Bond Markets – Influence of Economic Factors
Let us now understand why interest rates in an economy rise and fall usingÂ common sense reasoning that we will build upon later. During periods of high economic growth, the demand for goods and services is high due to higher incomes, higher employment and an overall â€˜feel goodâ€™ factor. Higher demand for goods and services causes firms to increase supply; but when demand outpaces supply the prices of goods and services increase. The increase of price growth above a certain threshold causes the central bank to increase interest rates to bring inflation to a more sustainable level.Â We will see how this central bank monetary intervention slows down the economy later in the book, but for now we need to remember that high inflation and high growth causes the central bank to increase interest rates to slow the economic growth to a more sustainable level. In periods of low growth, the central bank lowers interest rates to lower the costs of borrowing, which in turn increases the demand for goods and services.
Growth, Inflation, Interest Rates and Bond Prices
We can now make the connections between interest rates, inflation, growth, and the prices of fixed income securities. In periods of high growth and high inflation there is a risk that the central bank will increase interest rates to keep the economy in check. This increase in interest rates is bad for bond prices, as we have seen in the bond pricing section, and hence bad for bond markets. Therefore, any macroeconomic indicator that indicates the economy is overheating or indicates any sign of inflation will cause a drop in bond prices. The higher the deviation of actual data from market expectations, the stronger the reaction in bond prices.
On the flip side, when growth and inflation have slowed below the sustainable rate to such an extent that there is a chance the economy might slide into recession the expectation is that the central bank will lower interest rates to spur growth. This causes bond prices to rally and hence is good for the bond markets.
To conclude, any macroeconomic indicator that causes market participants to perceive a slowdown in the economy is good for the bond markets and vice versa.
Figure 4 : Bond Cash Flows and Economic Factors
Next you could study basic principles of stocks, the stock market, and the economic factors that affect the stock markets or move directly to understanding fundamental analysis in depth.Â