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Trading bond options can also be quite lucrative if you pay close attention to interest rates and inflationA Short Course in Economic Analyses The global financial marketplace strikes a delicate balance between a vast network of business interests. Fascinating events in one area of the global economy, such as energy prices, can trigger a reaction in other markets, like bonds, and the ripple effect can spread to other commodities and stocks. With technology helping to speed up the decisionmaking process and allowing traders to execute trades at the speed of light, capital can and often does shift from one countrys financial markets to the next. All of this movement in money and investments securities is often based on international events, the global economy, and the outlook for various financial markets around the world. Understanding the relationship among stocks, bonds, and economic events helps traders to obtain a better understanding of what is happening in the world, the daily movements in the financial markets as well as the long-term trends. This type of broad market analysis allows us to better understand the risk-reward profiles of various directional trades before we actually put money on the line and pull the trigger. This chapter seeks to assess the general behavior of and interrelationships among stocks, bonds, and interest rates and how various economic conditions impact all three. Historically, two factors have caused the stock market to crash: war and long-term interest rates. If bond prices drop too much, interest rates can climb too high because there is an inverse relationship between bonds and interest rates, or yields. If so, it can devastate the stock market. A 7.5 percent yield on the benchmark long-term Treasury bond has been a catalyst for a decline in the stock market, because it creates competition for investor money. For example, if bonds offer an attractive yield, a large institution might change its asset allocation from 60 percent of the money invested in stocks and 40 percent in bonds to 60 percent in bonds and 40 percent in shares. In addition, when bond yields go up, companies have to pay more to borrow from banks, which hurts their profits. As a result, the stock market is affected. In addition to bond yield concerns, investors also worry about the earnings of a company. If earnings are better than expected, they can override rising bond yields, which can cause stocks to go up. When stocks arent focused on earnings, which are released quarterly, they sometimes focus on bond yields. These interrelationships are both dynamic and constantly evolving. Here are 11 salient relationships I look for when developing a broad market analysis: 1.Lower bond rates help companies make more profits.2.Short covering in the bond market can boost the Dow Jones IndustrialAverage. 3. Falling bond yields can contribute to strength in financial stocks. 4. Bond yields follow the economy. If the economic indicators are com ing in strong, bond yields will rise; if they are coming in weak, bond yields will fall. 5. Inflation is not only the enemy of the bond marketits also the en emy of the stock market because a rise in prices affects corporate profits. 6.Shares are driven by corporate profits, and profits are driven by ahealthy economy with low inflation. 7. The inflation reports such as the Producer Price Index and the Con sumer Price Index will affect both stocks and bonds the same way. 8. With steady economic growth, stocks can increase even if earnings arent outstanding. 9. When the Fed hikes interest rates, this can cause the yield on the long bond to increase, which will create competition for shares. 10. If the Fed raises rates too high, this can cause a recession and can re duce inflation, during which time, bonds, and interest rate-sensitive stocks will rise. 11. When the dollar is strong, U.S. exports cost more; as the dollar falls, import prices rise, which is inflationary. If some of these relationships do not hold, then it behooves the trader to analyze the reasons for this divergence and look for opportunities to make money under the circumstances. Dissecting these 11 factors will give the trader a good feel for the current environment as we develop our broad market analysis scenario, which is always an excellent first step before implementing a particular directional strategy at the micro level. INTEREST RATES, BONDS, AND STOCKS Forecasting market direction is never a sure thing. Luckily, there are a few economic interrelationships that can help you to make consistent profits. One of the most important of these is the relationship between interest rates and bond prices. The following table illustrates the typical interrelationship of the change in interest rates to the price of a bond and the subsequent effect on the stock market. Although these relationships are relatively stable, occasionally there are deviations from typical economic behavior, referred to as divergences. This table, however, illustrates the normal expected action based on eco nomic theory. A bond is a debt instrument sold by governments or corporations to raise money for various reasons. The bond