Understanding Financial Markets
What are some important economic concepts that may affect bonds and stock prices at the macroeconomic level?
It is generally accepted that great economic growth in an economic system is good for stocks. As the economy expands, in order to meet demand, companies produce and sell more of what they offer. As a result, more people or workers are needed, and incomes begin to rise, fueling more demand and purchases, and so on. Consumers also will have more disposable income to save, invest, or direct toward purchasing more goods and services. But as this economic activity helps us all, it has some hidden consequences that may generally affect the prices we pay for stocks and bonds. Many practitioners believe this economic expansion may lead to inflationary movements, as material inputs and labor become scarcer. This begins the spiral of a gradual price increase. Higher wages and benefits within the labor pool of these producers must be recovered by slight price increases, which, when multiplied by millions of companies, helps to create a gradual inflationary chain of events.
Any indication of inflationary moves may adversely affect the prices of bonds, as available credit becomes more expensive. Bond prices must tick downward in order to create demand for the bonds. Higher interest rates eventually occur, and although it is considered good to maintain a large portfolio in cash, bond investors see a gradual decline in yields. When the economy begins to contract from this period of growth, interest rates commonly decline gradually. Bond prices tend to increase inversely to interest rates. Less economic activity means there is less demand for capital or credit from both end consumers and businesses because the price (or interest rate) of money becomes unaffordable.