Why do the stock and bond markets react negatively when there is news that the economy is doing well?

While it seems to defy logic, there are a number of reasons why this seemingly irrational "good news is bad news" phenomenon occurs.

The big player in this scenario is the Federal Reserve's Open Market Committee (FOMC). The FOMC is the monetary arm of the Federal Reserve Bank and has the authority to raise or lower short-term interest rates, which have a dramatic effect on the cost of borrowing by corporations and individuals.

The cost of credit can have substantial influence on corporate profits, job creation, growth and reinvestment rates, etc. these items, in turn, have a direct impact on the market prices of stocks and bonds.

If the economy appears to be heating up, the Fed may suspect the growth could cause inflation and decide to move to tighten credit by raising short-term rates. If indicators lead them to believe the economy may be slowing enough to cause a future recession, however, they may ease credit by lowering short-term rates.

Since the current yield (interest) on all bonds, short- and long-term, is directly tied to the cost of credit in the market, rising interest rates mean that lower yielding bonds will lose value. This happens because their price would be discounted relative to their par (face) value, in order for an invested dollar to earn a yield comparable to the new higher yields.

The opposite is also true. For example, lower interest rates cause a premium to be paid on bonds, which raises their value to bring the yield down to current market levels.

Hence, the "good news is bad news" phenomenon is a continual pattern.

Source: Raymond James & Associates, Inc. Investment Digest, Summer 1996.