Answer to Question #160978 in Macroeconomics for Hellen

Question

During the Covid-19 crisis of 2020, the UK government has increased borrowing dramatically, yet the interest rate on 10-year UK Treasury bond fell from 0.63% in February to 0.21% in July. Explain the rationale behind this phenomenon using the asset market approach. 

Answer 1

Solution:

According to the Asset Market Approach, the demand for an asset depends on Wealth, Expected return relative to that of an alternative asset, risk relative to that of an alternative asset, and liquidity relative to that of an alternative asset.

Treasury interest rates or Yields, especially the 10-year yield, are seen as being reflective of investor sentiment about the economy. Treasury yields fell as more fears of coronavirus sparked demand for the relative safety of government bonds. When investors are more worried about the health of the economy and its outlook, they become more interested in buying Treasuries. This increases their prices causing the interest rates or yields to decline, despite the high borrowing by the UK government.

Treasury bond prices and Treasury interest rates or yields move in opposite directions since they are inversely related to one another. Falling 10-year Treasury bonds prices increases the interest rates while rising 10-year Treasury prices lower the interest rates. So, when people are skeptical about the economy, they seek more 10-year Treasury bonds, which are seen a secure and this creates additional demand for 10-year Treasuries. This additional demand for 10-year Treasuries leads to lower interest rates.