05 March 2018, 12:57 GMT
This content was first published on 21 February 2018
Through the equity market jitters of recent weeks, bond investors couldn’t help but feel a little disappointed. After all, the common belief among asset allocators is that bonds are a good diversifier for equities, so it’s normal to see government bonds rally during equity market falls (and vice versa). Yet this didn’t happen - from top to bottom, the S&P 500 fell 10% while Treasuries also fell (albeit by a modest -1.3%, or 16bps higher in 10 year yields).
So what went wrong? The reality is that the correlation between equities and government bonds isn’t always negative. A look at this correlation over the last 60 years shows that a notable shift occurred in the late 1990s. Through that decade, central banks embraced inflation targeting and became successful in getting inflation under control. This pushed correlations firmly into negative territory. Since then, there have been instances where the correlation has turned positive but these have been short-lived (e.g. the 2013 taper tantrum and Trump election in late 2016).
What explains shifts in correlation? Over the long run, it boils down to growth and inflation. The table below shows average bond-equity correlations under different regimes for US growth (expressed versus trend) and CPI inflation. History shows that when the economy is expanding at an above-trend pace and inflation is high, correlation is positive. The reverse also holds true. By itself, high inflation has been a cause of positive correlation, although typically at inflation rates (e.g. 3.5-4%) that are well above the targets of central banks today.
Stock vs bonds correlations
Despite these long run themes, the problem remains that bond-equity correlations can and will periodically shoot higher. The recent spike in correlation was a sobering reminder of that. This time the rise in Treasury yields was likely triggered by an acceleration in U.S. wages, one of the cited drivers also behind the equity correction. Momentum and flow-driven investors then put further pressure on bonds, which was exacerbated by news of a deteriorating US fiscal position. In recent sessions however, correlations have reverted back into negative.
So is the diversification benefit from owning bonds dead? No, far from it. Consensus forecasts for US growth and inflation in 2018 and 2019 are benign (at 2.7/2.4% and 2.1/2.3% respectively). And even allowing for a moderate acceleration in those variables (including the recent uptick in inflation), we are still well away from danger territory. Unless we move into both a high growth and high inflation environment (or inflation shoots up substantially), bond investors should continue to enjoy the diversification benefit. Ultimately bonds are likely to continue to offer income but also excess returns during an economic slowdown.
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