Inverse Relationship Between SPY & TLT (should know)
Today we are reviewing one of the more iconic relationships - the link between equity (stocks) and debt (bonds).
The big difference between stocks and bonds is that people who buy shares of stock are owners of the company while people who buy bonds are lending the company money. Generally, buying stock let’s you participate in the success or failure of the company as the stock price rises and falls, while buying bonds lets you collect interest and hopefully get your full principal back.
A stark illustration of this distinction can occur during bankruptcy, when stockholders are basically the last group to be paid out if there are remaining assets. Bondholders on the other hand are among the first to get paid. Historically, there has been an inverse correlation between the movement of stock and bond prices. We’ll compare SPY for stocks with TLT for bonds.
Aside from illustrating negative correlation between TLT and S&P 500, also reveals during spring of 2015, this inverse relationship had broken down to some degree. Over the last 10 years, TLT and SPY had a negative relationship (inverse correlation) on a 1-month basis on 82% of trading days. But why? One reason is that earnings drive stock prices and interest rates drive bond prices. Performance of the economy, then, is the axis around which these two drivers revolve.
For example, when the US economy is acting poorly, central bankers tend to lower interest rates to help stimulate growth. As interest rates go down, bond prices go up. In contrast, stock prices generally go down when economic conditions erode. These realities therefore fit the hypothesis - declining economic conditions are typically paired with falling interest rates, rising bond prices, and declining equity prices. It's important to note that while the negative correlation between the TLT (bond prices) and S&P 500 (equity prices) may hold the majority of the time, there are instances where it breaks down. As, always this is not 100%, but actually closer to 96.5% negatively correlated & 3.5% positively correlated. This will tell which direction to trade for day.
The big difference between stocks and bonds is that people who buy shares of stock are owners of the company while people who buy bonds are lending the company money. Generally, buying stock let’s you participate in the success or failure of the company as the stock price rises and falls, while buying bonds lets you collect interest and hopefully get your full principal back.
A stark illustration of this distinction can occur during bankruptcy, when stockholders are basically the last group to be paid out if there are remaining assets. Bondholders on the other hand are among the first to get paid. Historically, there has been an inverse correlation between the movement of stock and bond prices. We’ll compare SPY for stocks with TLT for bonds.
Aside from illustrating negative correlation between TLT and S&P 500, also reveals during spring of 2015, this inverse relationship had broken down to some degree. Over the last 10 years, TLT and SPY had a negative relationship (inverse correlation) on a 1-month basis on 82% of trading days. But why? One reason is that earnings drive stock prices and interest rates drive bond prices. Performance of the economy, then, is the axis around which these two drivers revolve.
For example, when the US economy is acting poorly, central bankers tend to lower interest rates to help stimulate growth. As interest rates go down, bond prices go up. In contrast, stock prices generally go down when economic conditions erode. These realities therefore fit the hypothesis - declining economic conditions are typically paired with falling interest rates, rising bond prices, and declining equity prices. It's important to note that while the negative correlation between the TLT (bond prices) and S&P 500 (equity prices) may hold the majority of the time, there are instances where it breaks down. As, always this is not 100%, but actually closer to 96.5% negatively correlated & 3.5% positively correlated. This will tell which direction to trade for day.