Macroeconomics 101: inflation, bonds, interest rates, stocksHello fellow traders and dear padawans. The equities market has been hit very hard the past 3 weeks or so, specially growth stocks. I think it is important to address what is happening behind the scenes that caused the selloff in the equities market so that many of you can better understand what is going on.
This is a very basic explanation of macroeconomics and by no means thorough but I know that many of my followers would benefit from it at times like these. To establish a common ground I will start with some definitions of terms. I wanted to keep things straight forward so I am getting these definitions from investopedia.com because they did a much better job than I would, defining terms thoroughly yet concisely. Keep in mind these are short definitions of concepts that deserve in-depth study if you want to understand them fully. However, for the purpose of this discussion what follows is enough (you can always read full articles on investopedia.com or somewhere else). If you are well versed on those you can certainly skip ahead (or use this as a refresher).
DEFINITIONS
Inflation : Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed a a percentage means that a unit of currency effectively buys less than it did in prior periods. Inflation can be contrasted with deflation, which occurs when the purchasing power of money increases and prices decline.
Bonds : A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer. Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments made by the borrower.
Treasury Notes : A Treasury note (T-note for short) is a marketable U.S. government debt security with a fixed interest rate and a maturity between one and 10 years. Issued in maturities of two, three, five, seven and 10 years, Treasury notes are extremely popular investments, as there is a large secondary market that adds to their liquidity. Interest payments on the notes are made every six months until maturity. Treasury notes, bonds, and bills are all types of debt obligations issued by the U.S. Treasury. The key difference between them is their length of maturity. For example, a Treasury bond’s maturity exceeds 10 years and goes up to 30 years, making Treasury bonds the longest-dated, sovereign fixed-income security.
Federal Fund Rates : The federal funds rate refers to the interest rate that banks charge other banks for lending to them excess cash from their reserve balances on an overnight basis. By law, banks must maintain a reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank. The amount of money a bank must keep in its Fed account is known as a reserve requirement and is based on a percentage of the bank's total deposits. They are required to maintain non-interest-bearing accounts at Federal Reserve banks to ensure that they will have enough money to cover depositors' withdrawals and other obligations. Any money in their reserve that exceeds the required level is available for lending to other banks that might have a shortfall.
Note: although the Federal Fund Rates are charged to banks, banks pass them down to clients' personal/auto/student/mortgage loans and credit card interest rates so these interest rates cascade down to society as a whole.
With those out of the way we can start discussing the relationship they have with one another as well as the equities market and understand what is happening with the stock markets.
RELATIONSHIP BETWEEN INFLATION AND INTEREST RATES
In general they have inverse correlation, meaning when one goes up the other goes down. The inverse correlation happens because when interest rates are low people feel encouraged to borrow money, which leads to more spending thus creating more demand of goods and services than supply. When demand is bigger than supply prices will increase to both slow down demand and also (perhaps more importantly) to increase profit margins, which leads to inflation. Because the Fed can manipulate short-term interest rates via the Federal Fund Rates they are able to somewhat control inflation. When interest rates are high the process is inverse to the one described above: people feel discouraged to borrow and spend money; instead they prefer to invest in a fixed income instrument such as high yield savings accounts, CD, or bonds to take advantage of the high yields. It is therefore the job of the Fed to keep inflation and interest rates in balance.
Although not everybody agrees, it is understood by economists in general that some inflation is good for economy because it encourages consumers to spend their money and debtors to pay their debt with money that is less valuable than when they borrowed it. Thus some inflation drives economic growth. One of these economists is John Maynard Keynes, who believed that if prices of consumer goods are continuously falling people hold off on their purchases because they think they will get a better deal later on (who doesn't like a good discount?).
Another important element that factors into inflation is how much liquidity is injected in the economy (cash, or money supply). More money would translate into more demand and rise in prices.
RELATIONSHIP BETWEEN BOND PRICES, BOND YIELDS (or INTEREST RATES), and INFLATION
Bond prices and yields also have an inverse correlation: if the bond certificate price (AKA face value , or what the bond certificate is worth) increases the yield decreases and vice-versa. To make things simple and to better illustrate how bond prices and yields are related the example below uses what is known as ZERO-COUPON BOND, where the yield is derived from the relationship between the coupon payout and the bond face value (back in the day the bond certificate--a piece of paper--had small coupons that investors would rip off and present to the borrower to redeem their yields. That terminology is still used to this day although these coupons are not used anymore).
