Why Watching the Bond Market Can Help You in Stock Trading
The bond market can help predict future economic activity, which is why it can help you plan future investment decisions.
With an experienced online stock broker, trading stocks from your home is easy. But no trading can be successful unless you have the ability to understand the market and foresee what could potentially happen. Observing the bond market closely could give you a good picture of the market.
Why is the bond market so important? You may have invested in equity stocks, but the bond market is something you must keep tabs on because it’s good in predicting future economic activity. It is also an indication of future inflation levels. And these factors directly influence the price of stocks and even consumer goods.
Bond Yields and Interest Rates
There is a deep connection between bond yields and interest rates. As you know, the interest rate is the rate of borrowing money as a loan. Bonds too are regulated by an interest rate which determines coupon payments, though the real cost of investing in bonds or borrowing them is influenced by current yields.
Bonds have different maturity periods, from just a month to 30 years. So you’ve got short-term rates and long-term rates as well as those in between. Sometimes, short-term rates might come down while long-term rates may rise. Sometimes they could rise or drop together. These relationships between interest rates in the long term and short term need to be understood to make great investing decisions.
Short-term Interest Rates
Short-term interest rates in the US are determined by the Federal Reserve Board Open Market Committee (FOMC). It decides the federal funds rate which serves as the standard for the other short-term interest rates. The FOMC could raise or lower fed funds depending on its desire for promoting or regulating borrowing activity by consumers and businesses.
This borrowing activity directly affects economic activity. If economic activity slows, the FOMC could bring down the federal funds rate for stimulating the economy by facilitating greater borrowing. But following that strategy for too long could also raise inflation levels by pumping in too much cash into an economy that exhibits lesser demand for goods. So the FOMC needs to balance rate cuts with the need to cut down inflation.
Long-term Interest Rates
Long-term interest rates, however, are actually set by market forces. These rates are a result of the kind of effect the bond market feels the present short-term rates will have on future inflation levels. If the bond market feels the FOMC has got the fund rates set too low, expectations keep rising of a future inflation rise. That results in the long-term rates of interest rising again for compensating for the purchasing power lost. And if the bond market feels the fed funds set by the FOMC are too high, you have the long-term interest rates reducing as a result of the market believing that the future inflation levels would decrease.
Trading experts and analysts often rely on such information to make informed decisions. Advanced trading software also does its part in enabling smooth trading for online stock traders.