If you’re an equity trader or investor, you may not think much about the sleepy bond market. However, the bond market controls the stock market – most of the time.
The bond market, which is much larger than the global stock market, historically keeps stocks in check. Since bond yields are on the rise, this is the perfect time to examine the rationale behind this lop-sided relationship.
How the bond market controls the stock market
The bond market abhors inflation, as it erodes buying power. When inflation rises, bond buyers require higher returns (higher yields) if they’re going to invest in debt. As yields start to rise, so do interest rates and borrowing costs for consumers and businesses. Businesses pass along those increases in their costs to the consumer. Consumers reduce spending, which then causes a slowdown in economic activity.
Businesses react to lower consumer spending by lowering profit expectations and slowing down expansion plans or other money-making projects. Stock prices slump as a result.
Essentially, rising inflation starts a negative cycle in the economy that becomes difficult to break.
Some theories say that bond and stock market performance are mutually exclusive. The two markets recently moved together in the same direction. That is not common and has not happened for decades.
But it does tell us that demand for both bonds and stocks is high. Why is that? Investors want to be confident their returns will beat the markets, so they diversify.
Speaking of diversification, don’t go all-in on stocks. You want to hold bonds along with other assets like real estate and precious metals.
Plus, bonds are far more attractive and reliable from both risk and cash flow perspectives. They are issued by governments and pay interest regularly. By contrast, stocks that pay dividends are rare; so are stock buy-backs.
There are exceptions of course. Take the Mag 7 names, which are valued slightly higher than bonds. This has considerably narrowed that risk gap, though there will always be more risk (and higher returns) in stocks versus bonds.
