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Are Bond Yields The Canary In The Equity Market?

05/31/11 10:02:29 AM
by Billy Williams

The flow of capital can show you where the next big macrotrend will appear, but only if you know how to use bond yields to time your trade.

Security:   SPX, TNX
Position:   Hold

Every day in the bond market, future economic hopes are negotiated by every tick of every interest rate basis point speculated by traders. These economic reports often act as a match to dynamite and have far-reaching repercussions.

These reports also reveal to the global investment community when a country such as the US is healthy and displays a strong economic outlook. By doing so, it provides a safe haven for foreign investment and capital flows into the US, for example, purchasing bonds when the US conducts a bond auction by the US Treasury Department.

Bonds like the 10-year Treasury note, or T-note as it is commonly referred to, are offered in $100 increments at a set interest rate and mature 10 years from the point of issue.

The benefit of bonds like T-notes is that in times of uncertainty or extreme volatility in other investment arenas like the stock market, they offer the security and safety of being backed by the US and offering a set rate of return called the "premium."

This premium, or interest rate, multiplied by the price of the bond results in the expected yield for that particular bond. So if the US is offering 2.50% on a $100 10-year Treasury note, then your expected yield is $25.

At some point, however, T-note holders may decide to sell their bonds in the open market at a lower price in order to entice prospective buyers. For example, the bonds may be offered at a discount of $95, which now raises the yield to 2.63%. This higher yield attracts more risk-averse investors who seek out the closest thing to a guaranteed return that they can find in the form of the lower-priced investment of the T-note at the highest yield possible.

FIGURE 1: DIG AND TNX. Using TNX, an exchange traded fund (ETF) that paces bond yields, in comparison to the DIG ETF, which tracks oil prices, you can see where TNX acts as a lagging indicator to confirm an entry at point A and an exit at point B, where price diverges between the two.
Graphic provided by:
Again, over time, as demand for bonds begins to rise, so do the prices of bonds, resulting in a decrease of bond yields. When equities enter a bull phase, they become attractive to investors again as investors seek higher returns. They lure away from bonds onto higher dividend yields and capital appreciation.

This back-and-forth flow creates a cycle that is played out several times. Investor sentiment causes an investor to shift investment capital from one asset class to the other. These shifts in asset classes can be timed for optimal exits and entries by studying the flow of capital.

The flow of capital results when investor sentiment causes investors to move their capital from one market to another by observing the price action of bond yields. For the skilled trader, this is meaningful because it allows you to pinpoint when and where trillions of dollars of investment capital is likely to shift direction.

While the concept is difficult at first to grasp, by tracking bond yields you can determine when once risk-averse investors are now moving their money to higher-performing assets because bond holders must sell their bonds at lower prices to increase the yields. Therefore, bond yields can be a lagging indicator that confirms when the move into equities is confirmed.

The same holds true for exiting the stock market. As bond yields begin to change direction and trend down, it indicates to the observant speculator that volatility is rising. This, in a volatile stock market, creates the fear that the equity markets are likely to underperform in the future. Even though bonds may have shrinking yields, they are safe investments with reliable returns to keep their money working.

Professional speculators pay close attention to bond yields to help determine the state of the market and to capture the big trends and huge sums of investment capital that flow back and forth. By following their lead, you can put yourself on the right side of the market by flowing alongside a tsunami of capital flows. This way you will keep abreast of the shifts in the bond market.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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