Stocks and Bonds Can Have A Complicated Relationship

At a Glance

  • Federal Reserve policy over the last decade has at times thrown off the traditional relationship between equities and treasuries

There has always been a contrasting yet complimentary relationship between U.S. equities and the Bond market, and I believe there always will be.  In addition, one typically leads the other and that leadership continues to be debatable from market cycle to market cycle. Therefore, decades of market cycles have taught us that typically when stock prices go up, bond prices go down.

In other words, bonds and stocks have an inverse relationship.  If someone were fully invested, they would most likely have to sell one in order to buy the other. This periodically can create volatility. The relationship between stocks and bonds can be tumultuous at times but, the two have always found a way to live together.

Risk On, Risk Off

To better understand Treasuries, it is important to recognize that the relationship between treasury prices and yields of treasuries is an inverse one.  When bond prices are falling or going lower, the yield of that associated treasury note/bond is increasing.  From a historical perspective, when an investor sees a plunge in Treasury yields, that has usually signaled distress in the equity market.

When distress in the equity market arises, a “risk-off” environment for equites appears and a sudden yearning for the safe-haven characteristic of U.S. treasuries surfaces.  Investors commonly follow the notion of “risk-on” or “risk-off” and that risk appetite tug-of-war will typically dictate flows in and out of each respective market.

Over the years, an investor generally has witnessed outflows from stocks when equity investors have become cautious or concerned.  Subsequently, we commonly observe inflows into the bond market as investors rush to the perceived notion of safety which is inherent to bonds.  Inflows into the bond market have been classified as “flight-to-quality”. Conversely, to better understand the stock market during times when investors feel comfortable or confident, investors look to the stock market to provide a higher yield or a higher return on investment.

Market Leadership

Now that we have a better understanding of how this unique and inverse relationship routinely works, it is imperative to realize that the exact opposite has occurred on many occasions over recent years; stocks and bonds have risen and fallen in tandem.  This unusual nuance can arguably be attributed to the central bank involvement into the marketplace over the last decade, but this is a current market environment scenario that cannot be ignored.

As a former 30-year bond pit trader in the 1990s, I believe that the bond market typically provides market leadership, and the stock market indeed follows accordingly (at least eventually).  Moreover, when markets are sending mixed signals to investors, I tend to believe in the narrative being told by the bond market more than not.  This can be challenging to investors as this historic relationship has been when stock prices go up, bond prices go down.

Fed Pivot

For example, in the first half of 2019 when stocks rallied off of the carnage endured in Q4 of 2018, investors witnessed the 10-year note drop in yield from nearly 2.6 percent down to roughly 2 percent.  This perplexed investors but, it illuminated the fact that Fed policy was evolving and or pivoting from their previous forecast of rate hikes to a path of potential rate cuts.

The ebb and flow between stocks and bonds will persist.  It is imperative to understand the fundamental nature of this relationship, and it is even more important to grasp the “why” of each specific occurrence.

Jeff Kilburg has 25 years of investment experience and is the CEO of KKM Financial, an investment solutions provider based in Chicago, IL. KKM works with wealth advisors, financial institutions, and family offices globally. Follow Jeff on twitter @JeffKilburg

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