It's a general rule of thumb that stocks and bonds move in the same direction. While that hasn't always been the case, it has been the general trend of the market since the late 1990s.
It's when this correlation breaks down that investors start to grow concerned. That's because, when stocks and bonds move in opposite directions, it is often a sign that change is coming to the market. Here's a closer look at why this occurs and what that means for investors.
When bonds fall, but stocks rise
Stocks tend to rise when the economy is either doing well or starting to show signs of improvement. That's partially because profits are increasing, which leads to a higher valuation for stocks. However, rising profits can also lead to increased inflation. It's that increased inflation that can cause bond prices to fall when inflation forces the Federal Reserve to step in to try and slow the inflation rate by raising interest rates. Rising rates makes it costlier for companies to borrow money because they need to pay a higher interest rate when they issue new bonds. This impacts the bond market because these new bonds then push down the prices of lower-yielding existing bonds, which increases the rate of those bonds to match the rates of the new bonds. However, as long as profits are increasing, stocks could keep going up, while bonds could continue to fall even while rates are being lowered.
When bonds rise, but stocks fall
While stocks can fall for any number of reasons, they typically fall because the economy is either slowing down, or the market is worried that the economy might slow down. It's that second scenario that tends to lead to rising bond prices and falling stock prices because investors flee stocks and buy bonds, which are thought to be a safe haven. This will lead to falling interest rates, which are the result of rising bond prices.
Another scenario where bonds rise but stocks fall is when the Federal Reserve is lowering interest rates. This tends to be when the economy is either in recession or heading there. This causes existing bond prices to rise so that the yields fall to match those of newly issued bonds. It's a tool the Fed uses to spur investment, which should lead to higher profits and eventually higher stock prices.
Why this matters to investors
The reason why investors like to know when stock and bond prices are moving in opposite directions is because it can often be a leading indicator that change is on the horizon. For example, rising bond prices can be a signal that investors are growing scared, either of macroeconomic numbers or the stock market's valuation. As such, a breakdown in their correlation can hint that the market might be heading for a rough patch.
If you're reading this article because you're interested in having a balanced portfolio of stocks and bonds, visit our brokerage center to see what options you have.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!