Why Bond Rates Matter To The Stock Market

The 10 year bond yield pushed higher again yesterday. It is currently trading at 2.15%. So why does this matter to the stock market? Why has the stock market all of a sudden gone from a straight up move to a choppy pullback? The reasons are extremely simple and I will lay them out below.

1. When rates rise, borrowing money becomes more expensive. As interest rates rise, housing will take a hit. The Federal Reserve has made it clear they believe housing is the key to an economic recovery. If interest rates jump, fewer Americans will be able to afford to borrow money to buy a house. The housing market will slow and the economy will follow. The stock market senses this.

2. The 10 year yield is now at 2.15. On Tuesday, it crossed the dividend yield of the S&P 500. This means it is now more profitable to buy bonds than to invest in the stock market. Considering that the stock market is extremely high and possibly due for a correction, many investors are opting for the safety of bonds which are still going to pay out more than stocks on a yield basis. In simple terms, of two investments--one of which pays you 2.15% with little risk while the other pays you 2.00% with a lot of risk, which one do you choose? The answer is obvious and a major reason why the stock market has started to get jittery.

These are the keys to understanding why interest rates/yields matter. The Federal Reserve wants to keep rates low so housing recovers, the economy does better, and money flows into stocks. The Federal Reserve keeps rates low by printing money in the form of quantitative easing. However, they cannot print forever. The market senses this and is beginning to react.

Related: SPDR S&P 500 ETF Trust (SPY), SPDR Dow Jones Industrial Average ETF (DIA), PowerShares QQQ Trust, Series 1 ETF (QQQ), ProShares UltraShort 20+ Year Treasury Fund (TBT), iShares Barclays 20+ Year Treasury Bond Fund (TLT).