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RELATION BETWEEN BONDS, STOCKS, INFLATION
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- Bonds are creditorship securities. Shares are ownership securities.
- Bonds pay regular interest. Shares undergo capital appreciation (or fall) and some dividend (maybe).
- A bond yields a fixed amount that is paid regardless of other conditions, so a decrease in inflation raises the real yield of the bond. That makes bonds more attractive to investors, so bond prices rise. Higher bond prices mean lower nominal yields. (prices and yields move inversely)
- Bond yields are based on expectations of inflation, economic growth, default probabilities, and duration.
- Lower expectations for growth and for lower inflation mean that bond yields will remain low. Higher growth will lead to slightly higher interest rates and bond yields. Constantly low bond yields do not mean that yields remain at the same low level.
- During periods of economic expansion, bond prices and the stock market move in opposite directions because they are competing for capital.
- Selling in the stock market leads to higher bond prices and lower yields as money moves into the bond market. So more people trying to buy bonds, so prices rise (and yields fall). If fewer people buy bonds, prices do not rise as much, yields do not fall as much.
- Stock market rallies tend to raise bond yields as money moves from the safety of the bond market to riskier stocks.
- When optimism about the economy increases, investors transfer funds into the stock market because it benefits more from economic growth.
- Economic growth carries with it inflation risk, which erodes the value of bonds.
- Interest rates determine bond yields, and play a big role in the stock market. Bonds and stocks tend to move together right after a recession, when inflationary pressures and interest rates are low.
- So, lower bond yields = Higher stock prices.
- Central banks (e.g. RBI, US Fed) are committed to low interest rates to stimulate the economy during recessions. This lasts until the economy begins to grow without the aid of monetary policy or capacity utilization reaches maximum levels where inflation becomes a threat.
- Bond prices and stock prices both move up in response to the combination of mild economic growth and low interest rates.
- When bond yields go up, it is a signal that corporates will have to pay a higher interest cost on debt. As debt servicing cost goes higher, the risk of bankruptcy and default also increases and this typically makes mid-cap and highly leveraged companies vulnerable. So stocks will drop.
- So, equity markets normally move negatively with bond yields. As bond yields go down, the equity markets outperform by a bigger margin and as bond yields go up equity markets tend to falter.
- Bond yields represent the opportunity cost of investing in equities.
- For example, if the 10 year bond is yielding 7% per annum then the equity markets will be attractive if they can earn above 7%. Now equity being risky carries a risk premium, to be even comparable. If the risk premium on equities is 5%, then that 12% will act as the opportunity cost for equity. Below 12%, it does not make sense for the investor to take the risk of investing in equities.
- Whenever interest rates are cut by the RBI, it is positive for stocks. Why? The yield on bonds is normally used as the risk-free rate when calculating cost of capital. When bond yields go up then the cost of capital goes up, so share prices and valuations reduce (drop).
- Deflation is generally going to push the stock market down, as poor growth potential in stocks means that it is unlikely they will increase in value.
- Bond prices, on the other hand, will likely move higher to reflect falling interest rates (i.e., interest rates and bond prices move in opposite directions). Therefore, we must be aware of inflationary and deflationary environments in order to determine the resulting correlations between bonds and stocks.
- Bonds and foreigners: When bond yields in India go up, global investors (FPIs) find Indian debt more attractive in relation to global debt. This leads to capital outflows from equities and inflows into debt. So FPIs look at Indian equity and debt as competing asset classes and allocate according to relative yields.
- How do commodities, bonds, stocks and currencies interact?
- As commodity prices rise, the cost of goods moves upward. This increasing price action is inflationary, and interest rates also rise to reflect the growing inflation. So, bond prices fall as interest rates rise since there is an inverse relationship between interest rates and bond prices. Now, bond prices and stocks are generally correlated to one another. When bond prices begin to fall, stocks will eventually follow suit and head down as well. As borrowing becomes more expensive and the cost of doing business rises due to inflation, companies (stocks) will not do as well. We will surely see a lag between bond prices falling and the resulting stock market decline.
- Impact of currency
- Currency has an impact on all markets, but the main one is on commodity prices. These also affect bonds and stocks, while the U.S. dollar and commodity prices generally trend in opposite directions. As the dollar declines relative to other currencies, the reaction can be seen in commodity prices (which are based in U.S. dollars).
- Learnings
- During periods of economic expansion, bond prices and the stock market move in opposite directions because they are competing for capital.
- Bonds and stocks tend to move together right after a recession, when inflationary pressures and interest rates are low.
- Investors naturally demand higher yields from organizations that are more likely to default.
- Defaults and Bonds
- The chance of default plays a part in bond yields. When a government (or corporation) cannot afford to make bond payments, it defaults on the bonds. Investors demand higher yields from organizations that are more likely to default (why should we trust you? pay more interest first). Central government bonds are generally considered to be free of default risk in a fiat money system. When corporate bond default risk increases, many investors move out of corporate bonds and into the safety of government bonds. That means corporate bond prices fall, so corporate bond yields rise.
- High-yield (or junk bonds) have the highest default risk, and default expectations have more influence on their prices. During the 2008 financial crisis, default expectations for many companies rose significantly. As a result, corporate bonds temporarily offered higher yields.
- The 2021 situation
- Financial markets reflect the view that inflation will remain low. Nominal bond yields are negative in much of Europe and barely positive in America. In stockmarkets, there has been a sharp divide.
- Companies that do well in disinflationary environments (technology, branded goods) are expensive; businesses that might do better in inflationary ones (commodities, real-estate and banking) have generally lagged behind. The immediate prospect is indeed for an excess of supply.
- The unemployment rate in America is close to 15%. Inflation is already falling. Further out, though, the outlook for inflation is murkier. There is no shortage of pundits who say it is primed to pick up. Why so? Globalisation, a key reason for the secular decline in inflation, is reversing. Big companies are likely to emerge from the crisis with more pricing power. The rise of populism in rich countries is hard to square with endlessly low inflation.
- Fiscal stimulus is in favour. The more government debt piles up, the greater the temptation to try to inflate it away.
- In principle, equities are a good hedge against inflation. Business revenues should track consumer prices; and shares are claims on that revenue. In some cases, they may be the only available hedge. Iran, for instance, has had one of the better performing stockmarkets, because locals have sought protection from inflation. Sanctions make it dangerous to keep money offshore.
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