Pearl Quest, LLC. Investment Consulting & Education services

INFLATION AND DEFAULT SPREAD. 

Inflation (here, represented by the CPI) is important because any investment that succeeds in increasing your future purchasing power must earn a rate of return that exceeds the inflation rate. In addition, nominal interest rates (which increase with increases in inflation) generally impact traditional asset valuations negatively. For example, when nominal interest rates increase, bond prices decrease.* The 5-Year Breakeven Inflation Rate, available since 2003,  is derived from market prices and represents the average 5-year inflation rate forecast of market participants in the Treasury market. (It seems to lead by about 1 year rather than 5.) Inflation often (but not always) spikes during recessions. 

Default Spreads, here represented by the difference in the yields of riskier Baa (lower)-rated bonds and safe US government bonds (Moody's Seasoned Baa Corporate Bond Yield -  10-Year Treasury), are important because such spreads are generally an indication of market participants' perception of corporate risk. Safe Treasury rates are often decreased through the use of monetary policy tools during recessions (economic contractions) in order to stimulate the economy, thereby all else, equal, increasing the default spread. Increases in the yields of relatively risky debt can induce a "flight to quality" and cause Treasuries and safer AAA-rated bond prices to increase thereby decreasing Treasury rates (also contributing to an increase in the default spread, which may have originally stemmed from increases in riskier debt yields).

ECONOMIC ENVIRONMENT & IMPLICATIONS FOR FINANCIAL MARKETS

This page allows you to examine some economic and financial data from the Federal Reserve Economic Data (FRED) over various time periods (including the most current) by using the scroll bars at the bottom of each graph. Recessionary periods are indicated by light gray bars. Links to the underlying source at FRED allow for more detailed analysis and descriptions of the data series.

*However, properly managed bond funds can still do well in an increasing interest rate environment by investing in bonds that offer increasing returns as the interest rates increase.

If the data is not automatically updating, you can click on customize above, left button and enter latest date.

If the data is not automatically updating, you can click on customize above, left button and enter latest date.

GDP, INFLATION, UNEMPLOYMENT & the FEDERAL FUNDS RATE.

The first graph presents data relevant to the Fed's mandate to keep inflation and unemployment low, and Gross Domestic Product (GDP) growth healthy, by using monetary policy to decrease interest rates (e.g., changing the Federal Funds rate) when the economy is contracting and increase rates when it is expanding too rapidly-- such that it might ignite runaway inflation. It is important to understand that interest rates (Fed funds, corporate bond yields, etc.) tend to move together and the general level of interest rates impacts most financial asset prices. 

Clearly during recessions, unemployment peaks, GDP drops, and inflation tends to increase. The Fed funds rate begins to decline in front of many past recessions. Monetary policy has, however become more complicated since the 2007-2008 financial crisis.