Explained: When bonds and stocks trade in tandem and when the correlation is inverse

Explained: When bonds and stocks trade in tandem and when the correlation is inverse
  • In times of trouble, bonds are seen as a safe haven and yields fall with stocks.
  • Normally, lower yields boost stocks, an inverse correlation.
  • Understanding the situation is key to trading markets.

Could you explain to me the relationship between the movement of 10-year US government bonds and US stock indices? This is a question we have received from a user and the answer is complicated – it depends on the current market focus.

Markets are currently in times of trouble, with Russia and Ukraine apparently on the brink of war. Every negative headline prompts investors to sell stocks and buy bonds – moving yields down. So, yields and shares move in tandem. One example is the announcement by Russian President Vladimir Putin about the recognition of the breakaway Donetsk and Luhansk regions.

Every optimistic headline sends money to stocks and away from Treasuries, pushing yields up, alongside equities. Examples include announcements of high or top-level meetings trying to resolve the situation.

Headline-driven markets tend to experience this straightforward correlation between yields and stocks.

However, the correlation is inverse when fear of war does not grip markets. In such situations, investors focus on the Federal Reserve. If they think there is a higher chance of more rate hikes, they sell both stocks and bonds – with yields rising to reflect expectations of elevated borrowing costs. Statements about the need for a 50 bps rate hike or strong economic data are examples of such behavior.

When some Fed official says the path of rate hikes is slower, investors are happy to push yields lower by buying bonds and they also purchase stocks, which have a bigger advantage when the comparative safe investment in Treasuries results in a lower yield. A comment by a Fed official about settling for a standard 25 bps rate hike triggers such a reaction.

Normal markets tend to experience an inverse correlation between bonds and stocks.

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