Thursday, April 13, 2006

Interesting Pattern: Interest Rates and Equities

Note: IMHO, one of my best Trading Markets articles is scheduled for Friday publication. It deals with the psychological risks inherent in trading, even when you have a solid edge and good risk management.

In the wake of continuing rises in interest rates, I decided to look at what happens following two-day moves in the rate of the 10-year T Note. Going back to March, 2003 (N = 784), I found 116 instances of two-day periods in which the 10-year rate rose 2% or more. Three days later, the S&P 500 Index (SPY) was up by an average .26% (76 up, 40 down). This is stronger than the average three-day gain for SPY (.17%; 457 up, 327 down).

Interestingly, when the interest rates drop more than 2% in a two-day period (N = 102), the next three days in SPY average .03% (50 up, 52 down). This is distinctly weaker than average.

It thus appears that SPY tends to rise following drops in notes (rises in rates) and fall after rises in notes (drops in rates).

BUT - ever since we've started making new highs in interest rates, this relationship has broken down. Of the last six rises of 2% or more in rates, we've seen a weaker S&P three days later on five of those occasions. This suggests that the equity market may be responding to rising rates differently than it had from 2003-2005.


Steve Haughey said...

Guess the markets are realizing that this could be "the big one", the end of the bond bull market. I know everyone's staring themselves blind at the TNX, but with good reason. A break of 52 and you've not only broken the golden downtrend, you've also taken out the highs of 2002 and... blue skies until 68-70.


PS All the other tests since the 80s, while impressive, have been classic V-shaped countertrends. Up, bang, down. This one is launching off a three-year base...

Brett Steenbarger, Ph.D. said...

Very good point, Steve, about the launch from a base. It would not at all surprise me if we look back on the low rates/high bond prices of the past several years the same way we now look back at the NASDAQ and tech stocks.


b hong said...

I agree that your TradingMarkets article is one of your best. I was aware of the risk of boredome and of drawdown. This is the first time, to my knowledge, that the risk of sequencing was discussed. It was an eye-opener and helps to explain my (emotional) responses to the stress of trading. Thanks for an informative and helpful article. So much better than the ususal "you must work hard to control your eomotions" that you frequently see in 'Trading Coach' sites.

Brett Steenbarger, Ph.D. said...

Thanks for the feedback. The way that wins and losses occur in streaks affects even the most successful traders I've known and worked with. Once we *know* what kind of sequencing to expect, we have a chance to avoid overreacting to strings of wins and losses. Interestingly, I think the long strings of flat P/L performance affects traders every bit as much as the wins and losses.