1.1.2. Interest Rates and the Business Cycle
Interest rates often follow a pattern within the business cycle. During the later stages of an expansion, interest rates tend to rise as demand for goods begins to exceed supply. With an overheated economy, inflation appears. Lenders respond by raising both interest rates and loan qualification requirements. As a result, credit tightens. This marks the peak of the cycle and the beginning stages of a contraction.
In the early stages of a contraction, credit remains tight and interest rates high, but as inflation drops, interest rates start to come down as well. In the later stages of a contraction, when the Federal Reserve Board (the Fed) uses open market operations to buy government securities—thereby injecting money into banks and other lenders—credit loosens and interest rates fall further.
Bond yields follow the interest rate pattern: they rise in the later stages of an expansion and fall in the later stages of a contraction. Furthermore, yields in the early and middle stages of a contraction are higher than yields in the early and middle stages of an expansion. So, typically, during a contraction, investors like bonds because they pay higher yields than during an expansion, and they expect that yields will fall in the future. Also, bonds are generally perceived to be safer than stocks, and in an economic downturn, stock prices often fall as buy