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How war impacts bond markets

An instructive example from the U.S. Civil War

How and why do financial markets react to war? One aspect of war is to endure losses, and financial markets typically don’t respond enthusiastically to even the risk of loss, let alone widespread destruction on their own soil. Markets may also rise and fall over the course of the war as the fortunes of the warring parties change.

FRED has a peculiarly helpful dataset that provides examples of this dynamic: Weekly U.S. and State Bond Prices, 1855-1865. The authors, Gerald P. Dwyer Jr., R. W. Hafer, and Warren E. Weber, compiled a time series of bond prices for some U.S. states leading up to and through the U.S. Civil War.

The FRED graph above shows bond price data for two states in the South (Virginia and Louisiana) and two states in the North (Pennsylvania and Ohio).

The bonds in question were used for infrastructure, such as roads, canals, and railroads. The war’s potential to destroy that infrastructure could affect the ability of states to pay back the bonds. More generally, war disrupts productive capacity, impedes the raising of tax revenue, and ramps up state expenses—all of which increases the likelihood of state default.

Not surprisingly, the graph shows increasing risk, with prices dropping in late 1860 and then plunging as hostilities began in 1861. These effects were more pronounced in the South than in the North. And the graph also shows that Southern bonds stayed low as the war unraveled, while Northern bonds roughly returned to parity.

How this graph was created: Search FRED for “disunion bonds” and click on, say, Virginia. From the “Edit Graph” panel, use the “Add Line” tab to search for and select the other states.

Suggested by Christian Zimmermann.

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