Bond yields are significantly affected by monetary policy. These policies may come from the actions of a central bank, such as the Federal Reserve, a currency board or other types of regulatory committees.

However, monetary policy at its core is about determining interest rates. In turn, interest rates define the risk-free rate of return. The risk-free rate of return has a large impact on the demand for all types of financial securities, including bonds.

The Effect of Monetary Policy on Bond Yields

When interest rates are low, bond yields decline due to the increased demand for bonds. For example, if the yield on a bond is 5%, this yield becomes more attractive as the risk-free rate of return falls from 3% to 1%. This increased demand for the bond results in rising prices and falling yields.

Of course, the inverse is true as well. When the risk-free rate of return rises, money moves from financial assets to the safety of guaranteed returns. For example, if the risk-free rate of return rises from 2% to 4%, a bond yielding 5% would become less attractive. The extra yield would not be worth taking on the risk. Demand for the bond would decline, and the yield would rise until supply and demand reached a new equilibrium.

Central banks are aware of their ability to influence asset prices through monetary policy. They often use this power to moderate swings in the economy. During recessions, they look to hold off deflationary forces by lowering interest rates, leading to increases in asset prices.

Increasing asset prices have a mildly stimulating effect on the economy. When bond yields fall, it results in lower borrowing costs for corporations and the government, leading to increased spending. Mortgage rates may also decline with the demand for housing likely to increase as well.