It ’ s Your Money
or even shutting their doors . It is actually better for the economy when a business has pricing power as opposed to no pricing power . Again , look at home prices . The deflation in prices has caused a lot of people to see the value of their homes decline dramatically . In some cases , the prices dropped so low , their mortgage was worth more than their home and they just walked away ( foreclosed ) on their home . This negative wealth effect not only makes people feel poorer but also takes away the ability for them to borrow from their home , which many people did as a source of funds for many of their larger purchases , not to mention what it did to the construction industry . The Fed , like the stock market , looks at a myriad of economic reports to determine what decision it will make regarding the lowering or raising of interest rates in order to strike that balance between fostering economic growth and stable inflation . These indicators include but are not limited to GDP , housing starts , durable goods orders , consumer and producer price indices and the unemployment report . All of these stats are readily available to anyone who wants to ascertain them .
The Fed can only control very short-term interest rates and the market and market forces will determine long-term interest rates . In many cases , the bond market will bid up longer term interest rates in anticipation of the Fed increasing short-term rates or lower rates if the market feels the Fed will be cutting interest rates . In some cases , if the bond market feels the Federal Reserve is ahead of the curve when it increases shortterm interest rates , longer term bonds interest rates will actually decrease . Although this may seem contradictory to what I have written , this phenomenon is referred to as a bear flattening ; because the market believes the tightening of monetary policy will keep inflation in check even if this means a slowing of the economy , which will eventually lead to a lowering of interest rates . I know it gets confusing . Bond prices respond directly to these interest rate changes . There is an inverse relationship between interest rates and the prices of bonds . As interest rates increase , bond prices decrease and as interest rates decrease , bond prices will increase . Remember , just like stocks , bond prices are changing all the time . Of course , there are other factors that can affect the prices of bonds as well . However , you cannot be a serious bond investor without understanding interest rates and having some idea as to which direction interest rates are headed . For example , if you think interest rates are going up , you may want to buy short-term bonds so you can take advantage of buying longer term bonds when interest rates increase . On the other hand , if you think interest rates are going down , you may want to not only lock in higher interest rates with longer term bonds , but also take advantage of capital appreciation of your bond as rates decline . You are probably wondering how you know which way interest rates are going . First of all , as I write this article , interest rates are at a historical low and can only go up because they just cannot go any lower . Secondly , as mentioned before , you must keep abreast of economic indicators . Finally , you must understand and be able to interpret something known as “ the yield curve ” which fortunately , will be the next article in this series on fixed income investing . Stay tuned !
18 September / October 2010 • Pennsylvania Dental Journal