Lesson 6.1: Economic Theories

Question 1

When analyzing the business cycle, you would expect which phase to occur before reaching the trough?

Answer 1

Before reaching the bottom (the trough), the business cycle is in the contraction phase.

Question 2

A bond analyst notices that the yield spread between corporate bonds and government bonds is widening. This is typically predictive of:

Answer 2

an economic slowdown

A widening yield spread shows that the difference in yield between corporate bonds and U.S. Treasury bonds is increasing. This is usually caused by a flight to quality, the pattern of investors moving their investments to the safety of Treasury securities. This is commonly felt to be a prediction of a future recession or economic slowdown. During a slowdown, interest rates generally decline.

Question 3

If the Consumer Price Index (CPI) is down but consumer demand is up, the economy is likely in which stage of the business cycle?

Answer 3

Recovery to expansion

As prices trend downward and consumer demand increases, the economy is moving from recovery to expansion. As demand continues to increase, assuming supply remains constant, upward pressure will be put on prices through the expansion to the peak.

Question 4

A common measurement used to evaluate attitudes regarding future economic conditions is the difference in yields between U.S. Treasury bonds and corporate bonds. This is known as:

Answer 4

a yield spread

Many analysts compare the difference between yields on bonds with the same maturity but different quality (rating) to get a sense of the market sentiment. A common example of that is comparing the difference between the yield on a U.S. Treasury bond and a highly rated corporate bond. When investor sentiment is positive, the extra safety of the Treasury security is not considered as valuable, so the spread is narrow. When there is “gloom and doom” ahead, investors flock to the safety of the Treasury, causing the spread to widen. This spread is found by comparing the yield curves, but that doesn’t answer the specific question, which is dealing with the difference, and a difference in this industry is called a spread.

Question 5

Gross domestic product (GDP) is increasing. Real interest rates are relatively high. Consumer sentiment is strong, as are auto and retail sales. Labor productivity is declining. What state of the business cycle is the economy likely experiencing?

Answer 5

Expansion to peak

When the economy is moving from expansion to peak, labor productivity starts to decline and interest rates are at a level where the Federal Reserve Board usually starts to contract or slow economic activity.

Question 6

Which of the following statements regarding the economics of fixed-income securities are true?

I. Short-term interest rates are more volatile than long-term rates.
II. Long-term interest rates are more volatile than short-term rates.
III. Short-term bond prices react more than long-term bond prices given a change in interest rates.
IV. Long-term bond prices react more than short-term bond prices given a change in interest rates.

Answer 6

I and IV

There are two separate issues in this question: the volatility of rates and the volatility of bond prices. Short-term rates are more volatile than long-term rates and move more quickly than long-term rates. Often the most volatile interest rate is the federal funds rate, which is an overnight rate of interest. Given a change in rates, long-term bond prices move more than short-term bond prices because of the compounding effect over a much longer period.

Question 7

In comparing the change in the GDP from one year to another, to arrive at an accurate figure, each year’s GDP should be converted to what?

Answer 7

Constant dollars

The GDP must be adjusted for inflation to get an accurate comparison from one year to the next.

Question 8

Which of the following industries would tend to be the most cyclical?

A) Appliance manufacturers
B) Tobacco producers
C) Supermarkets
D) Food producers

Answer 8

A) Appliance manufacturers

Cyclical refers to whether the industry is affected by business cycles of the economy. Items such as luxuries and large-ticket items (autos, homes, appliances) are normally cyclical. Food and tobacco are normally not cyclical.

Question 9

Which of the following industries would be least cyclical?

A) Heavy equipment
B) Supermarket chain
C) Leisure products
D) Automobile manufacturing

Answer 9

B) Supermarket chain

Industrial activity usually follows business cycles, which have more impact on some industries than others. The food industry is one for which the demand is not generally based on economic conditions.

Question 10

Interest rates are rising. An analyst would be most likely to state that the business cycle is in which stage?

Answer 10

It is during periods of economic expansion that interest rates tend to increase. They tend to fall during contractions.

Question 11

Which of the following would not be considered a defensive security?

