expand production. As a result, both firms and consumers will likely in-
crease their demand for credit and push interest rates higher.
A second reason why interest rates rise in tandem with a stronger-
than-expected economic report is that such growth might be inflationary,
especially if it is near the end of an economic expansion. Economic
growth associated with increases in productivity, which often occur in
the early and middle stages of a business expansion, is rarely inflationary.
Going back to the example above, inflationary fears were the prin-
cipal reason why interest rates soared when the Labor Department re-
leased its report on July 5, 1996. Traders feared that the large increase in
wages caused by the tight labor markets and falling unemployment
would cause inflation, a nemesis to both the bond and the stock markets.
Reports on economic growth also have significant implications for
the actions of central banks. The threat of inflation from an overly strong
economy will make it likely that the central bank will tighten credit. If
the aggregate demand is expanding too rapidly relative to the supply of
goods and services, the monetary authority can raise interest rates to
prevent the economy from overheating.
Of course, in the case of a weaker-than-expected employment report,
the bond market will respond favorably as interest rates decline in re-
sponse to weaker credit demand and lower inflationary pressures. Recall
that the price of bonds moves in the opposite direction of interest rates.
An important principle to understand is that the market reacts
more strongly after several similar reports move in the same direction.
For example, if an inflation report is higher than expected, then the fol-
lowing month the market will react even more strongly to another
higher-than-expected reading. The reason for this is that there is a lot of
noise in the individual data report and a single month’s observation
may be reversed in subsequent data. But if the subsequent data confirm
the original data, then it is more likely that a new trend has been estab-
lished and the market will move accordingly.
ECONOMIC GROWTH AND STOCK PRICES
It surprises the general public and even the financial press when a strong
economic report sends the stock market lower. But stronger-than-ex-
pected economic growth has two important implications for the stock
market, and each tugs in the opposite direction. A strong economy in-
creases future corporate earnings, which is bullish for stocks. But it also
raises interest rates, which raises the discount rate at which these future
profits are discounted. Similarly, a weak economic report may lower ex-
240 PART 3 How the Economic Environment Impacts Stocks