costs, with a $1 trillion expansion in the monetary base corresponding to a 1-2% decrease in bond yields, as observed during the 2008 financial crisis when the Federal Reserve's quantitative easing program reduced US bond yields from 4% to 2% (Federal Reserve).
• Fiscal policy — expansionary fiscal policy, such as tax cuts or increased government spending, increases bond yields as investors anticipate higher borrowing costs and inflation, with a 1% increase in the budget deficit corresponding to a 0.2-0.5% increase in bond yields, as seen in the 1980s when the US budget deficit rose from 2% to 5% of GDP and bond yields increased from 10% to 14% (Congressional Budget Office).
• Credit risk — a higher perceived credit risk increases bond yields as investors demand higher returns to compensate for the increased likelihood of default, with a 1% increase in the default probability corresponding to a 0.5-1% increase in bond yields, as witnessed in the 2008 financial crisis when the default probability of Lehman Brothers' bonds rose from 1% to 10% and their bond yields increased from 5% to 15% (Moody's).
• Liquidity — a decrease in market liquidity increases bond yields as investors demand higher returns to compensate for the reduced ability to buy or sell bonds quickly, with a 10% decrease in market liquidity corresponding to a 0.5-1% increase in bond yields, as observed during the 1998 Russian financial crisis when the liquidity of Russian bonds decreased by 20% and their bond yields rose from 10% to 20% (International Monetary Fund).
• Term premium — a higher term premium increases bond yields as investors demand higher returns to compensate for the increased uncertainty and risk associated with longer-term bonds, with a 1% increase in the term premium corresponding to a 0.5-1% increase in bond yields, as seen in the 2010s when the term premium of 10-year US bonds rose from 0.5% to 1.5% and their bond yields increased from 2% to 3% (Federal Reserve).

How They Interact

The interaction between inflation expectations and monetary policy can amplify or cancel each other, as seen in the 1980s when the Federal Reserve's tight monetary policy reduced inflation expectations and bond yields, but in the 2000s when the Fed's expansionary monetary policy increased inflation expectations and bond yields.

• The combination of economic growth and fiscal policy can also interact, as a strong economy with expansionary fiscal policy can lead to higher inflation expectations and bond yields, as witnessed in the 1960s when the US economy grew at 5% annually and the budget deficit rose from 1% to 3% of GDP, leading to a rise in bond yields from 4% to 6% (Bureau of Economic Analysis).
• The interaction between credit risk and liquidity can also be significant, as a decrease in market liquidity can increase the perceived credit risk and bond yields, as seen in the 2008 financial crisis when the liquidity of Lehman Brothers' bonds decreased by 90% and their bond yields rose from 5% to 50% (Moody's).

Controllable vs Uncontrollable

The controllable factors include monetary policy, controlled by central banks such as the Federal Reserve, and fiscal policy, controlled by governments, which can be adjusted to influence bond yields.

• The uncontrollable factors include inflation expectations, economic growth, credit risk, liquidity, and term premium, which are influenced by a complex array of economic and market forces.
• Monetary policy is controlled by central banks, which can adjust interest rates and the money supply to influence bond yields, as seen in the 2008 financial crisis when the Federal Reserve reduced interest rates from 5% to 0% and increased the monetary base by $1 trillion, leading to a decrease in bond yields from 4% to 2% (Federal Reserve).
• Fiscal policy is controlled by governments, which can adjust taxes and government spending to influence bond yields, as witnessed in the 1980s when the US government reduced taxes and increased government spending, leading to a rise in bond yields from 10% to 14% (Congressional Budget Office).