Each day in the bond market, the future economic hopes of entire countries are negotiated as every tick of every interest basis point is speculated on by traders. Economic reports often act as a match to dynamite, resulting in explosive flurries of buying and selling as bond traders double-down or hedge risks on the future prospects of nations.
The risks are incredible, but so is the profit potential. However, to take advantage, you must have a solid trading approach combined with sound risk control. Fortunately, bonds trade in an event-driven market where economic reports result in predictable patterns that manifest in a bond’s price action and can result in a solid stream of profitable opportunities.
To capitalize on those opportunities, you must understand both how bond yields work and why they are critical to helping you profit across a broad breadth of asset classes.
Yields reveal the way
The U.S. Treasury conducts a number of bond auctions during the fiscal year to raise money to fund the various arms of the government as well as provide public services to its people. With the ability to print its own money as well as raise revenue in various types of taxes, the United States is a stable country with a strong economy that offers you, the investor, a strong guarantee that it has both the ability and the willingness to repay its debt to you, the bond-holder.
One of the instruments that it auctions is the 10-year Treasury note (T-note).
These notes are sold in $100 increments. For each sold, the U.S. government pledges to pay back $100 to the holder at a maturity date of 10 years from the time it was issued. These notes also have a fixed rate of interest that the Treasury sets at the time of the auction to give potential holders the incentive of a premium.
This premium, or interest rate, multiplied by the face value of the note, results in the expected yield for that particular note. So, if the United States is offering 3.50% on a $100 10-year T-note, then your expected yield is $35.
However, initial bond holders may decide to raise capital by selling their holdings of the T-note on the open market. Based on the current interest rate, they may have to entice prospective buyers. If this is the case, then the sellers may have to sell their T-notes at a lower price. This effectively raises the yield, which is a fixed 3.50% on the $100 face value, to attract those buyers.
Based on this example, a T-note owner may offer his or her note for a discount at $95 — effectively raising the yield to 3.70%. 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.
As time goes on, equities may offer attractive yields of their own in the form of dividends as well as the added benefit of potential increases in share value. Once the general market begins to experience a bull run, former risk-averse investors may grow more willing to accept a higher level of risk in the hopes of seeking out higher returns in the stock market. This shift in interest can signal to traders that it’s time to get back in the market (see "From bonds to stocks," below).
Soon, a pattern begins to appear as investors begin to move from risk averse assets, such as bonds, to higher risk/higher return alternative assets, such as the stock market.
A cycle is played out in the markets, over and over again, where investor sentiment causes an investor to gravitate from one asset class to the other based on the pursuit of two things: Higher returns on acceptable risk and a flight to safety to get away from risk.
First, understand that bond yields move inversely to bond prices, but move in tandem with the stock market, though not in lock-step. This occurs as bond sellers continue to sell at a discount to compete with the stock market by offering higher yields.
Yield prices rise but soon are left behind when the stock market emerges into a full-blown bull market, lifting all stocks among a tide of solid earnings reports and rising investor sentiment.
When investors sense that risk is on the rise in the stock market, there is a flight from equities as fear sets in. Once corporate America begins reporting poor earnings, investors typically become sour on equities. This triggers falling sentiment and causes investors to seek safer, more secure returns in the form of the bond market.
Eventually, as demand for bonds begins to rise, so does the price, causing yields to shrink. Even though the bonds offer secure returns, as the stock market begins to firm up and enter a bull phase, once-risk-averse investors are lured away from bonds by more promising prospects of higher dividend yields and capital appreciation.
It is within these shifts of investment capital between markets that a phenomenon called the flow of capital occurs, offering clues for the trader where fundamental support may exist for technical patterns as they play out in price action (see "Forex support," below). Capital may flow into one market and out of another altogether. In the process, investor capital may lead the way.
Flow of capital
The flow of capital results when investor sentiment inspires them to move their capital to one market over another by observing the price action of bond yields. For the skilled trader, it is of towering significance because it allows you to pinpoint when and where trillions of dollars of investment capital are likely to end up and why it is important for you to track yields.
As volatility rises in equities, investor sentiment and fear will spike and cause a retreat from the stock market and into risk-averse assets such as bonds, but also to currencies in stable countries.
For forex trading, it can help you find profitable setups as bond sellers and stock sellers liquidate their positions to seek out safety in the form of various currencies. Whether the investors seek to purchase that country’s bonds by first purchasing the currency or as an investment hedge against declining bond prices or the U.S. dollar, that sentiment first will make its appearance in that currency’s price action (see "Currency flows").
For the equity market, rising yields often lead a stock market rally as bond prices fall and bond-sellers are forced to discount their bonds on the open market to offer higher yields to compete against the stock market. For the stock trader, this can help you time the market and enter a position in undervalued stocks or speculate in S&P futures. Allow the fundamental basis to point the way while you use more time-sensitive methods to switch exposure into and out of the market.
Inevitably, the flow of capital swings the other way as current bond holders notice the bull market and blue chip stocks offer comparative or superior dividend yields to the bonds that they now hold. Investment capital floods the stock market, lifting the tide for all equities and taking them higher in a powerful bull market. With billions upon billions of investment dollars pouring into the stock market and equities in general, volatility begins to increase and wild price gyrations set in. The stock market appears to become increasingly unpredictable.
For the bond investor, price action diverging between the T-note’s yield and the S&P 500 index can be an indicator to buy bonds on the cheap while yields are still high just before prices begin to rise. Alternatively, it can be a clue to sell bonds before prices fall too far and the trader is forced to unload them at an even lower price, offering yields to compete with a stock market on a bull run.
All markets and asset classes are fundamentally driven by the desire to gain the largest return with the least amount of risk. By becoming a student of the bond market and the careful relationship between bond yields and bond prices, you can gain a competitive advantage across a wide spectrum of inter-related markets. Plus, you can gain an advantage over the traders who actively participate in these markets because it reveals the starting point at which money begins to shift.
To compete and prosper at a higher level of speculation, understanding the impact of bond yields can help you identify key inflection points in the markets where the flow of capital is taking place. This can offer you a glimpse into the hopes and fears of the people who participate in these markets at a seminal level.
By understanding the emotional directives these traders experience as they cope with risk while pursuing the highest returns, you gain additional insight into market moves. Most important, the ability to do so can help you gain the foresight to identify core changes within the markets and exploit new trends as they begin to emerge, capturing the enormous profit potential within.
Billy Williams is a 20-year veteran trader specializing in momentum trading. He is the publisher of www.StockOptionSystem.com.