Why Do Bond Markets Matter to the Stock Market?

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Why Do Bond Markets Matter to the Stock Market?

After 10 consecutive months of gains, the Australian share market declined in September, heralding a period of volatility that continues today. There is never a single catalyst driving markets, instead there’s a confluence of views that tend to drive either positive or negative momentum. But in this most recent period of volatility there has been one factor receiving the bulk of the finger pointing, and that is the bond market. To be specific, it is rising yields and falling bond prices.

So this week I wanted to discuss why it is that bond markets can have such a strong influence on the stock market. What it is that drives bond market shifts. And do some crystal ball gazing as to how this relationship might unfold in the months and years ahead.

How Bond Prices Work

The first key thing to get your head around when thinking about bonds is the relationship between the bond price and the bond yield. Put simply, they move in opposite directions. Think about a bond as having a maturity value of $100. That is to say the investor that holds that bond will receive $100 when it matures. If the current market interest rate was 2%, then one year away from maturity the appropriate price for that bond would be $98. The price therefore is the $100 maturity minus whatever the interest rate is. If the interest rate rose to 4%, then the appropriate price would fall to $96.

Now this is greatly simplified and the math nerds will note that 2% on $98 doesn’t get you to exactly $100. But it’s close enough to explain the relationship. As interest rates, referred to as yields in the bond world, rise, bond prices fall.

Another way to think about this relationship is through logic. Let’s say you buy a bond that has 10 years until it matures. You bought it with a yield of 2% per year. If interest rates rise so that new bonds being issued a paying 3% per year, then if you wanted to sell your 2% yielding bond, the only way someone is going to buy it is if you offer to sell it at a discount. Why would anyone want to buy your bond paying 2% when they could purchase brand new bonds paying 3%? So rising interest rates has caused you a loss on the value of your bonds. Now of course you don’t need to sell your bond, you can retain it all the way through until it matures in which case you will get the full maturity value. But the problem is that through the duration of that bond you will continue to get less than the current going interest rate.

The essential takeaway at this point – bond prices move in the opposite direction to interest rates.

What Drives Bond Prices

Okay, so you know that interest rates and bond prices are fundamentally linked. Opposite sides of the same coin. What drives bond prices to move?

Central banks change interest rates infrequently. The Reserve Bank of Australia can go years without making a change. Indeed at present they have indicated they don’t expect to change rates until at least 2024. Yet even in this absence of official interest rate changes, bond prices move about. So what’s going on?

Bond markets are reflecting expectations of future interest rates. They are not super useful in helping us understand with any precision what future interest rates might be, but they are very helpful in indicating the direction in which interest rates are likely to shift. So when bond prices fall, as they have been doing recently, that tells us the bond market expects interest rates to rise in the future. Now why do interest rates rise? They rise because of strong economic growth, causing central banks like our Reserve Bank to raise official interest rates. Initially those raised rates will simply be to unwind the current extremely low rates that were put in place to offset the potential damage of the COVID pandemic. Once they are able to return rates to some sort of neutral setting, there is the potential for them to raise rates further as a way to slow the economy and attempt to avoid a large boom then bust cycle.

So the bond market, and bond prices are essentially I live poll of financial market participants, guesstimating where they think interest rates will go in the future.

 

Why do Bonds influence the Stock Market

Armed with this understanding of the driver of bond markets I’m sure you can start to see why they have such an influence on the stock market. Higher interest rates will hurt businesses who carry debt, and make the cost of future funding to generate growth more expensive.

But there are other reasons why bond market gyrations impact the stock market.

The first is the potential for investment substitution. In recent years as interest rates fell to previously unimaginable lows, it’s been challenging for investors to hold bonds because the return they received was so meagre. This has undoubtedly pushed some investors who would ordinarily hold savings in bonds, to migrate that cash into the stock market for the higher returns available. At a granular level, here in Australia that might mean bond investors purchasing stocks like Commonwealth Bank and Woolworths which have a history of reliable dividend income streams. In the US the big tech companies like Apple and Microsoft have served a similar role.

But if interest rates start to rise, bonds will become more attractive again as a place for investors to place their savings. This would necessitate a rotation out of stocks, and of course stock prices, like every market price, are determined by the balance between buyers and sellers. If there are more buyers than sellers then the price goes up, but in reverse if there are more sellers than buyers the price will fall. So here, investors who were somewhat reluctantly forced into buying stocks because bond yields were inadequate to meet their requirements, could form a wave of sellers as they flock back to bonds when yields recover. Not good for stocks.

The other impact of rising bond yields is a little technical but relates to the way professional investors value stocks. This valuation approach is known as the discount cash flow valuation methodology. Investors form a view on the likely future profits or dividend income of a business and then ascribe a current value to that cash flow stream. A key input when doing these calculations is the risk free interest rate. The lower the risk free interest rate, the higher valuation you will get on future cashflows. Inversely, a higher risk free rate makes those future cashflows worth less.

These calculations can have particularly large impacts on companies with expected high levels of growth way out into the future. In a low interest rate world, investors are prepared to pay more for these stocks and be patient waiting for those future profits to arrive. But in a higher interest rate world, there is more of a cost to the investor for sitting in these stocks and waiting for them to produce future profits. The investor’s savings could have been sitting in a bond and getting that interest rate instead of sitting in the stock and hoping that the future growth materialises. This is why companies priced highly for future growth, such as the video conferencing solution Zoom that most of us have used over the last 18 months or so, have seen their share price more than halve from its peak.

What is the outlook?

Where to from here? I think we should all hope for interest rates to rise and bond prices to fall over the next year or two. That’s not to say we want big shifts, but interest rates have been at extreme lows, and it would be a positive sign if they were to return to more normal levels.

It does appear as though the world is learning to live with COVID so this would seem to set the scene for a normalisation of interest rates.

As I have already explained, rising bond rates in and of themselves, are a negative for stock markets. But there is another element here that needs to be considered. Our markets are pricing in higher interest rates because they anticipate strong economic growth. And strong growth is good for companies on the stock market. The reason we have seen increased volatility on stock markets recently is this push and pull between the negative consequences of higher bond yields on stock prices, versus the positive impact on stock prices due to the underlying reason for the higher bond yields, being a robust economic environment.

Stock markets are good at pricing the future. If the bond market is right, and the future is one of strong economic growth, then my 20+ years of investment market experience suggests that the stock market will ultimately adopt a positive stance and continue it’s long term upward trend.

 

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