Interestingly, the relationship between equity and bond markets differs in deflation-risk periods and inflation-risk periods. In inflation-risk periods, rising inflation rates push up long-term interest rates, reflecting the fear that aggressive monetary tightening will depress future earnings and hence stock prices. Thus, in periods of rising inflation risk, government bond prices and stock prices tend to fall. In deflation-risk periods government bond prices and stock prices usually go in opposite directions, because fixed income markets benefit from the expectation of falling interest rates, while equities suffer from the worsening profit outlook and increasing default risk. Credit spreads tend to benefit from rising inflation because it becomes easier for companies to pay down their debt.

Deflationary periods usually lead to a spread widening across the whole credit market, hitting consumer-related industries the hardest. However, long-term interest rates seem to have a minor influence on fluctuations of credit spreads in the short term. Companies that borrow at a fixed rate are immune to changes in yields and spreads over the life of the borrowing. Yet, there is a refinancing risk, when debt has to be rolled over. Conversely, when companies borrow at floating rates, they are directly affected by changes in money market rates, which are primarily driven by monetary policy.

Monetary policy, too, appears to be an important indicator for corporate credit spreads. Let us assume that the economy is at the brink of deflation. Generally, deflation tends to be accompanied by a rise in bankruptcies. When corporate revenues and earnings are weak, highly leveraged borrowers have difficulties to meet their obligations. In this situation central bank easing paves the way for future economic growth. The traditional channels by which a lowering of the federal funds rate tends to stimulate faster growth in real and nominal GDP are: (1) lower debt cost of capital, (2) higher stock prices, (3) dollar weakness, (4) consumer durables, including automobiles, and (5) housing. Hence, it lowers the equity cost of capital and bolsters consumer confidence through the wealth effect. We see that  Baa credit spreads usually reach their peak when the Fed has done approximately two-thirds of the interest rate cuts.

Similar to the level of interest rates itself the slope of the yield curve also is an indicator for the economic environment. Generally, the slope of the yield curve is seen as a good proxy for future economic growth and corporate profits.

Steep yield curves imply that future rates are expected to be higher than at present. Asteep 2s10s slope and a further steepening of the 2s10s slope in the past often have been followed by positive excess returns of corporate bonds. Usually, one observes a steepness in this part of the curve at the end of a recession and at the start of an expansion. When the expansion finally materializes the curve flattens, and inflation concerns cause central banks to raise interest rates. In this environment, credit usually suffers, and investors should be particularly cautious when overweighting cyclical credits.

Globally, the low interest rate environment in the first years of the new millennium has spurred investors’ interest in credit as a way to boost returns. However, one has to be aware that there is a correlation between the level of interest rates, the slope of the yield curve and credit spreads because both the yield curve and credit spreads reflect the state of the economy.

Since they are driven by expectations about the same underlying factor, the relation between the yield curve and credit spreads has an impact on top-down driven asset allocation and duration decisions.

In the past, credit spreads have been closely correlated with interest rates. There is typically a negative correlation between spreads and the level of interest rates. As interest rates increase due to an improving outlook for future economic growth and rising price pressure, credit quality tends to improve because firms have opportunities to strengthen their future earnings and cashflows. Similarly, a flatter money market slope (2 years–6 months) is usually positive for credit spreads because it indicates better economic conditions. In a difficult economic environment, such as at the trough of the recession, the money market curve tends to be very steep and credit usually underperforms treasuries, especially at the long end.

Although the close relationship between credit spreads and economic activity has held most of the time since 1950, the late 1990s witnessed a significant decoupling. Companies expected long-term stable and high growth rates, driven by new technologies like internet and mobile communication.

Coupled with a sustained rise in profitability, an idea strongly promoted by the Fed, this expectation caused companies to invest heavily and to leverage their balance sheets. In this period maximization of shareholder value was the credo of many managers. Despite strong economic growth credit markets punished the rise of financial and operating leverage that was observable across most industries and companies with widening credit spreads. Excessively high default rates in 2001 and 2002 showed that market participants anticipated the rise in systematic risk quite early. The sustained equity downturn and cases of fraud added to the woes of the credit markets.

