Tuesday, January 23, 2007

AGG: The Aggregate Bond ETF and What It Tells Us About Stocks

With the expansion of ETFs, it is now possible for stock traders to actively participate in the fixed income markets, as well as equities, commodities, and currencies. A popular fixed-income ETF is AGG, the iShares Lehman Aggregate Fund. This ETF invests in a spectrum of U.S. debt, with about a third of the portfolio consisting of government agency debt, a quarter in U.S. treasuries, and 14% in financial institution debt. 75% of the portfolio is invested in AAA rated debt, with a little over a third of the portfolio at 0-4 years maturity and a little over 50% between 5-9 years. In short, AGG represents a relatively broad and complete spectrum of the U.S. fixed income market.

Because AGG is such a good proxy for bonds, it also provides us with an opportunity to investigate how movements in the fixed income arena are associated with subsequent movements in the equity markets. I went back to 2004 (N = 154 trading weeks) and took a look at three-week changes in AGG and what happens over the subsequent three weeks in the S&P 500 Index (SPY); the NASDAQ 100 Index (QQQQ); and the Russell 2000 Index (IWM).

When AGG has been up over a three-week time frame--meaning that interest rates are falling over that period (N = 78), the next three weeks in SPY have averaged a very healthy gain of .80% (53 up, 25 down). When AGG has been down over three weeks (N = 76), the next three weeks in SPY have averaged a gain of only .08% (38 up, 38 down). Clearly, falling interest rates (rising bond prices) have been associated with superior large cap returns since 2004 over a several week period; rising rates (falling bond prices) have yielded subnormal returns going forward.

We see identical patterns in QQQQ and IWM. When AGG has been up over a three-week time frame, the next three weeks in QQQQ (IWM) have averaged a gain of .83% (1.32%) with 41 (53) occasions up and 37 (25) down. When AGG has been down over the past three weeks, the next three weeks in QQQQ (IWM) have averaged a loss of -.22% (-.12%) with 38 (32) occasions up and 38 (44) down. Stock performance in those averages has been dramatically better during periods of rising bond prices (lower interest rates) than during periods of falling prices (rising rates).

I'm especially impressed by the magnitude of the differences in IWM performance under different bond conditions. It may well be that rising rates dampen speculative sentiment for equities, particularly affecting small caps. Conversely, an environment of falling rates might be deemed positive for growth, encouraging speculation in the small caps. With the availability of data on a variety of ETFs across asset classes, we are more able than ever to tease apart such intermarket relationships.


Anonymous said...

Dr. Brett.

I'm convinced that all financial markets care about is that rate that they can borrow money. The US is a financed based economy. Cheaper money means more risk and speculation (russell). Just my two cents


Anonymous said...

Hi Brett. This is going to probably sound really picky, but since I got my professional start in the fixed income market, I can't help myself. :-)

Since the vast majority of the index is of maturities less than 10 years, you would not consider it representative of the 'bond' market. Bonds are instruments with initial maturities of more than 10 years. Less than 10 years is generally referred to as a 'note', especially when referring to Treasury instruments.

Semantics aside, the index clearly is short-term to intermediate-term interest rate focused being focused on mostly 9 years and under. It doesn't really take in the longer-term rates. That seems to me a decent thing to use in a short-term trading view. I can't help but wonder, though, how things would measure up with a longer-term index and/or a comparisson of short-term to long-term (yield curve).

Anonymous said...


I looked on Yahoo finance and, judging by the one year chart, it does appear that when the ten-year is rising the rest of the market does not like it.

When the ten year started rising in November, the indexes have been stumbling ever since. Now oil prices are on the rise again as well...I suspect that when the ten year gets to 5 and oil goes over 60 then we will probably see a pullback of some type in the market.

The combination of rising oil and rates will be like kryptonite to the S&P.


Brett Steenbarger, Ph.D. said...

Hi James,

I think you have a good point: cheap money and high liquidity fuel speculation, and that fuels stocks. Thanks--


Brett Steenbarger, Ph.D. said...

Hi John,

You make good points; thanks for the comments. It would be interesting to take the short duration and longer duration fixed income ETFs and check out their relationship to stocks. Of course, the shorter rates are more subject to Fed intervention and anticipated Fed intervention, so that makes them relevant. The longer term rates impact housing, so they're relevant in a different way.


Brett Steenbarger, Ph.D. said...

Hi Michael,

Good point; thanks. I do think rising oil and rates would pose challenges for the market.