What do Financial Market Indicators Tell us?

Each month the Federal Reserve Bank of St. Louis publishes a newsletter titled Liber8, which is a selection of useful economic information, articles, data, and websites compiled by the librarians of the Federal Reserve Bank of St. Louis Research Library. This month the article is about financial market indicators. If the financial lingo you hear reported on the news doesn’t seem to make a lot of sense, this issue should help you understand it better. We encourage your comments and thoughts at http://mufinancialtip.blogspot.com.

 

There is a classroom version of Liber8 available to teachers for free at: http://liber8.stlouisfed.org/newsletter/2012/Lib0112ClassrmEdition.pdf

 

To subscribe to their newsletter or for more information and resources, visit their website and archives at http://liber8.stlouisfed.org.

 

The views expressed are those of the author and do not necessarily reflect the official positions of the Federal Reserve Bank of St. Louis, the Federal Reserve System, the Board of Governors, the University of Missouri, the Personal Financial Planning Department or The Office for Financial Success.

 

By Linpeng Zheng, Research Associate

Financial market data are reported daily in the news—usually as prices, indexes, or interest rates. While these data provide direct information (e.g., a Treasury bill pays 2 percent interest), they also give some indication of future economic growth, inflation, and financial market stability. Changes in these data can also affect decisions about consumer spending, educational loans, and retirement plans. Financial markets are important in everyday life because making good business decisions is difficult without understanding how key financial indicators behave. Popular financial indicators usually fall into four categories: commodity prices, stock indexes, interest rates, and yield spreads (the difference between two interest rates).

We start with the simplest financial indicator—commodity price. Various commodities (e.g., corn, gold, oil) are traded on commodity exchanges, much like the stock markets for individual stocks. If an airline wants to purchase 1,000 barrels of oil today, it needs to pay the current price, which is called the spot price.^[1]

However, if the airline company wants to purchase 1,000 barrels of crude oil for delivery next year, then it can sign a contract at a fixed price today for the oil it will buy next year; this price is called the futures price.

If some event reduces the future supply of oil, which may increase the spot price at a certain time next year, the airline will pay only the locked-in price specified in the futures contract. Hence, this lower futures price reduces the oil expense for the airline. Futures prices are affected by various factors, such as the spot price, storage costs, and interest costs.

The most common financial indexes refer to the prices of the stocks of publicly traded companies. For example, the stock price of Microsoft was $25.76 on December 12, 2011. Other than individual stock prices, an aggregate stock price index also plays an important role. For instance, the Standard and Poor’s 500 (S&P 500) is a market value-weighted^[2] stock price index of 500 stocks chosen based on market size, liquidity, and industry. It covers various industries in the entire U.S. economy. If investors plan to allocate their funds to equity markets, they likely will pay attention to two factors: the prices of the stocks of individual companies and the prices across the broader stock market, as measured by indexes like the S&P 500.

Stock prices generally increase or decrease as a result of changes in expected future earnings. If a company’s new product launch is viewed positively by the market, the stock price of that company may rise. On the other hand, movements of aggregate stock indexes tend to signal changes in the state of the macroeconomy: Good economic news should increase the earnings of many companies. For instance, the S&P 500 may increase after better-than-expected job growth. Similarly, a sequence of bad economic news causes investors to lower their profit forecasts for firms. Thus, the S&P 500 is one of the most closely watched stock indexes because it incorporates new information about the future health of the economy. Just as stock price indexes cover equity markets, interest rates determined in the bond markets are also important.

An interest rate is simply the price of borrowing money for a fixed period. In the United States, the federal funds rate, which is importantly influenced by Federal Reserve monetary policy decisions, is one of the most important interest rates. It is the interest rate at which banks borrow money from other banks. In bond markets, interest rates are referred to as yields. Bonds with different maturities have different yields. It usually costs less to borrow for a few days or months than a few years because of a factor known as the term premium.^[3] If borrowers expect projects to generate higher profits in the future, they may be more willing to borrow at a higher rate. But interest rates can also be influenced by other factors. For example, if inflation is expected to be higher in the future, creditors or investors tend to require higher yields to compensate them for the inflation risk they incur.^[4] As a result, the nominal interest will increase. Thus, bond yields also convey information about future inflation and economic growth. In addition to Treasury securities, corporate bonds are also important financial indicators. Corporate bonds have letter designations (e.g., AA+, B+) that represent the quality of the bonds (i.e., the risk of borrower default).^[5] Lower-quality bonds tend to have higher yields to compensate investors who are willing to take more credit risk. A corporate bond is considered investment grade if its credit rating by rating agencies is “BBB” or higher.^[6]

Now that we know what yield is, let’s talk about yield spread. The yield spread refers to the difference between the yields on two different bonds. Popular spreads are those derived from yields of Treasury bonds of different maturities (i.e., the term spread) and of corporate bonds with different credit risk (i.e., the credit spread). First, the term spread on Treasury securities—the difference between the yield on a 10-year Treasury bond and a 3-month Treasury bill—is frequently mentioned in the news as the yield curve^[7]: When the yield curve slopes downward, future short-term interest rates are expected to fall because investors generally believe the economy will weaken or fall into a recession. The second type of spread—the credit spread—can also increase or decrease because of changes in the possibility of default risk. For instance, when credit spreads widen, it implies that the market is factoring a higher risk of default on lower-quality bonds, which may occur during times of financial distress.

 

Ryan H. Law, M.S., AFC

 

Personal Financial Planning Department

Office for Financial Success Director

University of Missouri Center on Economic Education Director

 

239E Stanley Hall

University of Missouri

Columbia, MO 65211

 

573.882.9211 (office)

573.884.8389 (fax)

 

---

[1] The spot price of oil contains information about the current demand and supply of oil conditions.

[2] A market value-weighted index is an index whose components are weighted according to the total market value of their outstanding shares.

[3] Investors need the extra compensation for locking up their money for a longer period

[4] Unexpected high inflation will hurt creditors if the dollars paid back to them are worth less than the dollars lent.

[5] U.S. government Treasury securities are also rated by credit rating agencies, such as Standard & Poor’s or Moody’s.

[6] Some institutional investors (e.g., pensions) will invest only in AAA-rated bonds based on S&P’s credit rating standard. Bonds with ratings below “BBB” are collectively called junk bonds.

[7] This is because the slope of the yield curve can be approximated as the term spread between the 10-year Treasury security and a 3-month Treasury security.