A) Steel company stock
B) Tobacco stock
C) Utility company stock
D) Food chain stock

Answer 11

A) Steel is cyclical and is not considered defensive; defensive stocks are generally less affected by the business cycle.

Question 12

What best describes the economic phase in which unemployment increases and businesses operate at their lowest capacity levels?

Answer 12

A trough in a business cycle occurs at the end of a contraction phase when businesses are operating at their lowest capacity levels.

Question 13

As current interest rates go up, the market price of existing corporate bonds bearing lower interest rates will:

Answer 13

Decrease

There is an inverse relationship between interest rates and bond prices. This means that as current interest rates go up, the market price of existing bonds will go down.

Question 14

Expansions in the business cycle are characterized by:

Answer 14

increasing consumer demand for goods and services, increasing industrial production, and rising stock markets and property values.

Expansions in the business cycle are characterized by increasing consumer demand for goods and services, increasing industrial production, and rising stock markets and property values. Simply stated, business activity is expanding.

Question 15

The contraction phase of the business cycle is least likely accompanied by:

Answer 15

decreasing unemployment

An economic contraction is likely to feature increasing unemployment (i.e., decreasing employment), along with declining economic output and decreasing inflationary pressure. Watch out for the double negatives.

Question 16

During an economic recession, what will most likely increase?

Answer 16

Bond prices

During a recessionary period, inflation and interest rates generally decline. This causes bond prices to increase because they are inversely related to the change in interest rates. Consumer confidence and profits are declining at this point in the economic cycle.

Question 17

What would probably not be an attractive investment during periods of rising inflation?

Answer 17

Corporate bonds

Interest rates tend to increase with inflation. Rising interest rates cause the values of all fixed-income securities to decline. That is why bonds are not an attractive investment during periods of inflation. Values of real estate, gold, and natural resources tend to rise with inflation.

Question 18

The economy has gone through three consecutive quarters of economic decline with no immediate end in sight; therefore, it could be said to be:

Answer 18

in a recession.

Recession is defined as two or more consecutive quarters of economic decline. It would have to be at least six quarters to be considered a depression.

Question 19

The gross domestic product (GDP) for the United States is composed of:

Answer 19

the sum of all consumer goods, capital goods, and services produced in the United States and net exports to other countries.

The GDP is comprised of all consumer goods, capital goods, services produced in the United States, and net U.S. exports (exports minus imports).

Question 20

If the yield curve is positive (sloping upward), this means that long-term interest rates are:

Answer 20

higher than short-term rates.

A yield curve shows the relationship between short-term and long-term interest rates. When the yield curve is positive, it slopes upward. This means that long-term interest rates are higher than short-term rates.

Question 21

When discussing employment and production, which of the following industries are typically more affected by a recession?

I. Capital goods
II. Consumer durable goods
III. Consumer nondurable goods
IV. Services

Answer 21

I and II

Durable goods and capital goods are more affected by a recession than are nondurable goods and services. This is primarily because they are larger items, last for a longer period, and are somewhat discretionary.

Question 22

An investor purchasing gold bullion is most likely looking for an investment that is:

Answer 22

Countercyclical assets are those whose prices tend to move in the opposite direction of the overall economy. Historically, the price of precious metals, especially gold (and stock in gold-mining companies), moves up when the economy enters the contraction phase and moves in the reverse direction during expansion. Cyclical stocks follow the cycle. There is no “gold bullion exchange.” It is a dealer market with bullion dealers all over the world setting their own spreads. A bar of gold does not provide income.

Question 23

An investment strategy that is designed to minimize risk and preserve the investor’s principal is:

Answer 23

An investment strategy can be either defensive or aggressive. A defensive strategy is one that is intended to minimize risk, preserve capital, and provide a somewhat-stable income. An aggressive investment strategy is designed to maximize returns and assume greater risks.

Question 24

Generally, an inverted yield curve is caused by:

Answer 24

investors buying long-term bonds and selling short-term bonds.

