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Apr 25, 2018

Bond Market vs. Stock Market: How Are They Connected?

By Team Stash

Fact: The U.S. bond market is worth around $40 trillion, and is actually much larger than the stock market.

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On Tuesday, the stock market had a wild ride. Key indexes fell, including the Dow, which dropped more than 400 points in response to news that the yield on a type of bond called the 10-year Treasury rose to 3%.

You may wonder what the bond market has to do with stocks, and why the two seem so interconnected.

When yields for bonds increase, it can make bonds appealing to investors. So investors may sell their stock holdings and purchase bonds, which are generally considered safer investments.

Confused? Read on, and we’ll explain.

What are bonds?

Something called the capital markets are where companies and governments go to raise money. The two key components of the capital markets are stocks, also known as equities, and bonds.

Whereas stocks are small shares of ownership that investors can buy and sell, bonds are a form of debt issued by a company or government.

Both stocks and bonds are used to finance operations for businesses and governments.

While stocks typically get all of the attention because they have the potential to earn large amounts of money, the bond market is actually much larger than the stock market, worth about $40 trillion in the U.S., according to research.

What do bonds do?

Bonds pay an interest rate, but they also have a price. The interest rate a bond pays is fixed, meaning it never changes. The price of a bond fluctuates, however, meaning it can rise and fall depending on what’s happening with interest rates and the economy.

Combined, a bond’s interest rate and price equal the bond’s yield, which is the return it pays an investor.

Here’s where it gets a little more complex. Typically, when interest rates increase, the price of existing bonds fall. Generally speaking, that’s because the interest rate for new bonds issued will be higher than those paid by existing bonds.

Prices for existing bonds with lower interest rates will tend to fall to make them more appealing to investors.

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Today’s interest rate environment

Something called the Federal Reserve (the Fed), which is the central bank of the U.S., has been steadily increasing a key interest rate, called the federal funds rate, which underpins numerous other interest rates, including credit card rates, car loans, and mortgages.

The reasons for the increases are also complex, and they are rooted in the financial crisis that began in 2008. At that time, the Fed lowered its benchmark interest rate to 0% in response to the crisis, as way to help the economy recover. As the economy has strengthened, however, the Fed has begun increasing interest rates. In fact, it has raised interest rates four times since 2017.

As the Fed increases its benchmark interest rate, that’s caused a ripple effect with other interest rates, including in the bond market.

What’s a Treasury?

The U.S. government issues notes and bonds called Treasuries, which have varying lengths of time to maturity, ranging from months to 30 years.

The 10-year Treasury is considered the benchmark bond issued by the U.S. government, and its rate tends to be reflected in other interest rates. The federal government has issued trillions of dollars worth of 10-year Treasuries, which it uses to finance its operations. Treasuries are considered among the safest bond investments, because they are backed by U.S. government.

As the Fed has raised interest rates, the ripple effect has also hit Treasuries. In fact, this is the first time the 10-year Treasury yield has hit 3% since 2014, according to the Wall Street Journal.

So are rising yields on Treasuries good?

Increasing yields for the 10-year Treasury are, generally speaking, a sign of economic strength according to numerous experts.

So then why are higher bond yields sending the markets down?

Higher yields for Treasury bonds indicate that interest rates in the debt market, in general, are going up.

Just like interest rates on your credit card or mortgage, higher interest rates in the debt market suggest it will be more expensive for businesses to borrow. And businesses often need to borrow to fund their operations, and to grow.

But higher borrowing costs can hamper corporate earnings, and even just the anticipation of that can send equity markets down.

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