Example: if the bond price is $1,000 and the borrower receives $1,100 back at the end of one year, the so-called coupon rate (the yield paid for each bond certificate throughout the lifetime of the bond) is 10% . So the formula to find the coupon rate is: COUPON RATE = ANNUALIZED COUPON VALUE/BOND FACE VALUE; in this case, 100/1000, or 0.1. That formula helps to understand why the bond price and bond yield (coupon rate) have an inverse correlation. It is important to keep in mind that bond yields reflect genereal interest rates. Like interest rates they can move up or down
Like other asset classes such as options, a bond certificate holder can sell that certificate back to the market (known as secondary market). If the current bond yield is lower than when the bond holder "bought" their bond it may be interesting for them to consider selling it because it is now more valuable than when they bought it due to the inverse correlation discussed above. So for bond holders, decrease in interest rates is beneficial.
Hopefully it is also clear that a rise in inflation that results in higher interest rates affects bond holders negatively. Who would want to sell a bond that is now less valuable than when they bought it? However, higher bond yields are attractive to new bond investors because it gives them more return for their investment overtime.
THE IMPORTANCE OF THE 10-YEAR TREASURY NOTES AND ITS YIELD
The government sells Treasury Bills/Notes/Bonds via auction. The yield of bonds is determined by investors' bids. The 10-year-yield's importance goes beyond the rate of return for investors; mortgage interest rates are derived from the 10-year yield for instance. But for the purpose of this text, it is important to understand that the market relies on the 10-year to gauge investors's confidence. Here we see another inverse correlation: if confidence is high, the 10-year yield rises and bond prices drop and vice-versa. Any change in the 10-year yield is closely watched by the markets and has enormous impact in other asset classes.
PUTTING IT ALL TOGETHER: BOND YIELDS, STIMULUS, EMPLOYMENT NUMBERS, STOCKS, AND THE FED
When Treasury bond yields rise bonds become an attractive investment because it is a safer than stocks--specially growth stocks where investors are placing their money on future success as opposed to present profits--since it is backed by the US government and provides fixed returns. While bond investors don't enjoy the big rallies of the stock market they also don't expose their capital to volatility and crashes.
With the reopening of the economy in clear sight due to vaccination, and the better than expected job reports investors started fearing higher inflation. That is a simple math: more people making money and out on the streets will boost consumption, which will lead to rise in prices. As explained before, higher inflation causes the Fed to adjustment interest rates, which causes bond prices to fall and yield to rise. Despite what Jerome Powell has said last week--that inflation rise is going to be temporary--investors didn't feel much confidence, which caused the recent sharp rise in the 10-year yield Treasury. With that, bonds became a good alternative to the stock market, causing investors to reallocate some of their capital into bonds. That and the fear caused by falling prices and the media (most of the media fuels panic--one month later everything is green again) resulted in the huge selloff we have seen the past weeks.
CONCLUSION
Phew, that was a lot. As I wrote on the preface of this text this is an overview of the subject matter so you can always read up on each one of the areas covered here to get more in-depth knowledge. However, I think this provides a good summary of what is going on on the markets right now. Hopefully you will have filled some gaps on your knowledge and will start making more sense of the interrelationship of the many aspects of economy covered here. This is a difficult subject to write about so I apologize if any idea is unclear. I can always clarify anything on the comments.
Bottom line: when things are clearer (inflation + interest rates) the markets will most likely stabilize and follow its due course. Growth stocks will continue growing (perhaps at a slower pace) and you will continue making good returns on good companies. I am using this selloff as an opportunity to lower my cost basis and enter positions in stocks that were too expensive before. Sometimes a pullback is all you were looking for even if you lose money in the short term. And hey, one can always buy put options to hedge against their long positions.
Good luck and safe trades!
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***The ideas shared here are my opinion, not financial advise to place trades. Please do your own research before buying/selling stocks***
