The Relationship Between Stocks and Bonds
One recent development is that the movement between stocks and bonds has changed over the past month. Over much of the time period since 2000 the value of stocks and bonds tended to move in opposite directions.
Recently on days interest rates are rising or the bond market is going down, stocks are also declining.
Likewise on days when interest rates are falling the stock market is generally rising. If this change persists it will be more consistent with much of the time period we saw in the 1970s, 80s and 90s.
While price movement in the past month may seem surprising, it might be argued that the past 10 years was an unusual period. In finance theory when interest rates fall the value of an asset, such as stocks or real estate should rise assuming everything else is equal.
The reason this relationship broke down over the past 10 years was that falling interest rates were perceived to reflect an economy that was in trouble.
Because interest rates were so low, a further decline did not offer any real benefit to the stock market. When interest rates rose there was the perception that the economy was improving, so the stock market advanced.
Holding both stocks and bonds was a good way to reduce risk over the past 10 years, since the two assets tended to move in the opposite direction. In general stocks and bonds move in opposite directions when the economy is weak, and together with a stronger economy.
Ten-year Treasurys are now around 2.5 percent, after being at 2.0 percent or lower for the past several years. This percent is still a very low interest rate, so I believe interest rates would need to rise at least another percentage point before having much of a negative impact on the market.
Assuming that the economy continues to heal I would not expect the stock market to revert to the period of having strong days when interest rates are rising.
My best guess is that the stock market eventually starts to act more independent from the bond market. That is, the stock market could do well, irrespective of the direction of the bond market.
Certainly if interest rates rise significantly or there is a return to higher inflation that would be bad for stocks.
However, I believe the recent shift in the relation between bonds and stocks reflects a potential change in Fed policy, and is a short-term adjustment.
Going forward a balanced portfolio between stocks and bonds may not reduce risk as much as it has over the past 10 years.
Still, I would not expect bonds and stocks to necessarily move in the same direction like they have over the past month. Therefore, having a balanced portfolio is still appropriate.
While interest rates are clearly higher than they have been, they are still quite low. With this the case I would still keep a bond portfolio relatively short, since I would expect rates to continue to rise over the next year.
When rates return to a more normal level that would be a better opportunity to invest in somewhat longer-term bonds.
In a 401(k) plan an investor may only have one type of bond fund to invest in. This would most likely be an intermediate term fund. Because interest rates are likely to continue to rise, there would be some price risk with this type of fund.
Therefore, I would not invest too much in a bond fund at the present time. A stable value fund or money market account would be a less risky alternative to bonds