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Question: I've heard that -- Kate, Washington, D.C.go up when go down. Is that true?
TheAnswer: Great question, Kate. The short answer is: Yes. Falling prices are a signal of falling confidence in the , and when investors pull out of , they seek safer classes such as .
So all of that stocks and going into bonds has the effect of pushing prices higher -- because newly issued bonds can lower yields, and the already-existing bonds with higher yields are more attractive.leaving
Economists would say that falling prices and rising prices means they are "negatively correlated."
But is the converse true? Do risingprices hurt prices? Not really. Although we've seen that falling prices can cause investors to flee to the safety of bonds, rising prices don't make bonds unattractive.
So the next question becomes: Do rising rates of inflation spell trouble forprices?
Yes, but only down the road.
Let me explain.
Right now, inflation and interest rates remain at extremely low levels. Yet these two measures could rise to 4%, for example, and actually be supportive of higherprices. That's because a moderate rise in inflation and interest rates implies that the economy is getting stronger. And stocks do well when the economy is strengthening.
But there's a hard limit to this relationship. If inflation and interest rates keep rising, perhaps to the 6% to 8% range, then the economy starts to face a powerful headwind. Because corporate profits would be eaten by up higher inflation, not only companies become hard-pressed to generate inflation-adjusted profit growth in such an environment (which is bad for prices), but many investors would increasingly gravitate from stocks to bonds. Indeed, the Federal Reserve would start to hike interest rates until they are high enough to slow down the economy and break the back of inflation.
That's just what we saw in the 1970s. Inflation soared toward the double-digit mark with government bonds handily yielding 10%. And when that happened, few wanted to own seemingly precarious stocks when bonds offered up such juicy yields. The massive bear market in stocks in the 1970s was directly tied to the fact that yields were so impressive. In this case, falling prices (as yields rise) and falling prices were what economists "highly correlated."
With inflation at multi-decade lows, few are thinking about this topic at the moment. But in the quarters ahead, if interest rates start to rise, as many suspect, this question pop up with greater frequency. Although stocks surely can tolerate a moderate upward move in interest rates and inflation, they start to suffer if those twin measures of cost pressures keep rising higher.