Many investors believe bond traders understand the economy better than equity traders. Bond traders pay very close attention to any economic factor that might affect interest rates. Equity traders recognize that changes in bond prices provide a good indication of what bond traders think of the economy. Since equity traders worry about many other factors that might affect the price of any equity, including corporate malfeasance, they tend to depend on bond traders to give them a heads up on economic issues.

In Pictures: Top 6 Uses For Bonds

Since the global bond market is more than twice the size of the world's equity markets, equities traders pay attention to what bond traders see. Bond prices tend to rise and interest rates fall when greater perceived risk looms. Many portfolio managers will move money from stocks to bonds if they see greater risk on the horizon. Transferring cash from stocks to bonds adds to the downward pressure on stock prices. At some point, the bond rally will end and money will flow back to equities. Is the rally in bond prices telling us stock prices will continue down?

Bond Prices Rally, Stocks Fall
The plunge in the markets accompanied the rally in bond prices, as many investors bailed out of stocks seeking safety in bonds, especially Treasuries. Some investors believe bond traders are "smarter" than stock traders, as bond traders focus on the economy and the role of interest rates more closely. But is the rally in bond prices telling us stock prices will continue to fall?

As long as investors fear the risk of a major economic slowdown, they will seek the safety of high-quality bonds and Treasuries. Rather than seek higher yield accompanied with higher risk, they are willing to receive less income in return for lower risk of losing their principal investment. This is what happened in the beginning of April, when high-grade bonds began their rally. Bond investors sought safety, fearing that the Greek credit crisis would become a major meltdown. This fear continues causing the higher volatility in the equity markets that we are experiencing, which increases risk to investors. (For a look into the Greek crisis, check out Greece: By The Numbers.)

High-grade bonds and Treasuries will tend to outperform the move by lower quality bonds when investors are seeking safety. One quick way to view this is to compare the performance of investment-grade corporate bonds with that of high yield corporate bonds. When bond investors believe that the risk trade is ending, they will begin to move their money into higher yielding and riskier debt securities. Until then the equity markets will remain volatile.

Getting Back to Stocks
With all the money that has moved into bonds and out of stocks, you might be wondering how you can tell when to get back into stocks. After all, drops in the market sometimes offer the best buying opportunities, as long as the trend does not continue down. Like so many things, the answer is, it depends. In this case, it depends on bond traders' view of risk. (They may not be sexy, but bonds offer undeniable benefits to investors. For more on bonds, read Savings Bonds For Income And Safety.)

What to Look For
Fear of economic troubles leads bond investors to forsake higher yield for the safety of their principal. As long as they believe the economy is weak and risk of a meltdown remains, they will remain in their safer investments. At some point, the risk of the economy will diminish and we will see demand for low quality bonds rise as investors seek higher yield. This is a signal to equity investors to get back into the market and own stocks.

Get a rundown of the latest financial news in this week's Water Cooler Finance: Buffett Buzz, Toxic CDOs And Facebook Privacy.

Related Articles
  1. Economics

    Why Enron Collapsed

    Enron’s collapse is a classic example of greed gone wrong.
  2. Stock Analysis

    5 Anticipated IPOs that Didn't Make it in 2015

    Pay attention to the IPO stock debt levels. Rising interest rates make debt more expensive. As the novelty of such an IPO stock fades, its price might follow.
  3. Term

    Understanding Treasury Yield

    Treasury yield refers to the return on an investment in a U.S. government debt obligation, such as a bill, note or bond.
  4. Investing Basics

    Corporate Dividend Payouts And the Retention Ratio

    An investor can use dividend payout and retention ratios to gauge an investment’s possible return, and compare it to other stocks.
  5. Entrepreneurship

    4 Signs Your Business is Ready for the Next Stage

    Is your business is ready for the next level? The signs may not be what you think. Structure, processes and mastering your revenue are the keys.
  6. Stock Analysis

    The Biggest Risks of Investing in Advanced Micro Devices Stock (AMD)

    Learn the biggest risks to Advanced Micro Devices stock, and discover the company's biggest competitors and how they threaten its market share.
  7. Investing News

    How Banning Buybacks Would Help the Economy

    Stock buybacks are popular, but they're not helping the economy. Here's what would happen if they were banned.
  8. Bonds & Fixed Income

    Explaining Government Bonds

    A government bond is a debt security a government issues.
  9. Economics

    How Leadership Impacts Investments

    Investors often overlook a company’s leadership when evaluating an opportunity, but it’s an important quality to consider.
  10. Economics

    Explaining Incorporation

    Incorporation is the process of legally becoming an entity that is separate from its owners.
RELATED FAQS
  1. What can working capital be used for?

    Working capital is used to cover all of a company's short-term expenses, including inventory, payments on short-term debt ... Read Full Answer >>
  2. Does working capital include short-term debt?

    Short-term debt is considered part of a company's current liabilities and is included in the calculation of working capital. ... Read Full Answer >>
  3. How do modern companies assess business risk?

    Before a business can assess or mitigate business risk, it must first identify probable or likely risks to its bottom line. ... Read Full Answer >>
  4. Why has emphasis on corporate governance grown in the 21st century?

    Corporate governance refers to operational practices, management protocols, and other governing rules or principles by which ... Read Full Answer >>
  5. What is the difference between the Daily Treasury Long-Term Rates and the Daily Treasury ...

    The daily Treasury long-term rates are the arithmetic mean, or average, of closing bid yields on all outstanding fixed coupon ... Read Full Answer >>
  6. What impact did the Sarbanes-Oxley Act have on corporate governance in the United ...

    After a prolonged period of corporate scandals involving large public companies from 2000 to 2002, the Sarbanes-Oxley Act ... Read Full Answer >>
Hot Definitions
  1. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  2. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  3. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  4. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  5. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center