Stocks and bonds are the two building blocks of most portfolios, and how they behave relative to each other decides how bumpy the ride is. Here’s how bonds and SPY, the ETF that tracks the S&P 500, tend to interact, and when that relationship breaks down.

The basics

Bonds are loans. You lend money to a government, city or company, it pays you interest, and you get the face value back when the bond matures. Bond prices and yields move in opposite directions: when prices fall, yields rise.

SPY holds the stocks in the S&P 500, the 500 largest public companies in the US, so it moves with the index.

What drives the relationship

1. Fear and greed

Government bonds are the classic place to hide. When investors get nervous about stocks, they buy bonds, which pushes bond prices up and yields down. When they’re optimistic, money moves the other way: out of bonds and into stocks, so yields rise while SPY climbs.

2. Interest rates

Central banks have a big hand in this. When they raise rates, existing bonds lose value and yields go up. Higher yields make bonds more competitive with stocks for anyone who wants income. When rates come down, bond prices rise and lower yields push investors back toward stocks.

3. The economy

Strong data, like good job numbers or fast GDP growth, raises the odds of higher rates, which is bad for bond prices. The same strength helps corporate profits, which is good for stocks.

4. Inflation

Inflation eats away at bonds, because their payments are fixed. When inflation expectations rise, bond prices fall and yields go up. Stocks hold up better because companies can raise prices, at least to a point.

The catch: it doesn’t always hold

The textbook says stocks and bonds move in opposite directions, so one cushions the other. That’s often true when the problem is growth. When the problem is inflation, it can fail badly. In 2022, rising inflation and rate hikes sent stocks and bonds down together, and the classic 60/40 portfolio had one of its worst years in decades.

What I take from it

  • Bonds still diversify a stock portfolio, but more reliably in a growth scare than in an inflation scare.
  • Watch the central bank and the inflation numbers. They’re what decide which regime you’re in.
  • Rates matter for stock valuations too. When yields rise sharply, expensive stocks usually feel it first. See what rising bond yields mean for stocks.

This is for information only and isn’t investment advice.