most widely considered by investors and traders is the 30-year Treasury bond. It has a corresponding futures contract that is traded at the Chicago Board of Trade and reflects one very important aspect of many Americans lives: mortgage interest rates. Bonds are rarely held by the same buyer until maturity. Instead, they are traded at a price that fluctuates according to interest rates and inflation. Since a bonds interest rate stays the same until maturity, its real value at maturity depends on inflations actual value of the dollars at repayment. In general, interest rates are also tied to inflation. According to economic theory, if interest rates go up, bond prices go down; and if interest rates go down, bond prices rise. Why does this inverse relationship hold true? Lets say that you decide you are going to lend me $1,000 for a five-year period. I agree to pay you interest at a rate of 8 percent each year, which happens to be the market rate for interest charges. Therefore, I will pay you $80 per year interest. The very next day, interest rates jump to 10 percent. Now you could lend $1,000 and receive 10 percent interest, which would bring in $100 per year, but you have lost the opportunity of lending that first $1,000 at the higher rate of interest. Did the value of the first loan go up or down with the rise in interest rates? The first loans value went down. If you want to sell that 8 percent loan as an investment to someone else, you will find that its value has decreased. A loan with a 10 percent interest rate has a greater value than one with 8 percent. Therefore, when interest rates go up, bond (loan) prices fall. Lets examine the converse situation: When interest rates go down, bond prices rise. If interest rates drop from 8 percent to 5 percent, an investor could receive only $50 on the $1,000 investment. A previous loan with an 8 percent interest rate would now increase in value, because it would make the investor $80 a year instead of just $50. In general, fluctuations in interest rates stimulate the bond market. Trading bond options can also be quite lucrative if you pay close attention to interest rates and inflation. It is also a good practice to monitor certain bond markets yield to maturity. This measurement predicts a bonds return over time by assessing its interest rate, price, par value, and time until maturity. To access this information, please consult our web site at www.optionetics.com. In general terms, the same inverse relationship exists between interest rates and shares as between interest rates and bond prices. Thus, bond prices and the stock market usually move in the same direction. Assume your company has to buy $10,000 worth of equipment. You dont want to pay cash for the equipment; therefore, you have to finance the purchase. In this case, you will pay 8 percent interest$800 per year. Interest is an expense that gets subtracted from what you earn. Therefore, if you earn $20,000 before interest, you will have earned $19,200 after interest is paid. If the interest rate were 10 percent for the same $10,000 loan you would pay $1,000 per year and your earnings would drop to $19,000 after you subtracted interest. Once again, we see an inverse relationship, this time between interest rates and earningsthe higher your interest rate, the less money flows to your earnings. If your company has reduced its earnings due to a higher interest expense, then your companys value decreases. This affects your companys stock price. Therefore, an interest rate increase (bond prices fall) usually decreases stock prices. This inverse relationship does not always hold. There are periods when a divergence will occur and a companys earnings will increase regardless of whether interest rates go up or down. However, these divergences are generally short-term in nature. You can usually count on the market coming back, reacting to the change in interest rates. If you watch the day-to-day price changes in the stock market, you may find that investors and traders are watching bond prices and interest rates very closely. Changes in either may determine whether it is a good time to buy or to sell bonds. In addition, if you see interest rates increasing quickly, you dont want to be a buyer of stocks. An increase in interest rates signals a time of caution due to the negative bias for individual stocks and the stock market in general. However, if you find that interest rates are stable or decreasing, being a buyer of stocks is a good idea because the stock market has an upward bias. Historically, the general bias of the stock market is to rise. Investors usually push markets up. Even after stock market crashes, the market usually rebounds strongly. The stock markets cyclical movement is directly related to economic, social, and political factors, with bull markets lasting longer than bear marketsdropping quickly and then rising slowly but steadily. However, when it comes to the stock market, there are no absolutes. Since no one has a crystal ball with which to see the future, I prefer to create trades that are nondirectional in nature using delta neutral strategies that reap consistent profits. |
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