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Chapter 4: How Financial Markets Function
professionals at picking stocks and bonds is a largely unproductive, but perhaps entertaining and addictive endeavour for most people.
Market overreactions can create buying opportunities. Efficiency notwithstanding, the financial markets that reflect the collective forces of millions of buyers and sellers can sometimes go to extremes. In the mid-1970s, for example, pessimism ran rampant in the U.S. President Richard Nixon resigned in disgrace, inflation and unemployment spiralled upward, and the stock market fell out of bed. However, smart investors took advantage in this time period. Throughout this book, we show you how to evaluate different investment markets to identify if they've gone to extremes.
Interest rates, inflation, the Bank of Canada, and the U.S. Federal Reserve
Although not as exciting to some as sex and rock and roll, the course of interest rates, inflation, and the monetary policies set forth by the U.S. Federal Reserve and, to a lesser degree, the Bank of Canada, captivates the attention of many investors. For decades, economists, investment managers, and other often self-anointed gurus have attempted to understand these economic factors. Why? Because interest rates, inflation, and monetary policies seem to move the financial markets and the world economy.
High interest rates are bad
Many businesses borrow money to expand. People like you, who are affectionately referred to as consumers, borrow money as well to buy things such as homes, cars, and educations.
Interest rate increases tend to slow the economy. Businesses scale back on expansion plans, and some debt-laden businesses can't afford high interest rates and go under. Most individuals possess limited budgets as well, and have to scale back some purchases because of higher interest rates. For example, higher interest rates translate into higher mortgage payments for homebuyers.
If high interest rates choke business expansion and consumer spending, economic growth slows, or the economy shrinks in size — the economy possibly ends up in a recession. The economist-sanctioned definition of a recession is two consecutive quarters (six months) of declining total economic output.
The stock market usually develops a case of the queasies as corporate profits shrink. High interest rates usually depress many investors' appetites for stocks, as the yields that guaranteed investment certificates, Treasury bills, and other bonds pay increase.
Part II: Stocks, Bonds, Bay Street, and Wall Street
Higher interest rates actually make some people happy. If you locked in a fixed rate on your mortgage or a business loan, your loan looks much better than if you had a variable rate. Some retirees and others who live off the interest income on their investments are happy with interest rate increases as well. Consider back in the late 1980s, for example, when a retiree received $10,000 per year in interest for each $100,000 that he or she invested in bonds or guaranteed investment certificates (GICs) that paid 10 percent.
A retiree purchasing the same bonds and GICs in the late 1990s, however, saw their income slashed by about 50 percent, because rates on the same bonds and GICs were just 5 percent. So for every $100,000 invested, only $5,000 in interest income was paid.
If you try to live off the income that your investments produce, a 50 percent drop in that income is likely to cramp your lifestyle. So higher interest rates are better ifyou're living off of your investment income, right? Not necessarily.
The in(latioi and interest rate connection
Consider what happened to interest rates in the late 1970s and early 1980s. After Canada and the U.S. successfully emerged from a terrible recession in the mid-1970s, their economies seemed to be on the right track. But within just a few years, they were in turmoil again. The annual increase in the cost of living (known as the rate of inflation) burst through 10 percent on its way to 14 percent. The explosion in oil prices, which more than doubled in less than five years, was largely responsible for this increase. Interest rates, which are what bondholders receive when they lend their money to corporations and governments, followed inflation skyward.
Inflation and interest rates usually move in tandem. If you knew that, because of the ravages of inflation, your salary dollars for the next year would buy much less than they do in the present, wouldn't you too demand more interest? This reason is why interest rates soared along with inflation in the late 1970s and early 1980s, peaking at over 20 percent in 1981.
The primary driver of interest rates is the rate of inflation. Interest rates were much higher in the early 1980s because Canada had double-digit inflation. If the cost of living increases at the rate of 10 percent per year, why would you, as an investor, lend your money (which is what you do when you purchase a bond or GIC) at 5 percent? Interest rates were so much higher in the early 1980s because you would never do such a thing.