Today we’re talking about the vital relationship that we as investors need to know to understand where our opportunities lie. It takes a lot of connecting the dots and understanding what factors affect what, but once you master it. You open yourself up to a whole new world of investing, a place where you can identify trends and see what is happening within the economy and financial markets. Instead of investing and hoping for the best you actually know what is going to happen and it feels a lot less like a gamble and a lot more like a sure thing. Yes, there are stages where you can’t predict the future such as will the RBA or Fed increase their interest rates. However, by having a full understanding of the current market economy that will minimize your risk substantially and give you the edge that allows you to make that investment that could change your career.
I’m going to get into the basics of the financial markets because if you have a strong understanding the base you can easily build off that knowledge which will give you that better understanding that you need as an investor. We will be discussing the bond & stock-market and their correlations to the overall economy.
Bonds: What are they?
Are loans you make to a corporation or government. The interest payments stay the same for the life of the loan. You receive the principal at the end if the company/government doesn’t default. Bond values change over time depending on other factors such as stock performance and interest rate movements.
Stocks: What are they?
Stocks are a share of the ownership of a company. The value depends on corporate earnings. Stocks value changes daily depending on the trader’s expectations of future earnings compared to competing companies and industries. Corporate earnings are released each quarter to give investors and clear picture on how they’re performing.
A well-known relationship between stocks and bonds is if interest rates increase the price of bonds fall as investors look for higher-yielding opportunities & vice versa.
The Correlation Between Stocks & Bonds
The prices of bonds & stocks are negatively correlated (move in the opposite directions). When the economy booms investors sell their bonds and purchase stocks due to the higher earnings in owning stocks. When the economy slows, consumers buy less, corporate profits fall and stock prices decline. This is when investors prefer the regular interest payments guaranteed by bonds. When both stocks and bonds go up. Happens at the top of the market. In these cases, there is too much liquidity. When investors are both optimistic and pessimistic about the future of the economy. When both stocks and bonds both fall. Investors in a panic and are selling everything. This is when we will see gold prices increase (a regular hedging tool for your investments).
What should you invest in?
There is no perfect answer to this as investors have different risk profiles, the riskier investors will look to have a portfolio of more stocks than bonds. On the other hand, a risk-averse (low risk) investor will choose to have a more diversified portfolio of stocks and bonds (for example, 50% stocks & 50% bonds). Overall, the best way to earn solid returns at the lowest risk is to be well diversified and not to have all your “eggs in one basket”. Active investors look to change asset allocations as different business cycles occur. For example, when the economy is booming. Investors look to increase their exposure to stocks as the returns will be higher. However, when the economy is in a recession, investors will look towards safe haven treasuries and bonds to protect their capital.
How Federal Reserve & Reserve Banks Control the Economy
To control interest rates, they both purchase and sell bonds. To reduce the interest rates, The Fed & RBA buys bonds this causes the money supply to increase and therefore the cost of borrowing decreases and therefore encouraging individuals and corporations to spend. Moreover, to increase interest rates, they both sell bonds this decreases the money supply and so on. This is using the law of demand and supply. When the supply decreases the demand for bonds rises (therefore their value) and vice-versa.
In the chart below I will explain the law of supply & demand. When investors move to stocks from bonds, the supply of bonds increases and therefore the price decreases. On the other hand, when investors move from stocks to bonds the supply decreases and the demand increases, therefore, causing a shift which increases the price of bonds.
Lower interest rates encourage the stock prices to rise as bond investors are receiving a lower interest rate return on their investments. Since the main aim for investors is to gain the best return possible they will move to stocks. Secondly, the decreased cost of spending boosts economic growth and in-turn increasing corporate earnings and higher stock prices as individuals and corporations are growing through investment and expenditure.
How can bonds be used to predict the future of the economy?
Bonds can be used for forecasting. Bond yields tell you what investors think the economy will do. Normally, the yields on longer-term bonds are higher than the short-term bonds due to investors expecting a higher return on their money as it is held by the government and corporations for longer. There is a positive relationship between the yield of bonds and the time the loan is going for.
This graph below shows the yield of current U.S Treasures for their corresponding periods.
An inverted yield curve tells us that the economy is about to go into recession. That’s when yields on shorter duration Treasury Bills, are higher than the yields on long-term on Treasurys.
There you go, your first step to understanding the economy and financial markets. Next, we will be highlighting current and forecasted events and how they work to affect our financial markets and potentially where the good investments are hiding. Stay tuned!