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

How bond yields predict price action

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).

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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.

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