Stock prices and interest rates are generally an inverse relationship, moving in opposite directions most of the time. Interest rates reflect the general level of business activity and inflation. Interest rates specific to a company are also affected by credit quality and the financial outlook. Equity prices are directly related to the ability to create profits from the existing business conditions and to increase opportunities in the future. Interest rates are an expense of corporate profits. The relationship of stock prices and interest rates only converge when steady economic activity is underway.
Economic Strength Determines Stock and Bond Prices
At the beginning of an economic recovery, stock prices are weak while bond prices are strong. Economic activity is beginning to improve and corporate profits are beginning to recover. Stocks anticipate a stronger recovery and begin to rise in advance of the return of profits. Bond prices are low as bond issuers have used cash and corporate profits to pay off debt rather than undertake expansion during the recession.
Economic Recovery Takes Hold
Bond prices are inverse to bond yields. Thus as economic activity increases short rates rise followed by yield increases in intermediate (seven to 10 year maturity) bonds. Bond prices fall as higher-yielding bonds become available. Stock prices usually have their strongest percentage gain during this time, rising from low levels. This is the period when stocks are considered inexpensive because public optimism is low and any rally is considered an opportunity to sell existing stock positions.
The Business Cycle Continues
Stock prices continue to rise as the business recovery is underway. Bond prices fall as investors choose the better returns available in stocks. Stock prices continue to rise even as the cost of borrowing rises because cash flow from corporate profits rises faster than the additional interest expense. As inflation begins to rise long term bonds (20 year maturity issues) rise in yield as investors want to be recompensed for greater inflation risk.
Economic Downturn Approaches
As stock prices peak, reflecting overenthusiastic expectations for stock profits, the higher yields of bonds look attractive as stock prices begin to falter. Investors change their risk and reward preferences to favor strong bond credits and lessened volatility over usually volatile stock market declines. Thus, stock prices fall as investor seek risk avoidance. Bonds increase in value as alternative cyclical investments including stocks, commodities and cash have dim near-term outlooks.