For asset allocators, it was always a comfort that stocks zigged while bonds zagged. But this year, they both are zigging together. And that creates problems for investors.
One problem: This newly positive correlation of equities and fixed-income prices presents investors with contradictory indicators on where the economy is headed. Another worry is that, if stocks tank, as they surely will at some point, bonds won’t be functioning in their customary role as a cushion.
What has caused the coupling of stock and bond prices of late? The Federal Reserve’s backing off its hawkish plans to jack up short-term rates and also to unwind its gargantuan bond holdings. And add in the massive stock rally prompted by the Fed’s sudden dovishness and hopeful (perhaps overly so) economic news.
Stocks, as the phrase goes, discount the future: They attempt to predict where the economy is going, and lately the direction has been up. The S&P 500 has climbed 16% in 2019, almost reaching its peak last fall. Over the past year, the index has risen about 7%.
Meanwhile, prices for both asset classes are trending upward. Yields on the benchmark 10-year Treasury note are down—indicating that their prices are increasing, since they move in the opposite direction. The 10-year yield now is 2.55%, off from April 2018’s 2.96% and from the October 2018 recent high of 3.22%. “Bonds are not as much of a buffer now,” lamented Norm Conley, CEO of JAG Capital Management.
Same Data, Two Views
It’s as if the stock and bond markets are living in two different worlds, upbeat for the equity bunch, downbeat for the bond crowd. “This is confusing,” said Eric Kuby, CIO of Northstar Investment Management. “Bond and stock investors look at the same data and see different things.”
Economic data are mixed on the US economy’s state. Dour predictions from a few months ago have given way to a slightly more upbeat picture, although few discern a continuation of the booming conditions of last year, juiced in part by the Trump tax cuts.
Oxford Economics sees iffy trade and manufacturing as stabilizing, and the Federal Reserve’s decision to stop hiking short-term interest rates as providing modest acceleration in the year’s second half. The Wall Street Journal survey of economists forecasts a 2.1% gross domestic product growth in 2019 and 1.8% in 2020. That’s down from 3.0% in 2018. Still, half of them expect a recession to occur sometime next year. Right now, unemployment is at a very low 3.8% and last week’s jobless claims sank to a 40-year low.
The Move to Positive Correlation
For most of last year, stock and bond price were in their usual polar positions. As a Pitchbook research piece describes the situation, “the narrative was centered on the robust economy and strong earnings growth. In that scenario, it made sense to sell bonds and buy stocks.”
Starting last October, though, two shocks occurred that set the stage for ending stocks and bonds’ customary yin-yang relationship, by taking stock investors on a roller-coaster ride. The trade war with China escalated and the Fed took a hawkish stance, promising to keep on boosting rates and shrinking its bond portfolio.
Visions of international trade devastation and ever-harsher borrowing costs provoked a panic among equity investors. Stock prices took a dive and bond prices rose, as investors clambered into Treasury paper as a refuge.
Then, following Christmas Eve, the menacing clouds parted. Negotiators in the trade tiff started talking about how differences were narrowing. Beijing and Washington agreed on a truce, halting the tit-for-tat tariff impositions that had unsettled the world. Even more consequential, Fed Chair Jerome Powell stated that further rate hikes were off the table for now and announced an end to the drawdown of its bond stash. Plus, futures markets show that many expect the Fed may even cut rates.
Stocks acted as if they’d been given a double-dose of adrenaline. The S&P 500, which had come within a whisker of a bear market (down 20%) in late 2018, sailed aloft. “Stock entered 2019 over-sold, and they reacted as you’d expect” owing to the better news, said Jim Keegan, chairman of Seix Investment Advisors. At the same time, pessimistic bond investors kept fixed-income prices high.
Positive correlation isn’t new, according to a recent research paper from hedge fund D.E. Shaw. Until the late 1990s, a “period of positive correlation had prevailed over the previous three decades.” Starting in the 1970s, stagflation acted to stifle both stock and bond markets: Mounting inflation was a curse to each, eroding bonds’ value and harming companies’ ability to make decent profits.
Then came Paul Volcker’s Fed, which amped rates to the skies and defeated inflation. Around 1982, both markets tracked one another in a much more pleasant way: They enjoyed huge rallies. For equities, this lasted until the late 1990s, when the dot-com bubble popped and sent stocks down once more. The bond price rally, for the most part, kept on trucking.
Since 2011, D.E. Shaw wrote, five episodes of positive correlation took place (six, if you count 2019’s). One revolved around the 2013 “taper tantrum,” when the Fed mulled ending its bond-buying stimulus program. (It backed off, in a bid to quiet all the market ruckus.)
Psychologically, investors take a long time to realize that fundamental changes have occurred. The inflationary plague of the 1970s was defeated in the early 1980s, but people took a while to believe the problem was dead.
The reason that the inverse relationship between stocks and bonds took hold, the D.E. Shaw paper argued, was that the investing world finally accepted that the Federal Reserve and other central banks had the chops to contain inflation. So investors began getting adept at using bonds to hedge against equity risk.
When positive correlations do crop up nowadays, “they don’t last long,” noted David Norris, head of credit for North America at Twenty Four Asset Management. Indeed, the Shaw data indicate that, except for 2013’s taper tantrum-fed spell, which stretched on for about six months, the others were over in a matter of weeks. Thus far, the current stock-bond twinning has been going on for almost four months.
What Will Bring Back Negative Correlation?
Two catalysts would likely produce a resumption of the usual inverse relationship between stocks and bonds: higher inflation or an economic slump. These haven’t occurred at once since the 1970s, so such a malignant pairing has little chance of happening. The Federal Reserve has learned, from those bad times, that aggressive action is needed to keep inflation in line. So don’t look for an inflation upsurge.
Inflation remains at a tame 1.9% for now. Odds are that price boosts will remain muted for some time due to a host of factors. Technology is a big one—among other things, it allows better price comparisons. With the decline of unions, wage gains are limited. Increased globalization means that manufacturing gravitates to low-cost nations. And aging populations in the West removes expanding populations as a driver of ever-higher prices.
“The Fed has indicated it will let inflation run hotter,” noted Bill Zox, CIO for fixed income at Diamond Hill Capital Management. More rapid inflation would tend to depress bond prices and push up yields “But,” he added, “the market is unconvinced.”
The more probable impetus for ending stocks and bond moving in unison is a recession, or at least a downturn. Fear of that animated the markets last year. Alas, Sino-American trade tensions, the mess of Britain’s exit from the European Union, and all the other calamities haven’t gone away.
While optimism regarding all these issues has blossomed lately, there’s no guarantee that inimical influences won’t, like a roaring movie monster, leap out and lay waste to the economic landscape. Then, two familiar things are sure to happen: Stocks will spiral downward, and everyone will pile into Treasury bonds, whose prices will vault aloft.
The bond market’s pessimistic view has a lot of credibility, history shows. “It has the better record,” Seix’s Keegan said.
By Larry Light