Stocks and bonds as signalsWhere big money shows what it expects next.
Stock and bond prices are built on expectations. Read them well and they tell you what the market expects from growth, interest rates and inflation, often before the central bank acts.
Stocks price the future
A share is a part of a company, and its price comes from supply and demand on the stock exchange. Multiply the number of shares by the share price and you get the company’s market value, its market capitalisation. That value rests mainly on what the market expects the company to earn in future, which is why it can swing a lot.
Those expectations depend on 2 forces. The first is the money supply. When rates fall and money is printed, companies can finance themselves more cheaply, profits should rise and share prices go up. The second is growth. If the market does not expect the economy to grow, it expects profits to fall, and nobody wants to own a company that will earn less. So stocks fall when growth stalls or central banks pull money out.
The S&P 500 sets the pace
A stock index bundles many companies into one number and shows how a whole market is doing. In developed markets the key indexes are the S&P 500 in the US, the Euro Stoxx 50, which holds the 50 largest companies of the eurozone, and the Nikkei in Japan. Among emerging markets, traders watch Brazil’s Bovespa, Korea’s Kospi and the Shanghai Composite in China.
The S&P 500, 500 of the largest US companies by market value, is the most important index in the world, and it sets the pace for all the others. If it falls 2% in a day, the German DAX is usually sharply lower too, and emerging markets tend to follow. The Bovespa and the Shanghai index contain many banks and commodity companies, so they also depend on commodity prices and global growth, and they swing more.
Bonds: where rates are priced first
A bond is a loan to a government or a company. The buyer receives interest and, at the end, the money back. The bond market is bigger than the stock market, and government bonds make up the largest part of it. Everything in it revolves around interest rates and the money supply, which is why it is often called the lifeblood of the capital markets.
Bond prices and yields move in opposite directions. When market rates fall, newly issued bonds pay less, so existing bonds with their higher interest become more attractive and their prices rise. When rates rise, new bonds pay more and existing ones lose value. A rising yield and a falling bond price are the same event, seen from 2 sides.
Central banks have become the dominant buyer of government bonds. When they buy through QE, prices rise and yields fall, as the lesson on quantitative easing showed.
Short yields, long yields and risk
What makes bonds so useful to a trader is what they reveal about expectations, and the maturity tells you which expectation you are looking at. Short-term government bonds, with 2 or 5 years to run, react most to central bank policy. If their yields fall, the market expects rate cuts. If they rise, it expects hikes.
Long-term bonds, with 10 or 30 years to run, react to inflation expectations. If their yields rise, the market expects inflation to rise. If they fall, it expects inflation to ease. So the 2-year yield is the market’s forecast for the central bank, and the 10-year yield its forecast for inflation.
The third signal is risk. A high yield on a country’s bonds means investors demand more interest because they see a greater risk of not being paid back. Rating agencies such as Standard & Poor’s and Moody’s grade that risk, and when a rating falls, the yield rises. Brazil was cut to junk status at the end of 2015, partly because commodity prices had slumped. When commodities recovered in early 2016, its bond yields began to fall again.
| Signal | Tells you | How to read it |
|---|---|---|
| 2 and 5 year yields | Where rates are heading | Falling: cuts expected. Rising: hikes. |
| 10 and 30 year yields | Where inflation is heading | Rising: more inflation expected. |
| Stocks, led by the S&P 500 | What companies will earn | Rise on cheap money and growth. |
| A high bond yield | The risk of default | Check the credit rating. |
Read the bonds before you trade
Compare the 2-year yield with the current key rate. If it has dropped well below it, the market is already pricing cuts, and a bank that only holds can surprise in the other direction.
A sudden rise in one country’s long-term yields while its neighbours stay calm can be a sign of worries about repayment. Check the news and the rating before you trade its currency or its stock market.
In short
- Stocks price expected earnings: they rise on cheap money and growth, fall when growth stalls or money is drained, and the S&P 500 sets the pace.
- Bond prices and yields move in opposite directions, and the bond market prices interest rates and the money supply first.
- 2 and 5 year yields show rate expectations, 10 and 30 year yields inflation expectations, and a high yield can warn of repayment risk.
Questions
Do I need to trade bonds to use this?
No. Most traders never buy a bond. They read yields as the market’s forecast for rates and inflation, and use that to judge currencies and stocks.
Key terms
- Bond yield
- The return an investor earns on a bond. Yields rise when bond prices fall. Short-term yields follow rate expectations, long-term yields follow inflation and growth.
- Credit rating
- A grade from an agency such as S&P or Moody’s that rates how likely a country or company is to repay its debt.
- Money supply
- The total amount of money in an economy. More money chasing the same goods tends to push prices up.
- Inflation
- The rate at which prices rise. Central banks usually aim for about 2% a year.
- Key interest rate
- The rate a central bank sets for lending to banks. It drives borrowing costs across the economy and is one of the biggest drivers of a currency.