First of all, what is an inverted yield curve? That is what we get when the yields on short-term debt are higher than the yields on long-term debt. Next, what happens to make the yield of a bond go up? When the price of the bond falls, the yield rises. Conversely, when the price of a bond rises, the yield falls. Finally, what causes the price of a security, any security, to go up or go down? Supply and demand in the marketplace. That is, when there are more buyers than sellers, that demand pushes the price up. Likewise, if there are more sellers than buyers, the price will go down. That’s the basic economics of supply and demand.

When investor demand is for long-term bonds, the price of those bonds will rise, causing the yields to fall. And, when investors are selling short-term bonds, that selling pressure causes the price to drop and the yields to increase. That is what has happened in this question: more demand for the long-term, resulting in higher prices and lower yields, and more supply for the short-term, resulting in lower prices and higher yields.

Question 25

Economists have determined that the economy is slowing down. Orders for durable goods have been declining and unemployment, while not a reason for concern, has been steadily increasing over the past year. Given the information provided, what phase of the business cycle is the economy currently experiencing?

Answer 25

**Contraction** The contraction phase is characterized by business sales falling, unemployment increasing, and the gross domestic product (GDP) growth falling.

Question 26

While reviewing nationwide industrial production figures, an analyst notices that inventories have been rising. From that information, one would gather that the economy is most likely in which phase of the business cycle?

Answer 26

**Downturns in the business cycle (a contraction)** tend to be characterized by rising inventories due to a lack of consumer demand. During expansion or recovery, demand is high and goods are less likely to remain in inventory.

Question 27

Which of the statements below best describes why a normal yield curve is positively sloped?

Answer 27

**Investors demand higher interest when lending their money for longer periods.** When the yield curve is positively sloped (and thus normal), long-term bonds carry higher interest rates than short-term bonds of the same quality.

Question 28

Ana is a bond analyst who notices a wider credit spread between Treasury bonds and AAA corporate debt. From this, she would be most likely to infer:

Answer 28

**the economy is weakening** The reason the spread gets wider is that investors are getting out of corporate bonds and getting into Treasuries. Why would they do that? Because, as the industry says, "It is an escape to quality." When there are economic clouds on the horizon, like a recession, you would much rather have your money invested in U.S. Treasuries because you know they will pay off. Higher corporate yields come from lower market prices.

Question 29

Which of the following is most likely to be regarded as a defensive stock?

Answer 29

**A food company** A defensive stock maintains future earnings that are likely to withstand an economic downturn. **Typical examples are stocks of those firms that supply basic consumer necessities such as foodstuffs.** A stock selling at an extremely high PE ratio is indicative of a speculative company or one that can decline in value rapidly.

Question 30

A bond analyst is plotting a yield curve and notices that **short-term maturities have higher yields than intermediate and long-term maturities**. This is an example of:

Answer 30

**an inverted yield curve.** An inverted, or negative, yield curve is one that results when debt with short-term maturities has higher yields than those with maturities that are longer. A positive, or normal, yield curve results when the yields increase as maturities do.

Question 31

Yield curve analysis plays an important role as a benchmarking and forecasting tool for the future direction of interest rates. In most cases, this analysis involves examining bonds of:

Answer 31

**a single issuer over varying maturities** The most common yield curves are drawn using U.S. Treasury securities. The curve is plotted using maturities ranging from the short-term T-bills to the long bonds. There are other curves drawn with bonds from other sectors, such as corporate bonds, to show the yield spread, but that is going beyond the scope of this question.

Question 32

An upward-sloping yield curve represents all of the following

Answer 32

**A) increased risk of default over time. B) time value of money. C) inflation expectations.** Foreign interest rate differentials are not reflected in an upward-sloping yield curve. Interest rate differentials between countries reflect differences in domestic monetary and fiscal conditions. The time value of money is reflected in the upward-sloping yield curve. Longer-term rates require higher rates to compensate for loss of current buying power and liquidity. Longer-term funds bear a higher risk of default than do shorter-term funds and, as a result, command higher rates. Increasing inflation expectations cause the yield curve to slope upward to compensate lenders for the loss of future buying power. This is an example of how you get a question correct by process of elimination.

