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As of this writing (March 17, 2008), the status of interest rates sends some important messages to the stock market investors. This article aims at reading and decoding these messages.

Debt Securities and the Stock Market
In his book, “Intermarket Technical Analysis” (see [2]), John Murphy stresses the positive relation between the bond market and the stock market: “The bond market usually leads the stock market”. This relation is not limited to long term bonds but it also extends to debt securities of all maturities (T-Bills and T-Notes). There are three main reasons this relation exists and all of them are based on the fact that the debt securities prices move in the opposite direction of the interest rates:

1. When interest rates are low, companies can borrow cheap money to expand their business thus increase their prospects. Fundamentalist love this and are usually more willing to buy stocks. As you probably know, increased demand for stocks means increasing stock prices.

2. Almost all methods of fundamental analysis discount the expected future dividends of stocks to determine its “fair” value. This discounting is performed using an approximation of expected interest rates. Lower interest rates raise the present “fair” value of the stock and higher interest rates lower it. As a result, the lower the interest rates are expected to be, the cheaper (and attractive) a stock appears to the fundamentalists and again increased demand for the stock by the fundamentalists is a positive sign for its price.
 
3. Investors of all kinds (either individuals of institutions) usually look for a satisfied Reward/Risk factor to find out what kind of investment vehicle is the best to be in. In addition, many of these investors use a predefined satisfactory rate of return for their investments as a threshold for switching assets between the various markets. The bond market is significantly less risky than the stock market (especially, the government bonds are considered as “risk free” investments because for example a government can always raise taxes to pay back its obligations) so, when interest rates are high, investing in risk-free securities is more attractive than investing in stocks. By the same token, when interest rates are low investors are more willing to accept some risk for a greater potential return in their money.

There is usually a lag before the behavior of interest rates affect the stock market and practically there is no way of knowing precisely the time duration of this lag. It must also be stressed that, falling bond prices offer a much more strong bearish signal for the stocks than the bullish signal provided by rising bond prices. This is due to the fact that though an overheated economy can be manipulated by just monetary policy, stimulating the economy usually needs both monetary and fiscal policies. Finally, as Murphy points out, the positive relation between bonds and stocks is destroyed in a deflationary environment: Deflation is good for bonds but devastating for stocks. In any case, knowing the implications of the fixed-income securities in the stock market is very important: In a normal non deflationary environment, when then bond market rises, it sends positive signals for the stock market and when then bond market falls, it sends negative signals for the stock market

The Yield Curve and its Implications
A line that plots the interest rates (yield) of debt securities having equal credit quality, but differing maturity dates is called yield curve. Not all type of debt securities of the same quality have the same yield and thus the curve is not a straight horizontal line but takes various shapes. These shapes are generally categorized in three classes: Normal, Flat and Inverted. Normally, short term maturities have less yield than the long term maturities due to the fact that the more an investor ties his/her money (thus exposing it in more time-risk), the more he/she requires as recompense. This creates a Normal yield curve and it is generally positive for the economy and the stock market. When, on the other hand, the shorter-term yields are higher than the longer-term yields it is regarded as a sign of economic slowdown or recession thus it is considered bearish for stocks. Inverted curves are present when the Fed has raised short term interest rates (and the left part of the yield curve) to fight inflation. As Peter Navarro points out in his book (see [3]), long term investors might fear that contractionary injections by the Fed could start a recession with deflationary impact so, they may try to tie their money in long term debt securities which in effect will raise their price and lower their yield thus dropping the right part of the yield curve. Finally, a Flat curve occurs when the yields of the debt securities of all maturities are more or less the same. This curve usually takes place during the transition from a Normal curve to an Inverted or the opposite.

Figure 1 outlines the typical shapes of Normal, Flat and Inverted yield curves. Note that the steepness of the normal and inverted curves further enforce their implications. Detailed practical information about the yield curve can be found in [3] and [5].