Thursday, January 15, 2009

Fixed Income and Stock Trading
I have written before on the value of understanding the fixed income market. Interest rates play a roll in every other market to a greater or lesser degree. Sometimes it’s a direct and obvious thing like the interest rate differentials which can drive forex rates. Other times it’s a bit more vague, like how interest rates are used in discounting cashflows for stock valuations, or in regards to carry costs in commodity markets.
These influences tend to be more general and slow changing, though. But there’s also a more direct and short-term relationship between stocks and interest rates. This is something which has become very much at the fore of the market action over the last year.
You see a large part of the stock/bond equation is asset allocation. When investors are feeling good they will tend toward equities. When worried, they will move toward fixed income. The more worried they are, the shorter term the fixed income. When the markets are really scared, money will flood into Treasury Bills. We saw alot of that in the last year during the market turmoils.
This is something one can use in short-term trading. I regularly watch what’s happening in 2 year Treasury rates to see how it matches up with what’s going on in stocks. Sometimes they can provide a leading indication as to what’s coming. Other times they either confirm stock price action or act as a divergent indictor to provide a warning. It’s quite useful.
One word of warning, though. The relationship between stocks and bonds is variable. Sometimes they go the same way. Sometimes not. It depends on the underlying reasons. For example, stocks would do well in an environment of strong growth, but bonds might not because of concerns about rising inflation. Be aware of what’s going on to make sure you are looking at things in the right context.

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