The notion that stocks should rise while bond prices fall, and vice versa, is an enduring piece of investing conventional wisdom. But history shows the relationship between the two asset classes is more complicated.
This is worth keeping in mind, market strategists said, as data from Morningstar show that Treasurys and large-cap U.S. stocks have rarely been more in sync than they are now.
On a rolling three-year basis, correlation between intermediate-term government debt and large-cap stocks peaked at 0.57 in December, its highest reading since September 1997, and has remained near this level through the end of April.
Since bond yields move opposite to price, periods of strong correlation between stocks and Treasurys mean that equity prices tend to rise as Treasury yields fall, and vice versa.
Two asset classes rise and fall in perfect unison at a correlation of 1.0; conversely, a correlation of -1.0 indicates that one consistently increases while the other decreases. A correlation of zero indicates that there is minimal association between the variables.
Numerous investors lament the apparent decline in the ability of bonds to safeguard stock portfolios against sudden declines. The agony of 2022, when bonds and stocks fell in tandem, continues to loom large in the minds of many.
And as U.S. stocks have continued to recover from their lows in October 2022, the return gap between stocks and bonds has prompted investors to question whether bonds warrant a significant portion of the portfolios of all but the most conservative investors.
The duration of the three-year drawdown in U.S. bonds is the longest in the history of the Bloomberg U.S. Aggregate Bond Index AGG, which includes municipal bonds, corporate bonds, asset-backed securities, and Treasury bonds. It debuted during the 1970s.
However, the belief that bonds will always come to the rescue when stocks suffer is often influenced by recency bias, as noted by Amy Arnott, a portfolio strategist at Morningstar who has extensively discussed the correlation between stocks and bonds.
The shift from a long-standing negative correlation between stocks and bonds to a positive one in 2022 was a significant departure from the norm. Prior to this, the correlation between stocks and bonds was typically close to zero, as stated by Arnott.
Many individuals have been examining the impact of correlations following the financial crisis and the extent to which they became highly negative. According to Arnott, when looking at historical data, it is uncommon to find a negative correlation between stocks and bonds.
Meanwhile, there have been periods in the past where the correlation between these two asset classes was quite high, similar to the current situation. These periods would usually last for a duration of one to eight years, according to Arnott.
Research indicates that two key factors play a crucial role in determining the relative trading patterns of stocks and bonds. According to Sébastien Page, head of global multiasset and chief investment officer at investment-management firm T. Rowe Price, the level of inflation is of utmost importance.
During an interview with MarketWatch earlier this week, Page shared a simple model that can predict whether the correlation between stocks and bonds will be positive or negative.
Is the model based on whether you experience an inflation shock or a growth shock? When faced with an inflation shock, such as the one we’ve experienced in the past three years, it is possible for both stocks and bonds to decline simultaneously.
If you’re experiencing a sudden surge in growth, it’s reasonable to anticipate that bonds will provide diversification for stocks and perform favourably during stock market downturns.
According to Arnott, the correlation between stocks and bonds traded closely in step during the mid-1990s, thanks to the impact of rising interest rates by the Federal Reserve. This highlights the significance of the Federal Reserve’s decisions on interest rates.
If inflation remains stable, bonds are likely to become better hedges for stocks when the Fed begins to lower interest rates, as anticipated by traders using CME Group’s FedWatch tool.
According to Arnott, bonds could potentially provide a cushion for stocks in case of a weakening U.S. economy, even if the Fed decides to keep interest rates unchanged for an extended period. Even at present, the lack of perfect correlation between bonds and stocks implies that bonds still offer a degree of diversification advantage.
“Given the correlation is still noticeably below 1, incorporating bonds into a portfolio focused on equities should enhance your returns when considering risk,” stated Arnott. “Even with correlations around 0.6 or 0.7, there is still a notable diversification benefit.”
Currently, commodities are closely correlated to stocks. However, the strategists at Wells Fargo Investment Institute believe that commodities still provide some diversification benefit.
On Wednesday, Treasury yields saw a slight increase, as the 10-year yield rose by 2 basis points to 4.48% BX:TMUBMUSD10Y. Meanwhile, U.S. stock futures indicated a lower opening on Wall Street.
Since the beginning of the year, the S&P 500 has experienced an 8.8% increase, reaching 5,187 as of Tuesday’s closing. Similarly, the Nasdaq Composite has also risen by 8.8% to 16,332, while the Dow Jones Industrial Average has gained 1,194 points, or 3.2%, reaching 38,884.
