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Economic Stimuli and Interest Rates

The following are economic stimuli and economic measurements that affect interest rates:

Inflation

Because bonds generally pay fixed-interest payments, rising inflation erodes the real rate of return an investor can earn. As a result, the values of outstanding bonds will fall if inflation strikes. Similarly, if inflation falls or is expected to fall, prices of outstanding bonds will rise because bondholders can receive greater real rates of return. Inflation fears creep into investors' minds when evidence suggests the economy to be expanding too quickly (ie: demand exceeds supply). Thus, economic downtowns are generally good for the bond markets because interest rates fall and inflation tends to decrease. The following is the formula for calculating a bond’s real rate of return:

RRR= Bond Yield – Rate of Inflation

For example, if a bond has a yield of 5.0% and inflation is 3%, the real rate of return is only 2.0%.

The following are the primary measurements of inflation:

The Consumer Price Index (CPI) is a measurement of inflation. The CPI is announced monthly by the Bureau of Labor Statistics who monitors changes in the prices of goods.

The Producer Price Index (PPI) is another important measure of inflation. The PPI is also announced monthly by the Bureau of Labor Statistics. The PPI monitors the cost of raw material used to make consumer products. The PPI allows more lead time in predicting inflation because it recognizes increased production costs before they hit consumers.

Employment Figures

Low unemployment figures are generally coupled with sound economic growth. A growing economy and low unemployment rates have historically caused increased inflation rates because demand forces push the threshold of supply. This is bad for the bond markets because, in addition to inflation, interest rates can rise causing bond prices to deteriorate. Similarly, high or rising unemployment figures generally mean a slow down in the economy. This is a precursor to falling interest rates, low inflation risk, rising bond prices, and happy fixed income investors.

There are three measures of employment: initial jobless claims, the unemployment rate, and payroll employment.

Initial jobless claims are released every week. Because of the short duration of this measurement, investors closely examine the trend of this index over time. In addition, they compare and contrast initial jobless claims with other measures of employment.

The unemployment rate is the percentage of the nation’s labor force that is unemployed. It is defined as the number of individuals actively searching for employment but unable to obtain it. This measurement is a lagging indicator, meaning it is a measurement of how unemployment faired at an earlier date.

Payroll employment provides specific employment data of different industries, wages paid, average hours worked, etc.

Industrial Production

Industrial production is a measurement of the units of products produced. The figure is reported monthly. Industrial production is a good indicator of economic conditions because it measures units, rather than value. Thus, inflation is not a factor.

Retail Sales

If retail sales are on the rise then consumers are spending more money. Increased consumer spending means the economy is on an upward trend. The bond markets suffer.

Corporate profits

If corporations are making money, investors generally take money out of the bond markets and purchase stocks.

Consumer Income and Spending

Increases in consumer income have historically led to increases in consumer consumption. Increased consumption is bad news for the bond markets because it can result in inflation (demand exceeds supply). However, if consumers save more of their earnings, it could be positive for the bond market and the demand for bonds could rise.

Consumer Sentiment

Consumer Sentiment is a consumer’s perspective on economic conditions. Consumers often spend more if they are optimistic about economic growth, salaries, and job security. If consumers see an economic downturn, or if they perceive salary cuts, an increase in lay-offs, war, natural disasters, etc., they will tend to spend less and save.

The University of Michigan produces data on consumer sentiment. This data is considered a leading indicator. If consumer sentiment is strong, investors feel they will spend money to fuel economic growth and the bond market will suffer. If consumer sentiment is weak, consumers tend to save and the demand for bonds could rise.

Housing Starts

Housing starts closely relates to consumer sentiment. An increase in housing starts means consumers are purchasing homes and are confident about economic conditions.

The Dollar

A strong dollar will entice foreign investors to purchase U.S. bonds and is therefore good for the fixed-income markets. A weak, or falling, dollar will scare away foreign investors.

Index of Leading Economic Indicators (LEI)

The index of leading economic indicators is comprised of data covering a wide range of indices from unemployment figures, consumer sentiment, production orders, and even stock performance. Generally, if LEI maintains a steady trend for one quarter (three consecutive months) it could mean a change in economic conditions.

Questions:

1. Describe the three measures of inflation.

2. Describe the three measures of unemployment.

Answers:

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