Most often, the prices of stocks and interest rate on bonds move in opposite directions. Interest rates are a barometer of business and industrial activities. Rates of interest as offered by a company are also dependent on financial outlook and quality of credit. Prices of equity are straightway connected to the capability of producing profit from the prevailing business environment and improving the possibilities for future. Interest rates of bonds or any other interest that the company needs to pay adds to its expense and thus reduces its profit. It is only under steady economic conditions that there is a convergence of rates of interest and stock prices.
Economic Strength Decides Prices of Bonds and Stocks
When economy is in the process of recovering, prices of stocks are not strong but bond prices are. That is because recovering economy enables the companies to start earning improved profits. Stocks expect a speedier recovery and start moving forward in anticipation of more returns by way of profits whereas bond prices remain low since issuers of bonds have already utilized cash and profits towards payment of debt rather than undertaking any expansion while the recession continued.
Economic Recovery Takes Hold
Prices of bonds are inversely proportional to bond yields. Therefore, with increased economic activity, short term rates go up and yield for intermediary bonds, having a maturity period of seven to ten years, also increases. Since higher yielding bonds are launched, prices of older bonds fall down. Usually, it is during this phase that the stock prices gain the most. This is the time when investors consider stocks to be reasonably priced as by and large public optimism is not high and considers any rally as an opportunity for selling accessible stock positions.
Business cycle keeps going
As the process of business recovery continues, stock prices keep going up while there is a drop in the prices of bonds as investors opt to invest in stocks, offering better returns. Stock prices keep rising even with increased cost of borrowing as cash flow from companies’ profits goes up faster than the added expense due interest. Once inflation starts going up, the prices of long term bonds, having maturity period of twenty years, begin to rise since investors would like to be compensated for higher risks of inflation.
Economic Downturn Approaches
When stock prices are at their peak, due keen expectations of profit, bonds with higher yields seem attractive with stock prices beginning to falter. Investors vary their risks and prefer bonds with strong credits having reduced volatility to generally unpredictable stock markets. Consequently, prices of stocks fall as investors avoid taking risks. There is an increase in the value of bonds since alternating cyclical investments like commodities, sticks and cash lack short term outlooks.