Interest Rates and Recessions....

"Why do bond prices increase in a recession?" - Catherine

That's an excellent question! First not all bond prices necessarily increase.... it depends in part on the conduct of monetary policy, as we'll see.

But first lets step back and think about how bonds work. A bond is a financial asset that will pay out a fixed sum of money at some point in the future, along with a stream of interest payments until then. Without loss of generality, we'll ignore the interest payments, since they can be accounted for by appropriately adjusting the bond price. So we'll focus on a bond that pays only at maturity.

Suppose you hold such a bond. For the purpose of our example, we'll suppose that the amount paid at maturity is $1. Further, suppose that the bond has a market price today of $B. The return (or interest rate) on that bond until maturity can be easily computed as Int = (1-B)/B. That is, the return less what you paid for the bond, divided by what you paid. The point to notice is that the interest rate is inversely related to the bond price: an increase in B causes Int to fall, and vice versa.

So we've established that the bond price and the interest rate that the bond pays are inversely related. Now, in a recession bond prices may increase significantly, for at least two reasons:

1) "flight to quality." Uncertainty about the state of the economy may lead investors to be worried about holding too many equities or other risky assets, and instead wish to hold relatively low risk assets like bonds instead. If investors start buying bonds in large numbers, the demand for bonds rises, driving up the price of bonds. The increased price of bonds provides a windfall for existing bond holders, and results in interest rates falling (as per our formula above).

2) monetary policy. In many countries, the central bank sets monetary policy to try to stabilise the economy in response to shocks. In a recession, they seek to reduce the severity of the economy by cutting interest rates and stimulating demand. But if interest rates for some classes of assets start to fall, investors will re-allocate their investment portfolios to take advantage of the new lower interest rates. The end result will be that interest rates tend to fall across most classes of assets. Again, a fall in interest rates on bonds implies an increase in bond prices, and therefore a gain for existing bond holders.

Of the two effects outlined above, 2) is the most important, as the case of Hong Kong illustrates. Here the Currency Board mechanism ensures that monetary policy is committed to maintaining the fixed exchange rate, rather than stabilising the economy in response to shocks. So the central bank cannot cut interest rates in response to a recession.

Further, the fixed exchange rate ensures that interest rates remain similar between Hong Kong and the United States; otherwise arbitrage opportunities would open up (borrowing money at low interest rates in one economy to lend at higher interest rates in the other economy). Given the relative sizes of the Hong Kong and US economies, that means our interest rates will tend to fall when the US has a recession, regardless of what is happening in Hong Kong!

So if you think there's going to be a recession in Hong Kong, holding Hong Kong Dollar denominated bonds is unlikely to offer much protection, or prospective profits!