The Relation Between Stock & Bonds When the Interest Rate Declines

The relation between stocks and bonds in a declining interest rate environment has three components: the effect of an interest rate decline on stock prices; the effect of an interest decline on bond prices; and the nature of the relationship, if any, between stock and bond prices in a declining interest rate environment. Determining the first two effects is relatively straightforward; determining the relationship between stock and bond prices in a falling interest rate environment is not.

Interest Rates and Stock Prices

When interest rates fall, big-ticket items such as houses and cars become more affordable. This stimulates consumer spending. When a critical interest rate falls, such as the rate banks charge other banks for overnight borrowing, banks lower interest rates for business borrowing in response. The decreased cost of business borrowing makes possible increased spending on business enterprise, such as physical plant expansion, advertising and product development. Economists agree that when consumer spending and business activity increase, businesses become more valuable and their stock prices rise. A 2009 study of 15 developed and developing economies found a significant negative relationship between interest rates and stock prices in all 15 countries -- when interest rates fell, stock prices went up.

Interest Rates and Bond Prices

Here's an example of the relationship between interest rates and bond prices: On March 1, 2013, you buy a 10-year $10,000 Treasury bond at par -- meaning you pay the full $10,000 price. The annual interest rate is 2.68 percent; your bond yields $268 each year. On May 1, 2013, you decide to sell the bond. The interest rate on 10-year Treasuries, meanwhile, has fallen to 2.44 percent, leading to a yield of $244 each year. You can sell your bond for more than $10,000 because it yields more than a current bond would. The price of your bond will include a premium over par that makes its annual yield close to the currently available $244. Hence, as interest rates fall, bond prices rise.

Stocks, Bonds and Interest Rates

In general, stock prices and bond prices rise when interest rates fall. Each is negatively correlated with interest rates. However, this does not mean they are correlated to each other. When the economy falls into recession, for example, stock prices fall. In order to stimulate the economy, the Federal Reserve may lower interest rates. As interest rates fall, bond prices rise. But the interest rate is not the only influence on the stock market. If sentiment is low among consumers, investors and business, spending may continue to decline. Although interest rates are falling, stock prices may continue to decline, even as bond prices rise.

An Uncertain Correlation

A 1996 study by the Federal Reserve Bank of San Francisco observed that the correlation between stock prices and bond prices was "tiny." The Fed economist also noted it was "unclear how stock and bond prices move together." He concluded that with so many unanswered questions about this weak correlation, investors should be cautious about using it as a basis for investment.