This is a question that I asked myself a few years ago and since the topic came up the other day, I thought it best to answer it here at Dividend Money.
The central bank fights inflation by attempting to control the rate of growth of the money supply. When inflation is rampant, interest rates will rise, as the central bank attempts to cool down the economy. The bank will attempt to decrease the supply of money available in the banking system, thereby causing demand in the economy to contract.
If this is done, the result will be a decline in the rate of inflation and a relative decline in the demand for money. If the economy shows signs of recession, the central bank will supply more money to the banking system and expansion will usually follow. Interest rates will decline for the short term even though the injection of more money into the economy is inflationary in the long run. A catch 22.
Use The Fed To Buy Fixed Income
Since fixed-income security prices move contrary to interest rates, the best time to invest in fixed-income securities is at the peak of an inflation cycle, when interest rates are high and fixed-income securities trade at low prices.
Such opportunities are likely to occur periodically every few years, due to the inability of federal governments to fight inflation with only fiscal policy and the limitations that the central banks face when trying to curb inflation with tight monetary policy.
That said, just how an investor determines when the peak in the cycle occurs is a question that is not easy to answer.
How Are Common Stocks Affected?
The reaction of common stock yields to fluctuations in interest rates, both nominal and real, is very similar to that of fixed-income security prices, and that similarity is quite natural. Regardless of whether an investment is made in common stocks or fixed income securities, the expected result is a satisfactory rate of return.
The typical measurement for common stock returns is the return available from short-term bonds or the risk free rate. When returns from fixed-income securities are low, the stock market becomes more attractive, since even common stocks with relatively low dividend yields provide a competitive alternative to fixed income securities.
On the other hand, at the peak of an inflation cycle, stock prices are very high. Their returns and yields compare unfavorably with the high yields available from fixed-income securities and there is less risk of loss of principal from fixed-income securities.
What Happens When It All Hits The Fan?
Sensitivity of the stock market to fluctuations in interest rates has been particularly pronounced in the last couple of decades – however, in the recent crisis this correlation has been all but thrown out the window!
Knowing this, where do we stand in this cycle today?
What does this mean for stock prices in the near term? The long term?