From the July 01, 2011 issue of Futures Magazine • Subscribe!

How bond yields predict price action

Investor sentiment

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.

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