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Last Updated : Oct 03, 2016 05:13 PM IST | Source: Moneycontrol.com

Why an equity investor should track bond markets?

Bond market affects almost everything under the sun. Bond markets are the fundamental base for all markets.

Vikas Singhania
Trade Smart Online

Globalisation of economies has made flow of money seamless between various countries. Technological developments in the finance space have resulting money moving from one continent to another at the click of the button. But the moot point is why money hops from one place to another. The money we are talking of is the one which is available for investment in the financial market. It flows to countries where it can sense the chance of earning highest incremental money.

Not only countries but money will also move between asset classes in search of higher returns. But since this money is supposedly managed by cautious fund managers, they would like to protect their capital. The trade-off then is between safety and returns, what in financial jargon is called a risk-reward trade-off. Safety comes at the cost of returns and vice-versa.

The various choices of financial instruments available which can give returns, either through capital appreciation or interest are currencies, bonds, equities, commodities, precious metals and REIT among many others, where the underlying assets represents value and to some extent is a store for value.
But the one underlying current that connects all asset classes is the bond market. Probably the oldest financial instrument it is also the widest, deepest and biggest. In his epic book ‘Ascent of Money’ Niall Ferguson informs how bond markets have been instrumental in changing the course of history of the world repeatedly over the years.

US ex-President Bill Clinton’s election strategist James Carville highlights the importance of bond market in his famous quotes “I used to think if there was reincarnation, I wanted to come back as The President or the Pope or a 0.400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.’

Bond market affects almost everything under the sun. Bond markets are the fundamental base for all markets. From cost of production to purchasing power of an individual, it is like the omnipresent monetary factor which controls everything that has a price or is affected by price. Equity markets are no different. Bond markets affect the stock markets in many ways. In its most basic form the relationship between the two is that bonds and equities do not move in tandem. A rising bond market is bad for equities and a rising equity market is a time to sell the bonds.

Bonds are basically loans that government takes from individuals, corporates, banks and almost any entity that is willing to lend to the government. But the relationship between government bond (bonds are also issued by municipals, state governments and corporates) and interest rates is not simple.

Government uses the bond markets as an instrument to influence interest rates, inflation and growth in the economy. Thus if the government wants to see growth in the economy they would have to bring down interest rates which will bring down cost of production and enthuse consumer to buy rather than save. Mortgage products like houses, electronics and other non-consumables receive a boost in a falling interest rate scenario.

Growth is the fuel on which equity markets run. Further, lower interest rates would also mean ability to raising money at a lower rate, which can be used by traders and investor to indulge in the equity market. In case if the market is overheated, one of the best instruments that central bankers use is to start increasing interest rates. Most market bubbles have been blown when central bankers started raising interest rates which caused money to flow back from equity markets to safer shores of the bond market.

Like a driver who keeps a frequent watch on the rear view mirror, an equity investor needs to keep his eye on the bond market. There is a tipping point at which money moves out of bond market to equities. This happens when the interest rates offered by bonds are so low that it makes sense to invest in equities. This happens near the bottom of a market, when smart investors start picking up high dividend yield stocks.  

There is also another point when money moves out of bonds to equities; this is when the equity yield nears the long term bond yield. In India the long term bond yield is around 8 per cent, thus when the equity yield, measured as earnings to price ratio or inverse of the commonly used P/E ratio, nears the bond yield money flows into equity. It is no surprise that the lower valuation band of the Indian stock market is around the 12.5 per cent (1/8*100 where 8 is the long term interest rate) mark.

While the thumb rule says that bond and equity markets move in opposite directions, there are periods when they move together. This happens near the tops and bottoms of the equity market. In an overheated equity market, interest rates rise (making bond prices to fall) on account of central bank interference, which later causes the equity market to fall as money is pulled out.

During market bottoms inflationary pressures are weak and central banks want to pump up the economy by reducing interest rates, thus increasing bond prices. Smart investors start using the opportunity to invest money in the markets, taking the equity markets higher. While in the top and bottom of the stock market the bond and equities move in tandem, but for most part of the move they are moving in opposite direction.

For an equity investor, it will be difficult to identify the top of the market in the prevailing euphoria. One should also notice that the market has bottomed out in absence of investors. But a look at the bond market will easily help him identify the turns. Getting the trend right is a major battle victory in investing.
First Published on Oct 3, 2016 04:46 pm