Question 33

During the past **two quarters**, the GDP declined by 3%, the unemployment rate rose by 0.7%, and the Consumer Price Index fell by 1.3%. This economic condition is called:

Answer 33

Two consecutive quarters of economic decline, as measured by the gross domestic product (GDP), is termed a recession. Six quarters would be considered a depression, and an increasing CPI could be considered a sign of inflation.

Question 34

What is considered the most accurate method of measuring GDP?

Answer 34

Constant dollars are mathematically adjusted to remove the effects of inflation, so when economists compare the gross domestic product of one period with that of another, they measure economic activity rather than inflation.

Question 35

A bond analyst reports that there is currently an inverted yield curve. That would mean:

Answer 35

**the closer the bond is to its maturity date, the higher the yield.** An inverted yield curve shows near-term maturities with higher yields than those of long-term maturities. Sometimes called a negative yield curve, it is usually an indication that interest rates are near a peak and the trend should soon reverse.

Question 36

In the investment industry, the term spread has many different meanings. When used in a discussion about bonds, what would be most appropriate?

Answer 36

A **credit spread** refers to the difference between yields of bonds with similar maturities but different ratings. For example, a bond analyst might compare the yield of a 10-year Treasury note with a AAA rated bond with 10 years to maturity. Wider spreads generally indicate a concern about the economy (investors are seeking the safety of the Treasury issue), while narrow spreads generally indicate economic optimism. Debit spread and calendar spread refer to options (as does credit spread, but our question asks about bonds). Bond prices and interest rates have an inverse relationship, but that isn't called an inverse spread.

Question 37

**Interest rates are declining**. An analyst would be most likely to state that the business cycle is in which stage?

Answer 37

**Contraction** It is during periods of economic contraction that interest rates tend to decline. They tend to rise during expansions.

Question 38

If an economist were to describe defensive issues, he would probably not include companies that produce

Answer 38

**building materials** Defensive issues are issues that are defensive against a downturn in the economy. Building materials are usually susceptible to downturns when the economy is bad.

Question 39

In the secondary market, U.S. Treasury bond prices are most influenced by:

Answer 39

**the inflation rate** There are two major influences on the price of bonds in the secondary market. One of those is the amount of credit risk (chances that the issuer won't be able to pay the interest and/or principal). That is not considered a risk with U.S. Treasury securities. The other, and generally stronger, influence is the inflation rate. Inflation eats away at the fixed income and principal of bonds. To compensate, the bonds must offer a higher return. That is either in the form of a new bond carrying a higher coupon rate or, as this question refers to, trading in the secondary market at a lower price. Remember the inverse relationship between interest rates and bond prices. Interest rates follow the inflation rate, so when inflation rises, so must the yield on bonds. The yield on outstanding bonds increases as the market price decreases.

Question 40

If the Consumer Price Index **(CPI) is up and consumer demand is also up**, the economy is likely in which stage of the business cycle?

Answer 40

**Expansion to peak** As prices trend higher and consumer demand increases, the economy is moving from expansion to a peak. As demand continues to increase, assuming supply remains constant, upward pressure will be put on prices through the expansion to the peak.

Question 41

If a customer purchases a food company stock and a utility stock, the customer's portfolio is:

Answer 41

Food company stocks and utilities are **defensive investments**. Defensive investments are those that tend to hold up well in economic downturns. Defensive industries are least affected by normal business cycles. Companies in defensive industries generally produce nondurable consumer goods, such as food, pharmaceuticals, tobacco, and energy. Public consumption of such goods remains fairly steady throughout the business cycle. During recessions and bear markets, stocks in defensive industries generally decline less than stocks in other industries.

Question 42

While listening to a commentator on cable TV, you hear the statement, "The flight to quality has ended." What would you expect the effect of this to be?

Answer 42

**Yield spreads are narrowing** The term yield spread refers to the difference in yield between very-high-quality debt instruments, such as U.S. government bonds, and those with lower ratings. The spread compensates for the additional risk. When investors perceive that the risk has lessened, they won't demand as much in return from the lower-rated instruments.