What Happens to Stocks When Bonds Decline

What Happens to Stocks When Bonds Decline – Historical Analysis

The relationship between stocks and interest rates is at the center of financial theory. Why? Because the interest rates determine the value of stocks. High rates equal less appetite for owning risky assets, and investors will only own risky assets if they are compensated for taking this risk. What happens to stocks when bonds go down (what happens to stocks when interest rates go up)?

When bonds go down and interest rates go up stocks perform poorly. A lower price for the bond means that the yield and interest rates go up, and future cash flows get discounted at a higher rate. When rates go up, it’s less attractive to own risky assets like stocks as it’s more attractive to own less risky assets. We backtest our hypothesis.

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The relationship between bonds and stocks

It’s crucial to understand the relationship between bonds and stocks. They both correlate to each other. When bonds go up in price, stocks also tend to go up. Higher bond prices mean the yield goes down, which is positive for stocks.

Opposite, when bond prices go down, meaning rates go up, it is bad for stocks.

Let’s give you a short primer on bonds:

A bond pays the same coupon during its life – until the bond matures. The coupon is being paid annually to the bond owners (for taking the risk of owning it).

For example, a bond with a coupon of 5% pays 5% until the bond matures. Let’s say 20 years. A one billion bond that has a coupon of 5% pays 50 million annually to the bond owners.

But during the bond’s life, the interest rates vary a lot. If the rates go down, the 5% loan is more attractive and thus investors bid the price of the bond up. Why? Because the price of the bond needs to go up to reflect the falling rates. The price of the one billion bond needs to go up 10% to reflect the change of the rates to 4.5% (this is just an example, in the real world a bond is influenced by a lot of factors). This means that stocks and rates have an inverse relationship.

What happens to stocks when interest rates go up? A video

Stocks are riskier than bonds

When a company goes bankrupt, what is left in the company is paid to the bond owners before anything is paid to equity holders. Thus, bonds are less risky than stocks.

When rates go up (bonds go down) it gets less attractive to own stocks. Stocks get bid down. When rates go down, it’s more attractive to own riskier assets like stocks, gold, and
Bitcoin.

The bond and stock relationship is, of course, not constant. That is why both of them move up and down daily to adjust to new future expectations. However, we believe it’s safe to anticipate that the correlation between bonds and stocks increases when inflation increases. Since the early 1980s, we have witnessed a 40-year bullish run with falling rates, in some countries even negative nominal rates, not to mention substantial negative real rates.

What happens to stocks when bonds go down?

We hypothesize that a falling bond market is not good for stocks. Let’s backtest what happens to stocks when bonds go down:

We are long stocks (SPY) when bonds (TLT) are below the N-day moving average, and we sell when it’s above the N-day moving average.

For example, when TLT crosses below its 20-day moving average, we buy SPY at the close. When the close of TLT crosses above its 20-day moving average, we sell SPY at the close and are out of the market until TLT later crosses below its 20-day moving average.

What are SPY and TLT? SPY is the ETF that tracks the S&P 500 and TLT is the ETF that tracks US 20-year Treasury bonds. When TLT goes up in price, the interest rates go down and vice versa.

We backtest by doing an optimization where we test a wide range of moving averages from 5 days up to 100 with 5-day intervals (in total 20 backtests). The results look like this:

What Happens To Stocks When Bonds Go Down?

The first column shows the number of days in the moving average and the following columns show the trading results of each number of days in the moving average. The important column is number 3 which shows the average gain per trade. The averages in column 3 are lower for all rows compared to any random day.

Let’s look at a specific backtest: we chose the 15-day moving average. This is how the equity curve looks like from 2003:

What Happens To Stocks When interest rates go up? Backtest

There are 355 trades, the average gain per trade is 0.16%, CAGR is 2.37%, and max drawdown is 50%.

Opposite, if we flip the buy and sell signals, we get much better results:

What happens to stocks when bonds go up?

What happens to stocks when bonds go down? Video

What happens to stocks when bonds go down? Conclusions

Our backtest shows what happens to stocks when bonds go down: that stocks perform much worse than any average random period. This is according to financial theory, and proves that it’s less desirable to own risky assets like stocks when bonds go down.

FAQ:

Why are stocks considered riskier than bonds?

When bond prices rise, it usually implies a decrease in interest rates. In this scenario, the yields on bonds become more attractive compared to stocks. In case of bankruptcy, bond owners are paid before equity holders. Thus, bonds are considered less risky than stocks.

What is the correlation between bonds and stocks?

The correlation between bonds and stocks is a crucial aspect of financial markets. Generally, these two asset classes exhibit an inverse relationship, meaning their prices often move in opposite directions. Understanding this correlation is essential for investors and traders in managing portfolios and making informed decisions.

How do bonds and stocks adjust to new future expectations?

A falling bond market is hypothesized to be unfavorable for stocks. Both bonds and stocks adjust daily to new future expectations, leading to their continuous movements. The correlation between them may increase with rising inflation.It’s important to note that while this inverse correlation is a general trend, market dynamics can be influenced by various factors, including economic conditions, central bank policies, geopolitical events, and investor sentiment.

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