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It was a great first half of the year for both the stock and bond markets.

While there is always a myriad of factors that drive returns in various asset classes, the strong market has been driven largely by macro1 factors, and specifically, interest rates.

Let’s dive in by revisiting exactly how interest rates impact the economy:

When an economy is weak, the Federal Reserve will often “push a button,” lowering interest rates to “wake up” the economy and get it going again.  I always find it interesting when someone accuses the Fed of manipulating the economy.  In fact, that’s its purpose for existence.2

When interest rates are low, business owners are more likely to borrow to purchase equipment and hire employees. Consumers are more likely to buy cars, remodel or buy homes, and make other major purchases.  Lowering rates basically drives demand. Think of it as if the Fed was simply flying a plane over a city and dumping money on it.  Of course, soon the money will be spent and prices will eventually rise.  This leads to the biggest concern, which is that eventually there will be “hell to pay” for the nearly-free money.  Many worry about runaway inflation or the consequences of another business, market and/or housing bust when rates rise and return to more normal levels.

This brings us to why