As the latest US rate-hiking cycle enters its final phase, market participants are paying ever-closer attention to comments and actions of Federal Reserve Bank officials. The recent moderation in the rate setters’ rhetoric may have granted equity and fixed-income investors a temporary reprieve, and historical evidence suggests that share prices can indeed continue to rise, even as the yield curve flattens or, possibly, inverts. However, the corresponding co-movement of stock and bond prices also resulted in reduced diversification opportunities and higher portfolio risk. This has, in fact, been a familiar pattern we have observed whenever traders seemed to be concerned about inflation, irrespective of the stage within the cycle and the direction of the overall market.
‘Good’ inflation + hawkish Fed = Trump rally
When the Federal Open Market Committee (FOMC) decided to raise its target rate on Dec. 14, 2016, it was seen as a sign that the central bank shared the general optimism for the US economy, ignited by promises of reduced taxes and increased infrastructure spending from the newly elected presidential administration. Inflation was seen a sign of a healthy and growing economy and US equity markets embarked on a 38% bull run between November 2016 and January 2018. Over the same period, the Fed raised rates 8 times by 25 basis points each, while the 10-year Treasury yield climbed 0.85%.
Concerns were mostly about consumer price growth being too ‘weak’—as sentiment we observed twice in July and November 2017. While share prices were still supported by the so-called Trump rally, bond prices benefitted from declining interest rate expectations. The latter also made the dollar less attractive to foreign investors, and the greenback depreciated against its major rivals. This was very beneficial for US-based global multi-asset class investors, who profited from higher share and bond prices as well as an appreciation in their foreign-currency holdings. On the flipside, the co-movement of almost all asset classes meant fewer diversification opportunities and increased overall portfolio risk.
‘Bad’ inflation + hawkish Fed = stock market correction
The opposite market movements could be observed in February 2018. Suddenly, ‘good’ inflation turned into ‘bad’ inflation and equity and bond markets dropped in unison. The dollar, on the other hand, was lifted by the prospect of a more severe response from the central bank. While this had a similar effect on portfolio risk, as bond prices, share prices and exchange rates once more moved in the same direction, US multi-asset investor were now hit by a perfect storm of falling valuations everywhere.
Easing inflation + dovish Fed = share price recovery
More recently, inflationary pressures started to ease and the Fed significantly softened its rhetoric, using words like “neutral” and “patient” to describe its monetary policy stance. This resulted in a significant reduction in short-term interest-rate expectations from 3-4 hikes back in October to 1-2 more raises presently. Long US Treasury yields, too, fell by more than 60 basis points from their 7-year peak 4 months ago, back to levels observed at the start of 2018. Meanwhile, the Dollar Index lost around 2% between mid-November and late January. The alleviation of fears that the central bank could tighten monetary conditions too much also led to a recovery in the stock market, so that once again all asset classes appeared to move in the same direction.
Inflation concerns = limited diversification + increased risk
All these different scenarios seem to indicate that whenever markets are concerned about consumer price growth and central bank action, cross-asset class correlation tend to turn positive—at least from the point of view of a domestic investor (in this case the US). When inflation is perceived as too high, stocks and bonds sell off simultaneously, while the currency is lifted by the prospect of higher short-term rates. During periods of (too) low inflation, on the other hand, equity and bond prices rise and the currency devalues. While in both cases the co-movement of the various asset classes significantly curtails diversification opportunities, the impact on portfolio performance very much depends on the stage within the interest rate cycle.
Yield curve inversion = lower stock prices + recession?
As the global economy begins to run out of steam, market participants appear to have come the conclusion that the Federal Reserve Bank has almost reached the end of its present hiking phase. Yet, share prices are still going up. In fact, as we found in a recent study on past central bank cycles, historical evidence suggests that stock markets can continue to rise for another 6 months after long-term yields dropped below short rates. While this may indicate a near-term continuation of the recent simultaneous rise in stock and bond valuations, investors should still start preparing for reduced diversification opportunities and higher overall portfolio risk.