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Ask The Expert: When Stock Prices Crash, Do Bond Prices Always Go Up?

Friday, March 15, 2013 - 10:00am

Editor's note: Each week, one of our investing experts answers a reader's question in a Q&A column at our sister site, InvestingAnswers.com. It's all part of our mission to help consumers build and protect their wealth through education. This week's question will be answered by Investment Analyst David Sterman...

Question: I've heard that bonds go up when stocks go down. Is that true? -- Kate, Washington, D.C.

Answer: Great question, Kate. The short answer is: Yes. Falling stock prices are a signal of falling confidence in the economy, and when investors pull money out of stocks, they seek safer asset classes such as bonds.

So all of that money leaving stocks and going into bonds has the effect of pushing bond prices higher -- because newly issued bonds can offer lower yields, and the already-existing bonds with higher yields are more attractive.

Economists would say that falling stock prices and rising bond prices means they are "negatively correlated."

But is the converse true? Do rising stock prices hurt bond prices? Not really. Although we've seen that falling stock prices can cause investors to flee to the safety of bonds, rising stock prices don't make bonds unattractive.

Instead, bond prices are impacted by perceived inflationary pressures in the economy. So bond prices will fall -- and bond yields will rise -- if it looks like inflation is moving higher.

So the next question becomes: Do rising rates of inflation spell trouble for stock prices?

Yes, but only down the road.

Let me explain.

Right now, inflation and interest rates remain at extremely low levels. Yet these two measures could rise to 4%, for example, and actually be supportive of higher stock prices. That's because a moderate rise in inflation and interest rates implies that the economy is getting stronger. And stocks do well when the economy is strengthening.

But there's a hard limit to this relationship. If inflation and interest rates keep rising, perhaps to the 6% to 8% range, then the economy starts to face a powerful headwind.

Because corporate profits would be eaten by up higher inflation, not only will companies become hard-pressed to generate inflation-adjusted profit growth in such an environment (which is bad for stock prices), but many investors would increasingly gravitate from stocks to bonds. Indeed, the Federal Reserve would start to hike interest rates until they are high enough to slow down the economy and break the back of inflation.

That's just what we saw in the 1970s. Inflation soared toward the double-digit mark with government bonds handily yielding 10%. And when that happened, few wanted to own seemingly precarious stocks when bonds offered up such juicy yields. The massive bear market in stocks in the 1970s was directly tied to the fact that bond yields were so impressive. In this case, falling bond prices (as yields rise) and falling stock prices were what economists call "highly correlated."

Action to Take --> With inflation at multi-decade lows, few are thinking about this topic at the moment. But in the quarters ahead, if interest rates start to rise, as many suspect, this question will pop up with greater frequency. Although stocks surely can tolerate a moderate upward move in interest rates and inflation, they will start to suffer if those twin measures of cost pressures keep rising higher.

This article originally appeared on InvestingAnswers.com:
Ask The Expert: When Stock Prices Crash, Do Bond Prices Always Go Up?

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.