A:

Bonds and stocks compete for investment money at a fundamental level and that suggests that a strengthening equity market would attract funds away from bonds. Facing decreased demand for bonds, sellers would have to lower prices to attract buyers. Based on this theory, the price of bonds would go lower until bond yields rose to a level that was competitive with the risk-adjusted returns found in the stock market.

Even though the actual relationship between bonds and stocks often doesn't fit this simple theory perfectly, it does help to describe the dynamic nature of these investment alternatives.

The Effect of a Bull Market in Stocks on Bonds

In the short run, rising equity values would tend to drive bond prices lower and bond yields higher than they otherwise might have been. However, there are many other variables at play in any given investment market, such as interest rates, inflation, monetary policy, government regulation and overall investor sentiments.

Bull markets tend to be characterized by investor optimism and expectations of future stock price appreciation. This adjusts the risk-return dynamic in the marketplace and often leads to investors and traders becoming relatively less risk-averse. Most bonds (not junk bonds) are a safer investment than most stocks, which means that stocks have to offer a higher return as a premium for increased risk. This is why money leaves equities and goes into the bond market during times of uncertainty. The opposite is often true during a bull market as stocks begin to receive funds at the expense of bonds.

Whether declining bond prices are a positive effect depends on the type of bond investor. Current bondholders with fixed coupons become increasingly harmed by dropping bond prices as their securities approach maturity. Those who are purchasing bonds like dropping bond prices because it means that they will get higher yields.

The Fed and Interest Rates

The interest rate policy of the Federal Reserve (and other central banks for markets outside of the U.S.) must also be considered. The Fed sets short-term interest rates in an effort to affect economic conditions.

If the economy is perceived to be struggling, the Fed may try to force interest rates lower to spur consumption and lending. This causes bond prices to rise. If the strong bull market develops concurrently with strong economic data, however, the Fed may decide to let interest rates rise. This should drive bond prices even lower as yields rise to match interest rates. Fed intervention has a large impact on both stocks and bonds.

Economists and market analysts have ideas about what causes changes in the economy, but the entire system is too interrelated and complicated to predict with certainty what will happen. It may be possible for bond prices to rise while stocks are enjoying a bull market. Investor confidence is never fixed, and the expected outcomes of government or central bank policy may create results that were not anticipated. This is part of why it is difficult to develop effective trading strategies based on macroeconomic factors.

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