How Economic Growth, Interest Rates, and Inflation Work Together
Three of the strongest forces to affect the markets, and subsequently your portfolio, are economic growth rates, interest rates, and the inflation rate. It’s relatively easy to track each of these separately by looking at GDP data, the yield on the 10-year treasury, or the latest CPI chart. But understanding how these interact with each other is the key to predicting market moves and protecting your portfolio.
After several years of stagnation, interest rates and inflation are back on the rise. Rates are at their highest level in four years and don’t look to slow down anytime soon. Inflation meanwhile is around 2.5% along with a global economy that appears to be growing healthy and strong. But these currents are what drive markets, and investors need to know how to navigate the waters if they want to keep their portfolios in the black.
A complex relationship
Nothing in the economy exists in a vacuum. A change in bond yields affects the value of the dollar which impacts stock prices that in turn can influence commodities. The market is a dynamic organism that expands and contracts during the business cycle on a fairly regular basis, but it’s not limited to just cyclical changes.
Many investors are under the false impression that bond yields and the economy have a strong positive correlation. That is, when yields rise, the economy must be growing. Unfortunately, there’s no evidence to suggest that this is true. Data from the Federal Reserve shows that since 1930, the actual correlation between the GDP and the yield on the 10-year treasury is effectively 0.
Anomalous years in which yields are high but growth is low and vice versa mean that there’s something going on. For example, in 1980 the yield on the 10-year was 12.8% but GDP growth was at 0%. And in 1950 GDP growth was an astounding 13.4% but yields were only at 2.4%.
It’s actually inflation that has the highest correlation with bond yields. As inflation rises, the Fed raises interest rates which in turn impact bond yields. In order to combat purchasing power parity, yields need to rise to create an equilibrium.
Inflation is the one commonality between bond yields and GDP. Usually, rising inflation kicks off higher bond yields and higher GDP. But it’s not always the case. Stagflation – when inflation remains high but GDP lags can also come with high bond yields.
Economics isn’t a hard science. At best, economists can give a general idea of how things relate to one another, but there always seems to be that one case that disproves the hypothesis. From one-off events like war or a depression to stagflation, it’s not always possible to create a one-size-fits-all rule. Investors should keep an eye on all three – inflation, GDP data, and bond yields – in order to keep their portfolios optimized for profits.