The Bond and Stock Correlation

Credit markets are not very well understood. In the futures market, these encompass all debt instruments such as Bonds, Notes, and U.S. Treasury Bills, and are not limited to derivatives of debt issued by the U.S. Treasury. Debt instruments can be either long-term obligations or short-term obligations. Short-term debt instruments, both personal and corporate, come in the form of obligations expected to be repaid within one calendar year. Long-term debt instruments are obligations due in one year or more, normally repaid through periodic instalment payments. German treasuries can also be traded in the U.S. on the Eurex exchange. The Bund has the maturity of 10 years, the Boble has 5, and the shortest is the Schatz with 1 year. These government bonds trade on the Eurex market, and they all have their own characteristics. They are each different in terms of liquidity, speed, volatility, but they all tend to move in correlation, one leading the other 2.

It’s good to know about these particular markets in Europe and none are as more important as the Italian, Spanish or Greek debt market. You can easily gather clues as to what will happen in the stock market by understanding how debt instruments work.

The first point about bonds is that Bond prices fluctuate with changing market sentiments and economic environments but in a much different way and from different factors than stocks. Factors such as rising interest rates and economic stimulus policies have an effect on both stocks and bonds, but each reacts in an opposite way. When stocks are on the rise, investors generally move out of bonds and flock to the booming stock market. When the stock market corrects, as it inevitably does, or when severe economic problems ensue, investors seek the safety of bonds. As with any free-market economy, bond prices are affected by supply and demand.

In the chart below, we can see the inverse relationship as the Yellow line representing the S&P 500 futures rally whiles the Black line representing U.S. T-Bond futures declines.

SP500 and U.S. T-Bond Inverse Correlation

In times of uncertainty a majority of people move money into treasury securities and when it comes to conservative investments, nothing says safety of principal like treasury securities. These instruments have stood for decades as a bastion of safety in the turbulence of the investment markets – the last line of defence against any possible loss of principal. The guarantees that stand behind these securities are indeed regarded as one of the key cornerstones of both the domestic and international economy, and they are attractive to both individual and institutional investors for many reasons.

A Treasury Bill, or T-Bill, is short-term debt issued and backed by the full faith and credit of the U.S. government. These debt obligations are issued in maturities of four, 13 and 26 weeks in various denominations as low as $1,000. T-Bills are issued at a discount to the maturity value. Rather than paying a coupon rate of interest, the appreciation between issuance price and maturity price provides the investment return. For example, a 26-week T-bill is priced at $9,800 on issuance to pay $10,000 in six months. No interest payments are made. The investment return comes from the difference between the discounted value originally paid and the amount received back at maturity, or $200 ($10,000 – $9,800). In this case, the T-bill pays a 2.04% interest rate ($200 / $9,800 = 2.04%) for the six-month period.

In the futures market, we trade the notional value of the cash Treasury notes and bonds for which the symbols are (TY) for the 10-year note and (US) for the 30-year bond. U.S Treasury debt is broken into 32 parts; hence, futures prices are quoted in 32nds. That being the case, it would make sense that every tick would be 31.25 ($1000/32=31.25). In the TY (T-Notes), however, they’re broken into half again or 64ths, which makes every tick worth $15.625.

The bond market can be helpful as an odds enhancer in timing turning points in the stock index futures, as was the case recently and most likely will be again in the future.

The conclusion here is that going forward, the stock market will find it hard to move lower if bonds continue their steep decline. The trick is to know when the odds will increase that bonds will stop falling.