The Only Market Lesson You Really Need

[Â The Only Market Lesson You Really Need](#) We're back in red territory with our signal. So, how do the bond markets impact our understanding of stocks? Garrett {NAME} OCT 31 [Icon]([Icon]([Icon]([Icon]( Dear Fellow Expat, I'll be dressed as Mario. My daughter, Princess Peach. But there's one terrifying costume I'll be looking for while out trick-or-treating... Treasury Secretary Janet Yellen. (or any central banker) [undefined] Because today's bond market is turning our momentum signal RED yet again. Let's discuss one of finance's fundamental lessons: how the bond market affects the stock market... The Bond-Equity Connection The global debt market is the backbone of finance. The relationship between bonds and stocks drives the markets in ways most retail investors don't consider. When bond yields rise, every company's cost of doing business increases. Higher rates mean higher borrowing costs. This affects everything from working capital to expansion plans. More important, it changes the risk-reward calculation for investors like you. When bonds offer attractive yields with significantly lower risk, the premium for holding stocks must increase. Remember, bondholders get paid first in the event of bankruptcy. Shareholders get what the bull left at the fair. The basic question is simple: Why take equity risk if you can get solid returns from risk-free government debt (after all, they can always print more money)? Investors also know how rising borrowing costs impact the balance sheets of companies they own. Credit and the ability to access it and refinance it will impact corporate growth prospects. This shift in risk assessment leads to lower equity valuations, particularly in technology stocks that have traded at nosebleed levels for years. Next, Risk at the Banks To understand how bond markets impact equity markets, you need to understand how capital is borrowed, how debt is created, and how existing debt is refinanced. The first players are traditional U.S. banks. Banks are active participants in financial markets. They own bonds as a core part of their business model, aiming to generate returns based on the spread (difference) of the Treasury securities they own and the amount of money they pay to depositors. But if rates go up, their balance sheets take a hit. In some cases, the value of their bonds falls so much that the bank looks insolvent on paper. This can cause a run on the banks, which was the case in 2023 with Silicon Valley Bank. Even though the banks might be able to get emergency funding from the Federal Reserve, depositors want to know their money is safe. Any worries about the bank's solvency can fuel a rush on that capital. This is a reminder that "safe" investments carry risk when mismanaged. As rates rise, money markets or short-term bonds could offer higher returns than the banks... If depositors move their money out of the bank chasing higher returns, there's less money for the banks to lend. That could force the bank to sell their bonds at a much lower price, again raising insolvency fears. That brings us to another side of the global lending market. In the Shadows The shadow banking system – hedge funds, private equity firms, business development companies (BDCs), and other non-bank lenders – controls far more leverage than traditional banks. These institutions operate with much less regulation. These shadow banks have much more aggressive leverage ratios and can fuel major financial crises. That was the case with Long Term Capital Management in 1998, the 2008 Great Financial Crisis, the 2018 Repo Crisis, and the big, bad COVID selloff. Why does it go wrong so often? Shadow banks aren't sitting on stable deposit bases like traditional banks. Instead, they rely on short-term funding markets and complex financial arrangements that use bonds as collateral. Collateral? Bonds serve as collateral throughout the financial system. When their values decline, a cascade of effects ripples through the markets. Financial institutions must either post additional collateral or reduce leverage. This deleveraging process can force asset sales across all markets, creating a self-reinforcing downward spiral. Since stocks are liquid and an easy source of raising capital, they can sell off quickly. It quickly makes the U.S. dollar – an instrument to settle debts (it says so on the front) a very popular asset. Cash becomes king to settle and refinance that debt. Weaker Leverage Is Bad for Equities Finally, there’s the element of leverage. Funds are always trying to beat their benchmarks – like the S&P 500. Well, leverage is based on margin – which is borrowed money. Since rising interest rates increase borrowing costs. That makes leveraged positions far more expensive and riskier. Higher rates decrease demand for leverage. And they increase pressure in equity values. If stocks start falling, the value of those leveraged positions weakens. If you’re losing with borrowed money, you must get out fast. Otherwise, you might lose more than you have and go bust as an investor or hedge fund. When equity values move lower quickly, it can amplify losses and force margin calls (where borrowers take collateral that was part of the borrowing process. So, when rates start to rise, investors cut that leverage. As market leverage starts to unwind, a key in understanding outflows among institutions, it can manifest selloffs like we've seen since last week. There is good news. If we have a major global financial market problem, the Federal Reserve will likely step in to manipulate bonds as best as possible by purchasing assets. We'll talk more about how that will likely work tomorrow. For now, I have to squeeze into a plumber's outfit... Stay positive, Garrett {NAME} Secretary of Finance [Icon]([Icon]([Icon]([Icon]( [Logo Image](#) Postcards from the Republic 1125 N. Charles St. Baltimore, MD 21202 This email was sent to you because you subscribed to this publication via FinPub. To stop receiving these emails from Postcards from the Republic, Please click [unsubscribe](. © 2024 Postcards from the Republic, All Rights Reserved. Any reproduction, copying, or distribution, in whole or in part, is prohibited without permission from the publisher. Financial Disclaimer: Nothing in this email should be considered personalized financial advice. Do not consider any communication between you and Postcards from the Republic and its employees or writers as financial advice. The communication in this email is for information and educational purposes only. Model portfolios are tracked to showcase a variety of academic, fundamental, and technical tools. Insight is provided to help readers gain knowledge and experience. 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