Could someone explain to me why large investors (eg Bill Gross) are shorting bonds now?
Why are people/media believing that bond price crashing down is related to the Fed potentially increasing interest rate?
My understanding is when increasing interest rate, would result deflation (reversing what was done last year) thus raise the bond price back up (bond buyers will no longer need to factor in inflation effect on the yield).
You have to consider the impact of market interest rates on existing bonds. Assume that market risk-free interest rates are 2%. If I purchase a bond for $1000 that has a 2% yield and 10 year maturity, then that means I'm getting $20 per year, and my $1000 back in 10 years.
Now, let's suppose market interest rates go up to 5%. My bond is still sitting there yielding $20/year though. Now it's not looking so hot. While I was happy to pay $1000 for that bond before, now if I want to sell it to someone else they won't pay as much for it, because for the same $1000 they could buy a bond paying $50/yr. So now maybe they will only pay $800 (or something) for my bond.
So because market interest rates went UP, the value of my existing bond went DOWN.
Consider that if the Fed increases interests rates, investors can earn better interest elsewhere, e.g., in a savings account. Thus, less need for crappy, low-yield bonds.
