Open market operations (OMOs) directly influence the money supply, which in turn impacts interest rates. Interest rates are negatively correlated with bond prices due to opportunity cost. Thus, central banks can indirectly affect bond prices through the purchase or sale of debt securities on the open market.
OMOs are a tool used by central banks such as the Federal Reserve to implement monetary policy. OMOs involve the purchase or sale of securities, typically government debt securities, on the open market. Banks must often borrow reserves from one another to meet overnight reserve requirements, and these funds are loaned at an interest rate called the federal funds rate.
By affecting money supply through OMOs, the Fed can influence the federal funds rate. Low reserve borrowing rates make it relatively easy for banks to procure money, leading to lower borrowing rates for businesses and consumers. Bond prices are negatively correlated to interest rates due to opportunity cost. When interest rates go up, existing bonds bearing the old coupon rates are no longer as valuable as new bonds with the higher coupon rate. On the open market, the price of lower-interest bonds must fall so that expected return is equal for all comparable bonds.
From 2008 to 2014, the Federal Open Market Committee targeted very low interest rates in an effort to stimulate economic activities and keep financial institutions functioning normally. As part of this expansionary policy, the Fed purchased $600 billion of Treasuries and $600 billion of mortgage-backed securities. This increased the money supply, drove down interest rates and sent bond prices higher.
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