Bonds 7 – How does the state of the economy influence the bond market?

Susan
By Susan July 11, 2012 09:17

Bonds 7 – How does the state of the economy influence the bond market?

 

Where do you find information, not just about bonds themselves, but about all the factors that affect the bond market? And what do you do with it?

 

When I lead investing seminars, many attendees have the nagging feeling that they should follow the news more, or that they should be able to make better sense of it. But they feel powerless as they are bombarded with news all day, every day: how can you possibly choose who to listen to and sort through the noise of infotainment, let alone digest the sheer amount of information you are force-fed every day?

 

Here are a few pointers, or: where to find out about everything you’ve ever wanted to know about economic indicators and financial markets, but were too afraid to ask!

 

 

Choose perspective and context over raw data

 

Following economy news is like building a jigsaw puzzle: one piece with its jagged edges and its jumbled colours won’t make any sense. It’s only in the context of the other pieces that each bit takes on meaning.

 

Gathering information happens over time. It’s not so much what you read in the papers today, as what you read today, compared to what you read yesterday, and last week, and last month. A statistic will only be of interest if you can make sense of the way it evolved: a number alone won’t tell you whether it is up or down from last time.

 

It is the same difference as between a movie and a movie still: the movie still might look very good, but doesn’t tell you much about the action. It might even give you the wrong impression!

 

 

Where do I start? What do I watch?

 

Well, inflation is a good place to start. Inflation is a measure of the way prices rise over time. It is correlated with economic growth: mostly (although not always), rising prices reflect a growing economy. If supply can’t completely keep up with demand, prices will rise since there isn’t enough of a commodity to satisfy all the demand. Then a seller can afford to ask a higher price for the same amount of goods.

 

Since inflation is a measure of rising prices, keeping tabs on prices is the best way to measure it. This is done through a consumer price index: the European Central Bank uses the Harmonized Index of Consumer Prices to monitor inflation.

 

Historically, high rates of inflation have often resulted in troubled times. When people weren’t able to buy vital things such as bread because prices were too high, they often took to the streets in protest. Think of the French Revolution – or even World War II, since hyperinflation in Germany just before WWII was one of the causes of the growing discontent that resulted in Hitler being elected.

 

As you can imagine, governments keep a very close watch on inflation and use the tools they have at their disposal to keep it within a healthy band.

 

 

Where do you find relevant news?

 

Now the Harmonized Index of Consumer Prices consists of rather too many charts and graphs for most people’s taste. So where do you find relevant, reliable economy news that will show you how the economy and the bond market interact?

 

– Specialized newspapers
You could start with general economy news: Bloomberg, the Financial Times, the Wall Street Journal all offer information and commentary about the general state of the economy, which policies governments are planning and what results these are expected to bring.

 

– Rating agencies
Standard and Poor’s, Moody’s and Fitch all have information-rich websites, with their analysts offering their opinion on market developments.

 

– Investment research companies
I personally work with Gillenmarkets and VectorVest (full disclosure: I have a commercial relation with these companies, although the two links above are NOT affiliate links). Both of these sites offer free and paid information.

 

– The “Key economic indicators” page on the NTMA website
On this page you will find the latest data about consumer prices and other statistics, specifically for the Irish economy.

 

 

Expectations are as important as actual data… in fact, expectations are data!

 

And then what do you do with all this information? Well the information in and of itself isn’t the whole story – once again, what you want is context. What the bond market will react to is – economic indicators not being what they were expected to be.

 

Indeed, various institutions will publish forecasts about different economic indicators, but forecasts are hardly ever spot-on: they are educated guesses. These forecasts, though, will create expectations. Will inflation rise? Will it rise enough that central banks will decide to do something about it? When actual data is published, it will correspond to or defy expectations.

 

This was clearly demonstrated last week when the world was waiting for Mario Draghi, the President of the ECB, to drop the ECB rate… and he did.

 

If data conforms to expectations, this is not a big deal, business will continue as usual, since nobody will need to change course: investors based their actions on what they expected, and their expectations have not been challenged, so they can continue to do what they were doing, strategy-wise. In fact, you might often see the market not changing at all when news is published, as it has been “priced in”.

 

If on the other hand the data that is released is at odds with expectations, the bond market will have a reaction to this – it’s the surprise that counts. The magnitude of its reaction will depend on how much the data is at odds with expectations: you might picture it as ranging from a raised eyebrow to a double-take… There will be a small or a big scramble as people, financial institutions, investors adjust their course of action.

 

And this is why I’m fascinated by finance: it is a living, breathing illustration of the “butterfly effect”. Imagine being able to follow the ripples from a butterfly flapping its wings as they become waves – and possibly a tsunami…

 

 

Why you shouldn’t fight the Fed – or the ECB!

 

One ripple that certainly has the potential to rock the boat is when a central bank decides to modify interest rates. The modification is apparently extremely tiny: usually between 25 and 50 basis points, that is, a quarter to a half of one percent… And still, it’s one mighty change: ask anybody on a tracker mortgage!

 

You might have heard the saying “Don’t fight the Fed”. The “Fed” is the American central bank, the Federal Reserve. The ECB is its equivalent in Europe, and “Don’t fight the ECB” is just as valid a saying! Now what does that mean?

 

The ECB and the Federal Reserve, as central banks, administer monetary policy: they set the interest rate with which banks benchmark their activity. This target interest rate is not chosen at random, but depends on what the central bank thinks the economy needs, in order to adhere to its inflation target. This is why it makes sense to monitor what the central bank is saying, as well as economy news.

 

An important concern in setting this rate is inflation: in a strong economy, inflation (and prices) will rise. To curb inflation, a central bank will raise (or “tighten”) the target interest rate. This will increase the cost of borrowing, since banks will have to pay more to borrow this money, and hence charge more for lending money.

 

This will have the effect of slowing down the economy, since people and businesses won’t be able to spend as much as they could, if they were able to borrow money easily. On the other hand, when the economy is weak, central banks will lower the target interest rate, in an effort to spur credit demand and spending, as we have seen since 2008.

 

Usually, the consequences of a change in interest rates, decided by a central bank, won’t be apparent immediately for everybody, but take a few months to a year to be felt in the economy: that is why a lot of people underestimate these changes and their consequences.

 

And that would be a foolish thing to do… Indeed , a lowered interest rate (“accommodative monetary policy”) is a policy tool which is used to cultivate stronger economic growth, while a lifted interest rate is an attempt to slow growth and inflation, and can lead to contraction. The effects of the central bank’s decision will be felt at some point, and trying to counteract this is futile – this is what is meant by “don’t fight the Fed” or the ECB.

 

Are you on the list?

Sign up for my monthly newsletter and get more content like this, learn about business opportunities, and never miss my Savvy podcast.

 
Previous post: Bonds 6: Duration – Yes, you do need to know about it!

Next post: Bonds 8 – Why “making more money” is the worst investment strategy you can have

Facebooktwittergoogle_pluslinkedin
Susan
By Susan July 11, 2012 09:17