Interest rates have long been tied to movement in the stock market. Here's how to test trading rules for the stock market based on a six-month moving average of the 30-year Treasury bond yield, showing us when it may and may not be profitable to invest in stocks. By Mark Vakkur, M.D.
I nterest rates exert a powerful influence on equity prices. Since World War II, there has been a strong,
inverse relationship between the movement in the stock market and prevailing interest rates, such as the yield
on the 30-year Treasury bond. Here, I will explore the development of a simple trading system that uses the
trend in interest rates to generate buy and sell signals for the Standard & Poor's 500 stock index. By using
these signals, a trader could have generated substantially greater returns than a buy-and-hold strategy would
have produced and with less risk.
The 30-year Treasury yield is an excellent stock market indicator. Widely available and actively traded, the
bond market reflects international and domestic traders' consensus on, among other things, inflationary
outlook, future economic growth and confidence in the fiscal and monetary policies of the US government.
All things being equal, a falling yield means traders are discounting future good news about inflation, one of
the most powerful negative influences on stock prices. Falling yields, of course, result from rallying bond
prices, and over any significant historical period - as John Murphy most cogently pointed out in his
Intermarket Technical Analysis - bonds and stocks move in tandem. Ignoring this relationship is like
ignoring a red light at an intersection; you might beat the odds several times in a row, but eventually you'll end
up in a crash.
As every trader and investor knows, making a general observation such as "Falling yields translate into rising
stock prices" is useless unless we can first objectively and rigorously define what we mean by falling yields,
then develop buy and sell signals, and finally, back-test the system.