# Ask Colin

Interest rates and equity prices are related for the simple reason that interest rates relate to the return on fixed interest investments like bonds. Since bonds are competing investments for equities (shares), they are also related.

First it in important to understand that interest rates relate to the level of prices in our economy. Prices are measured by things like the Consumer Price Index (CPI), which is simply a gauge of percentage movements in the total prices for a basket of goods and services.

Prices usually go up, so the change in prices is positive and called inflation. However, prices can decline overall and that is called deflation. Delation is relatively rare in recent times unless you live in Japan.

Investors in bonds will not logically lend money unless they get an attractive return. One of the measures of attractiveness is that, at the time of investing, the return on bonds is greater than the rate of inflation, so that the investor's savings hold their value. So, if inflation rises, so do interest rates, to compensate new bond investors for the greater loss of the real value of their savings. If inflation falls, so do interest rates because new bond investors will see the wisdom of accepting a lower return because prices are rising more slowly.

It is actually more complicated than this, to take into account the length of time money is tied up in bonds and expectations of inflation rates as apart from current rates, however, this is the general idea.

Now, we return to the idea that bonds and shares compete. At any time we have a choice of investing in bonds or shares. If bond yields are higher than the yield on shares, we have an incentive to invest in bonds. Investors will tend to sell shares, so their prices fall and invest in bonds, so their prices rise. This process tends to bring bond yields and share yields into line when one gets away from the other.

Of course, bond yields and share yields are never identical. Shares are more risky than bonds. So the yield on shares (earnings yields, not dividend yields) should be higher than bonds. To make life even more difficult, sometimes there are share market bubbles or panics, when share yields get right out of line with bond yields. Also, even when markets are relatively rational, some shares and all shares at some times are seen to be more risk than at other times, depending on the outlook investors have for the economy. So, the relationship between interest rates and bond yields and share yields are joined, but by a "rubber band" that stretches and contracts over time depending on the conditions.

In summary, when interest rates and bond yields fall, share prices tend to go up (their yields go down to match the lower bond yields) and when interest rates and bond yields rise, share prices tend to fall (their yields go up to match the higher bond yields).

Now, bond yields are not a free market entirely. Interest rates are controlled by governments and reserve banks. They increase interest rates to slow down the economy when it is growing too fast and inflation gets out of control and reduce interest rates if the economy grows too slowly. This tends to be a gradual process so that people can adjust over time. The alternative of sudden big shifts in interest rates tends to produce panic moves in markets. So, we tend to have cycles of rising interest rates as governments try to slow down the economy and cycles of falling interest rates as governments try to get the economy growing faster.

These cycles in interest rates produce cycles in equity prices. However, there is no mathematical relationship. It is all rather loosely related with many leads and lags in the process, that change with the conditions. There is therefore a general tendency, but the economic system is too complex to allow any precise mathematical calculations.

This is a five-minute summary of years of study of economics.

Keywords: