THE ECONOMIC ENVIRONMENT & 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. If the data is not automatically updating, you can click on "customize" and enter latest date. Additional resources include the yield curve and various uncertainty indices.

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.

Pearl Quest

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).

*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.

YIELD CURVE

This is a visual interactive permalink to the yield curve. Note how the yield curve flattens before the financial crisis in 2008. It is normally upward sloping but historically, consistently flattens or becomes inverted before a recession.

CAPE Ratio

This is a visual interactive Shiller's CAPE ratio. Note how the Cyclically Adjusted Price Earnings ratio tends to peak prior to large drops in the stock market. CAVEAT: The usefulness of this ratio has deteriorated over the past two decades. Specifically, there has been a lack of mean reversion which has been attributed to the low interest rate and low inflation rate environment. Yet, a hybrid machine learning- vector autoregression technique increases forecast accuracy for 10-year annualized US stock returns (Wang, Ahluwalia, Aliaga-Diaz and Davis, 2021.)

Uncertainty Indices

Here is a link to the VIX term structure. Most investment practitioners are familiar with the CBOE VIX, but some other uncertainty indices now also incorporate word searches in newspapers, social media data and other alternative data. Examples are given by the Economic Policy Uncertainty Index and the Partisan Conflict Index.