Your 6-month Treasury bill is ready to mature. It's time to check current interest rate levels as you consider rolling over your funds for another six months. Wow!  The latest auction produced a 5.5 percent yield. Only six months ago, yields on Treasury bills amounted to 4.75 percent. What happened during this period? U.S. economic activity surged; global conditions improved; inflation fears heightened and the Federal Reserve tightened monetary policy.

If you were monitoring economic activity more closely, you would have noticed daily changes in bond yields and bond prices. These changes are due to the daily spate of economic indicators reported by government and private agencies. Each indicator is a clue to the economic puzzle that we face as consumers and investors.

Robust activity leads to rising interest rates (falling bond prices)

Logic tells us that economic growth is good. When the economy expands, companies are increasing the quantity of goods and services they are selling. Increased sales eventually translate into greater demand for workers. Whether additional workers are hired or the same number of employees work longer hours, it generates higher income. Consumers will have more money to spend on goods and services-or additional funds to save and invest.

Economic rules of thumb suggest that robust economic growth could eventually lead to inflationary pressures. Supply bottlenecks will cause producers to bid up prices for raw materials; employers will have difficulty in finding skilled workers. This leads to higher wage and benefit costs as companies attempt to entice workers.

This is one of the connections between higher interest rates and a booming economy. Bond investors fear inflation whenever they get a whiff of healthy economic activity. The Federal Reserve also fears inflation - and one of their mandates set by Congress - is to maintain price stability. Consequently, the Fed will tighten the screws on credit and raise interest rates in this kind of environment.

Higher interest rate yields might be better for those individual investors who are parking some money in bank certificate of deposits or short term Treasury bills. Higher interest rates spell trouble and falling bond prices for professional bond market players.

Soft economy leads to falling interest rates (rising bond prices)

A weak economy creates a falling interest rate environment for two reasons. First, anemic activity means that consumers and businesses are not borrowing money. Interest rates are the price of borrowing. If money demand declines, so does its price, and interest rates are reduced. Second, in a period of extreme weakness, when many fear recession, the Federal Reserve eases credit conditions, which further reduces interest rate levels. (The other mandate of the Federal Reserve instituted by Congress is to promote economic growth.)

Professionals in the bond market closely monitor every signal that points to softening in the economy. They do this by following such indicators as retail sales which reflects consumer demand and the employment situation which reflects income and production. When economic indicators are moderating their rate of growth or declining, bond market participants anticipate slower economic growth and lower interest rates.

The average consumer and individual investor is not necessarily crazy about low interest rates unless they are big borrowers. Savers prefer to see higher interest rate yields on their savings accounts or bonds. Low interest rates are good for the equity market, however, helping to stage bull markets.

Why bond prices fall when interest rates rise-and vice versa

Bond market players take the two sides of the market-those who hold and sell bonds (supply side), and those who buy bonds (demand side). Professional bond buyers want to buy bonds when they are low in price and high in yield. They sell bonds when prices rise and yields are relatively low, or falling.

Most individual investors who buy bonds hold them to maturity. In some ways, bonds are similar to bank certificates of deposit because an investor knows the interest earned over the life of the bond just like they know the rate on their bank CD. In addition, bonds (like stocks) can be traded in the secondary market.

Since bonds are issued at various times over the business cycle, they carry different interest rates. Since interest rates (the coupon rate) on bonds are fixed over their maturity period, bond prices must vary. Bond prices are determined by a variety of factors including but not limited to the following: the bond's coupon rate, the maturity of the bond, the credit risk, and the current level of market interest rates. The rule of thumb is that the interest yield on the old bond will be equal to the market level of interest rates for bonds of similar maturity and credit risk. This means, by definition, that the price of the bond will adjust. For example, new bonds are purchased at par for $1,000. If the level of market interest rates increases six months after you bought your bond, you will only be able to sell it at a discount for a price less than $1,000.  If the market level of interest rates decreases six months after you bought your bond, you will be able to sell your bond at a premium, for a price greater than $1,000.

When you decide to hold on to your bond, you will receive the same interest payments every six months for the life of the bond, with the return of principal when the bond matures. It doesn't matter whether the level of interest rates rise or fall in the meantime. Your interest payments are fixed over the life of the bond.

However, if you keep your bond in a brokerage account, your monthly statement will reflect the current market value of the bond. When market rates rise above the interest rate you are earning, the value of your bond declines. Conversely, when market rates are falling, the value of your bond increases. Whether you face a gain or loss from the potential sale of the bond, you might consider weighing alternative investment options. If none are preferable to your current holdings, selling the bond for a gain or a loss is inappropriate.