Although closely related to and integrated with economic growth, interest rates move independently from the economic cycle. They fluctuate freely via trade in the fixed income markets. As such they are both a component of the fundamental analysis of stocks and other markets, and a market in their own right. What that creates is a highly dynamic element for the fundamental analyst as interest rates move continuously and are influenced by other market elements.
Most specifically, interest rates (a component factor of fixed income security prices) are highly sensitive to inflation. Consider a bond which pays out annual interest of 10% on a fixed principal amount (par value). The real value of those interest payments will depend on the level of inflation. The higher the inflation rate, the lower the real interest rate, and vice versa.
In order to keep their real rate of return at a steady level, fixed income investors will demand higher nominal rates from their fixed income securities. For example, at a 3% rate of inflation, a 7% yield for a bond might be fine, but if inflation was 5%, the required yield may be 9%, keeping the investor’s real rate of return at 4%. As bond prices and yields are inversely related, bond prices fall as inflation rises so as to provide the higher yields demanded by investors.
Since inflation is so important to the interest rate market, it should be no surprise that traders spend considerable time looking at those things which measure inflation such as the Consumer Price Index (CPI). The CPI is a basket of goods and services designed to reflect the expenses of the average person. Changes in the CPI outline how much more (or less) expensive those goods and services have become. Since inflation is the rate of change in price over time, the CPI provides us a reading on just that. The Producer Price Index (PPI) does essentially the same thing on the business side.
It is not current inflation the markets concern themselves with, though, but rather future inflation. Analysis of the fixed income market therefore focuses on those things which can give a reading on inflation rates down the road.
So from where does inflation come? Well, what makes prices increase? It’s a supply and demand situation. If there is a preponderance of demand, prices will tend to rise as the competition to purchase drives buyers to pay more. Where there is an excess supply, prices drop as sellers cut their demands to unload their inventory. When demand increases in the face of supply shortages, prices move rapidly higher. If supply surges, but demand decreases, the rate of price decline is more rapid.
Since copper, oil, grains, and other commodities are the inputs in to the products purchased by consumers and businesses, they are watched closely as potential indicators of inflation. After all, as we have seen, if oil prices are rising we are likely to see higher gasoline prices as the pump. We can also see an impact on competitive products. Sticking with our example, when oil prices rise, there can be a similar move higher in natural gas. This is the result of increased demand in that market as people shift away from oil.
Labor is another input in to the cost of producing goods and services, so traders watch the employment data for signs of pressure on that market. Labor operates like any other market. When demand increases, wage demands increase. That is why economists and fixed income traders become nervous when the unemployment rates get very low. It suggests the potential for wage rate increases.
That said, however, higher input costs do not always translate in to higher prices for the consumer or business. Modern technology has led to serious gains in efficiency. As a result, businesses have been able to cut costs in other areas to keep their own total expenses from rising. At the same time, we come back to supply and demand. If businesses are in a highly competitive situation with others, one where there is an excess supply (in some manner of speaking) or demand is pressured, prices will be held down. As such, one cannot just assume that higher input prices mean higher output prices and rises in the measures such as CPI. It does not always work that way.
There is another supply/demand element involved in inflation. That is money supply. Some have legitimately defined inflation (in its negative, excessive sense) as too much money chasing too few goods. We have already addressed the goods (and inputs) side of that definition. The other side is the money. Just like anything else, too much money means a decrease in the value of it. So if the supply of money is rising while the supply of goods and/or services is falling and demand for them rising, devastating inflation can occur. (Germany between World War I and World War II is a very dramatic example).
This, by no means, is a comprehensive discussion of interest rate analysis, but it does get one started. Tracking interest rate changes can be quite exciting and rewarding both for trading purposes, and for use in one’s life (mortgages, etc.).
John Forman is author of The Essentials of Trading, and a near 20 year veteran of trading and analyzing the markets. John is Managing Analyst & Chief Trader for Anduril Analytics, which offers free trading reports here.
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