The relationship between bonds and stocks is one of the most important concepts in financial markets. Understanding how these two asset classes interact can help you make better trading decisions, manage risk more effectively, and anticipate major market moves. In this guide, we will explore how bond and stock correlations work and how to use them in your trading.
The Basic Relationship
Traditionally, bonds and stocks have an inverse relationship. When stocks fall, investors seek safety in bonds, pushing bond prices up. When stocks rise, investors move out of bonds to capture equity gains, pushing bond prices down.
Key concept: Bond prices move inversely to interest rates. When yields rise, bond prices fall. When yields fall, bond prices rise. Most discussion of "bonds" in relation to stocks actually refers to interest rates and yields.
Why Interest Rates Matter to Stocks
Interest rates affect stocks through multiple channels:
1. Discount Rate Effect
Stock prices represent the present value of future cash flows. Higher interest rates mean a higher discount rate, which reduces the present value of those future earnings. This hits growth stocks especially hard since more of their value comes from distant future profits.
Example: Discount Rate Impact
A company expected to earn $100 in 10 years:
- At 3% discount rate: Present value = $74.41
- At 5% discount rate: Present value = $61.39
- At 7% discount rate: Present value = $50.83
A 2% increase in rates can reduce the present value of future earnings by 17% or more.
2. Cost of Capital
Higher rates increase borrowing costs for companies. This reduces profits, limits expansion, and can stress highly leveraged businesses. Sectors that rely heavily on debt, like utilities and real estate, are particularly sensitive.
3. Competition for Capital
When bonds offer attractive yields, some investors shift from stocks to bonds. Why take equity risk when you can get 5% guaranteed? This flow of capital out of stocks and into bonds puts downward pressure on stock prices.
The Stock-Bond Correlation is Not Constant
While bonds and stocks often move inversely, this relationship is not fixed. The correlation changes based on market conditions:
- Risk-off periods: Strong negative correlation as investors flee stocks for bond safety
- Inflation concerns: Positive correlation as both stocks and bonds sell off together
- Normal markets: Weak or inconsistent correlation
- Central bank intervention: Correlation can become unpredictable
2022 example: Both stocks and bonds fell sharply as the Fed raised rates to fight inflation. This positive correlation (both falling together) was unusual and caught many investors off guard who expected bonds to provide portfolio protection.
Key Yield Levels to Watch
Certain Treasury yield levels have historically acted as important thresholds for stocks:
- 10-year yield at 4%: Often cited as a level where stocks face headwinds
- 10-year yield at 5%: Historically significant resistance, can trigger corrections
- Rate of change: Rapid yield moves are more disruptive than gradual ones
Example: Yield Thresholds
In October 2023, the 10-year yield touched 5% for the first time in 16 years:
- The S&P 500 dropped about 10% from its July high
- Growth stocks underperformed value stocks
- When yields retreated, stocks rallied strongly into year end
Trading Strategies Using Bond-Stock Correlation
1. Yield as a Leading Indicator
Watch for divergences between yields and stocks. If stocks are rallying but yields are rising sharply, the stock rally may be on borrowed time. Conversely, falling yields often support stock prices.
2. Sector Rotation Based on Rates
Different sectors respond differently to interest rate changes:
- Rising rates favor: Banks (higher net interest margins), insurance companies
- Falling rates favor: Utilities, REITs, dividend stocks, growth stocks
- Rate-sensitive sectors: Homebuilders, autos, any business dependent on financing
3. The 60/40 Portfolio Check
Many investors use a 60% stock, 40% bond allocation expecting bonds to hedge stock risk. When correlation shifts positive (both moving together), this protection breaks down. Monitor correlation to understand your actual portfolio risk.
Tools for Monitoring Bond-Stock Relationships
- TNX: CBOE 10-year Treasury yield index
- TLT: 20+ Year Treasury Bond ETF
- IEF: 7-10 Year Treasury Bond ETF
- HYG: High Yield Corporate Bond ETF
- LQD: Investment Grade Corporate Bond ETF
What to Monitor Daily
- 10-year Treasury yield direction and magnitude of move
- 2-year Treasury yield (more sensitive to Fed policy)
- TLT price action (inverse of long-term yields)
- Credit spreads (HYG vs Treasury yields)
Credit Spreads: A Refinement
Beyond Treasury yields, watch credit spreads (the difference between corporate bond yields and Treasury yields). Widening credit spreads often precede stock market weakness as they indicate growing concern about corporate defaults.
Pro tip: Credit spreads often start widening before stocks peak. They can provide an early warning that risk appetite is declining even while stocks are still near highs.
Track Bond and Stock Correlations
Pro Trader Dashboard helps you monitor the relationship between bonds, yields, and stocks so you can make better-informed trading decisions.
Summary
The bond-stock correlation is a critical concept for any trader or investor. Interest rates affect stocks through discount rates, borrowing costs, and competition for capital. While bonds and stocks often move inversely, this relationship is not constant and can shift during inflationary periods. Monitor Treasury yields, watch for divergences, and adjust your sector exposure based on the rate environment. Understanding this relationship will make you a more complete trader.
Learn more about market relationships in our guides on yield curve trading signals and credit spreads as a market indicator.