How are bond prices related to the stock market?

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How are bond prices related to the stock market?

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 How are bond prices related to the stock market?
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Highlights

  • In general, the bond market is inversely proportional to the stock market
  • An ideal portfolio has a judicious mix of both, and the ratio of this asset allocation has a vast impact on the portfolio’s performance.
  • However, this inter-relationship is not steadfast.

There are many asset classes that are traded in the financial market, such as – bonds, equities, commodities, etc. However, it may or may not be necessary for every asset to move in sync with the other one. For example, gold prices generally tend to move in the opposite direction of equity prices. Gold is considered as a safe haven asset, so whenever there is uncertainty or pessimism in the stock market, investors tend to switch to the safer asset, i.e. gold.

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Similarly, investors also make a choice to shuffle their portfolio holdings between bonds and equities. An ideal portfolio has a judicious mix of both, and the ratio of this asset allocation has a vast impact on the portfolio’s performance.  

Relation of bonds prices with equity market

Generally speaking, the bond market is inversely proportional to the stock market. In simple words, when equity prices fall, bonds’ prices tend to go up and vice versa.

In a booming economy, wherein consumer spending is on a rise, interest rates are at a comfortably low level, companies are clocking higher earnings, etc., equity prices move upwards as investors feel confident. To look at it in another way, when investors see an opportunity for high capital growth in equities, they pull out their investments from a relatively safer asset (bonds) to invest in equities. This affects bonds’ prices and they decline.

In an opposite scenario, when the economy decelerates its growth due to subdued consumer spending, leading to a downtick in corporate profits, investors feel more confident with regular interest payments from the bond market. This leads them to liquidate their equity holdings and channelise those proceeds to investing in bonds, hence equity prices decline and bonds go up in value.

However, this inter-relationship is not steadfast. Although uncommon, both bonds and equities can fall or rise at the same time as well. For example, when there is excess liquidity in financial markets (generally pumped by central banks), both assets could see an uptick in prices. Similarly, when there is extreme pessimism, so much that investors get skeptical about the government’s ability to service its debt obligations, both assets can see a fall in tandem.

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Can the bond market be a useful indicator for equity investors?

One thing is clear by now both the markets generally move in the opposite direction. Therefore, an investor can gauge the movement of one market and forecast the movement of the other one.

To gauge the movement of bonds, one has to understand how they react to interest rates.

Bonds also have an inverse relationship with interest rates. When interest rates rise, the price of bonds falls and vice versa. In other words, when interest rates go up, investors try to get out of existing bonds as their interest would fall short of what new bonds would offer (due to higher interest rate) hence, bonds fall.

Likewise, if interest rates fall, investors flock to buy existing bonds as their returns would be higher than upcoming bonds (due to lesser interest rate).

This way bonds can help investors gauge periods of high interest rates, which can help them make informed decisions in the equity market. E.g. sectors such as real estate witness some selling pressure and investors can expect some correction in such sectors.

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