Good economic news can be bad news for a bond portfolio. A hot jobs report hints at higher inflation and a less patient Federal Reserve (the Fed), so rates jump and bond prices fall that morning. To explain that to a client, you follow one chain of cause and effect.
The economy never grows in a straight line. Output, jobs and profits rise for years, stall, shrink and then grow again. That repeating pattern is the business cycle, and nearly every asset your client owns reacts to it.
The business cycle has two phases, expansion and contraction. The peak and trough are the turning points between them, and recovery starts the next upswing. Here is how output, jobs, profits, inflation and interest rates usually behave in each:
- Expansion: Real output grows, businesses hire and profits rise. As spare capacity runs out, inflation builds and interest rates usually climb.
- Peak: Output, jobs and profits top out. Inflation pressure is strongest and rates are high.
Common mistakes
- Official recession test: Two straight quarters of falling real GDP is only a rule of thumb. The NBER sets official dates and counted 2020's two-month slump.
- Who sets which rate: The FOMC sets a target range held mainly by IORB, and banks set prime. Reserve requirements are 0%, not the 10% older books show.
- Disinflation versus deflation: Inflation falling from 6% to 3% is disinflation, because prices still rise 3% a year.
Bottom line
- Business cycle: expansion, peak, contraction, trough, then recovery; two straight quarters of falling real GDP is only a rule of thumb, and the NBER sets official U.S. recession dates.
- Indicators: leading are stock prices, building permits, new orders, average weekly manufacturing hours, initial jobless claims, consumer expectations and the yield spread; payrolls and GDP are coincident; the unemployment rate, CPI and prime rate lag.
- Fed: statutory goals are maximum employment, stable prices and moderate long-term rates; the FOMC sets a federal funds target range held mainly by IORB; buying Treasuries eases, selling or runoff tightens; reserve requirements have been 0% since March 26, 2020.
- Fiscal policy: Congress and the President control taxes, spending and borrowing; it acts more slowly than monetary policy, and deficit borrowing can crowd out private borrowing.
Exam shortcut
Trace every policy question as a chain. Fed buys: reserves up, rates down, dollar down, bonds and stocks up. Fed sells or lets bonds run off: flip every arrow. Read the stem for its trigger word: "Unexpected inflation" makes the lender or bondholder the loser; "deflation" makes the borrower the loser. "Official recession" points to the NBER, never the two-quarter rule.
The full lesson (about 5,129 words, 34 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- A1
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