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Good News Bad News: The Economy

 Background: The 30-year Treasury bond was down 2-2/32, bringing the yield up to 6.39%.

Question

How can an announcement by the Fed’s Chairman that the economy is "on track" (i.e., steady growth and low inflation) have a considerable negative impact on bond prices? Doesn’t it sound like good news? (Announcement made on Feb. 20, 1996 to a House Banking sub-committee.)

 Answer

I like to use this piece of news to illustrate two extremely important concepts in finance, namely: (1) market prices are "forward looking," and (2) interest rates and prices are inversely related.

 Prices are the sum of expected cash flows discounted by the consensus/market interest rate. If you consider government bonds, then the cash flows are fixed, and thus their value changes as market interest rates change.

 Using these concepts, since we observed that bond prices went down, this must mean that market interest rates must have changed, and more specifically they moved in the opposite direction, that is inversely related.

With market prices "forward looking," the average/consensus investor must have been expecting the Federal Reserve (Fed) to lower interest rates. And thus, must have interpreted "on track" to mean that the Fed was not planning to lower interest rates in the near future.

Note that in the above analysis there was nothing about trying to explain what the consensus investor was expecting, or why, on average, investors reacted negatively to the news. That is what psychologists do. We in finance try to use models as tools to explain what might happen to a variable if one of its determining factors/components changes, holding everything else constant. We can only infer what the consensus investor was expecting and how the news was interpreted. In this case a relevant question would be: what would happen to bond prices if interest rates are expected to, say, go up.

By Alex Tajirian