Last Updated on 17 November, 2020 by Samuelsson
The financial industry is always one interesting topic. With such a complex market, you can never say you learned everything there is to know. For example, there is one question that investors and traders wonder quite often: When stocks go down, what goes up?
When stocks go down, bonds go up. This is because falling stock prices signals that the economy is weakening, which increases the demand for safer investments. Bonds are regarded as safe investments, and as the demand increases, the price does too.
This is the reason why bond prices tend to rise when the market enters a bearish phase. Let us explore the relationship somewhat further.
What Is the Relationship Between Stocks and Bonds?
Stocks and bonds are two financial tools traded on the market by investors and traders. These two are similar and different at the same time, but in time of crisis, they develop a special relationship. The investors call it the inverted relationship between stocks and bonds. Simply, this means that when stocks go down, bonds tend to go up.
When this happens, economists know that the interest rates and inflation are going up as well. However, while low inflation and interest rate guarantee that the market is in a good place, a moderate growth of these can still support a higher stock price on the market. In fact, moderate growth of inflation means the economy is also growing stronger, which is good for the financial medium.
The problem is when this growth hits a limit. When the interest rates and inflation continue to rise, the economy becomes sensible to changes. Many things happen when inflation grows; for example, corporate profits go down because of the higher inflation and companies try to adjust their profit growth. This is not good news for the stock market. That is the moment when investors usually choose to bet on bonds instead of stocks and stay on the safer side. This is why the relationship between stocks and bonds is called an inverted relationship.
Why Do Bonds Go Up When Stocks Go Down?
So, bonds and stocks have a unique relationship in the financial market. Bonds are the only ones that go up when the stock market falls, which shows there is a critical moment for the financial market.
Bonds increase their value when stocks fall because investors choose to go on the safer side and put their money away from the chaotic stock market. Traders and investors are practical people and they try to read the ups and downs of the market. When something spikes in the stock market, they are quick to pull out their money and look for other ways to keep investing. The bonds are very attractive because of the yield offered: bonds that are already on the market have higher yields and new bonds have better prices.
Economists say that this relationship between stocks and bonds (in this situation) is negatively correlated.
However, don’t get fooled by the idea that bonds only go up when stocks go down. As it has been observed on the market, when stocks start rising again, this doesn’t really affect the bonds market. Bonds remain attractive for most investors even when stocks go up. On the other hand, bonds are impacted by other factors in the economy. For example, the inflationary pressures influence bond prices. Therefore, when bond yield rises and bond prices fall, investors know the inflation is going up. There are, however, situations when bonds fall and stocks rise. What does that mean? There are various answers to that, but when stocks rise, it’s usually a good sign for the economy. Profits are increasing and stocks become more valuable. In that moment, bonds begin to fall. There is an entire process through which the financial market is regulated, especially after a recession. Most of the time, bonds will start to fall because of this.
The Inverted Yield Curve
The yield curve is a financial line that shows the interest rates in time and of bonds with the same credit quality, with different maturity dates. The yield curve can be reported by authorities at 3 months, 2 years, 5 years, 10 years and 30 years.
The inverted yield curve shows investors and traders that bond yields that have a short duration are higher than bonds yields that have a longer duration. The inverted yield curve triggers the concern of financial players, because it’s an abnormality of the market and it often predicts a recession.
Historically speaking, an inverted yield curve has predicted recessions in the past. For example, the yield curve has been a predictor of the most famous recessions of 1981, 1991 and 2001. Also, the yield curve has inverted just before the most recent financial crisis, in 2008. It was first observed at the end of 2005, but it took two entire years to have the entire market fall.
Why Is This Important for Investors?
The inverted relationship between stocks and bonds is very important for investors. This way, they are able to predict what will happen next on the market and prepare for it. Traders want to know if bond and stock prices are moving because this is a potential sign that the market will soon go through massive change.
For example, if bond prices are going up, it’s a signal that traders and investors are playing it safe because they are scared of something that happens in the market. Therefore, this can be a hint that the market will go through a hard time in the foreseen future.