While liquidity risk is primarily a function of the willingness and ability of banks and brokers to provide liquidity and of investors’ readiness to take on risk, in other words, risk appetite, the other two points are related to the economic environment. The companies’ ability to generate sufficient cash flows to service their liabilities is central for the probability of default and is reflected in ratings. In general slowing economic growth, usually coupled with lower private consumption due to weak growth of labor income and rising unemployment undermines the profitability of the corporate sector.

In this context, it is worth remembering the definition of a recession. Market participants often define recessions in terms of two consecutive quarters of decline in real GDP. The National Bureau of Economic Research (NBER) which is responsible for dating recession periods, however, claims that recessions are characterized by a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale–retail sales.

Numerous empirical studies confirm that the economic cycle is an important determinant for the performance of credit and government bond markets. They find that credit spreads are negatively correlated with GDP growth.. Historically, spreads tightened during the early stages of economic expansions, and spreads widened during economic recessions. Crabbe and Fabozzi (2002) note that during the ten economic cycles since the end of the Second World War, the Baa–Aaa quality spread typically already widened in the months leading up to a recession. After a recession began, spreads usually continued to widen, peaking approximately 10–14 months into the cycle. The magnitude of the spread widening as well as the duration of the spread widening, however, varies from cycle to cycle, depending primarily on the duration of the recession period and the magnitude of the economic downturn. The fact that credit spreads tend to widen before the business cycle peaks indicates that corporate bond investors often anticipate future economic developments.

Focusing on macroeconomic activity variables, therefore, is not sufficient to predict changes in corporate bond spreads. Investors should carefully analyze leading economic indicators as well as any evidence that corporate profitability slows or leverage increases. Both factors result in a reduced ability to generate cash flows and weakens credit quality, resulting in a higher risk of default.

Savings evoke deep emotions. Saving is about entitlement and faith, not fear and greed. Entitlement and faith are derived from generational experience, religion, and the meaning of life. Every community has had a Great Depression. Hard work does not always produce excess. When the well runs dry, the community ends. Communities such as the Inca and the Anasazi tribes worked hard, created vast roads and irrigation system, yet disappeared from the planet. Hard work does not guarantee anything. The Roaring 20s were full of frivolity, yet produced abundance; the 30s witnessed hard labor that did not overcome scarcity.

Good gods or good government are required to produce savings. The ancient tribes had rituals, harvest festivals, and the like to protect and celebrate their savings. Their feelings were primal and intense: gratitude for the bounty of nature but entitlement to share that bounty once harvested and stored. Every member of the tribe was involved. Today, feelings about savings are just as primal and intense, and involve every member of society.

When savings systems collapse, no one is unaffected. In the 1930s, massive bank failures lead to deflation in some countries and hyperinflation in others. Incredibly strong feelings were unleashed. Desperation led to Nazism, wars, revolutions, and massive New Deals. When all savings disappear, gods are abandoned and governments overthrown.

Saving is as old as humankind. Ancient tribes stored grain, seeds, implements, and ceremonial objects. Anthropological digs unearth bins and storage jars filled with valuable treasures.

The emotions associated with savings are deeply ingrained in our psyche. Saving requires work beyond producing the daily bread. Hard work creates a sense of entitlement. Workers earn their Social Security payments. Savings are not a gift from anyone. Savers do not trust individuals with their hard-earned cash. Only God or good government can be trusted.

Saving requires a deep faith that the excess will be preserved for future use. A safe community is necessary; without it, savings will be stolen. Saving tests our faith in the community.

Today we save as a community through government-guaranteed bank accounts, Social Security taxes, and other government taxes and programs. The current debate over Social Security and Medicare is part of our ritual and ceremony. A threat to savings is a threat to the whole community. The idea that Social Security should be “invested” in stocks challenges the sacred nature of savings.

This blog will help you consider how you react to savings instruments such as CDs and annuities. Also, it will show you to what degree you are a saver, an investor, or a speculator. Emotional traps are embedded in us, as well as in investment products. Internal traps come from our nature as savers, investors, and speculators. Everyone has an internal saver, investor, and speculator. However, everyone has different comfort levels with each aspect of his or her investment personality. When you hand money to a broker, you need to know which part of you is opening your fist.

Not all readers need to study this chapter. After reading the following section, you might wish to look only at the sections on savings instruments you now own or have owned in the past. Then, those of you who have a strong sense that you are a saver should study the entire chapter. Those who are confident that savings instruments are not within your comfort zone should skip the rest of the chapter. If you are not sure, skim the rest of the blog.