Blog Posts — September 15, 2021

The Top 3 Drivers of the Stock-Bond Correlation (and, Yes, Inflation is One of Them)

by Christoph Schon, CFA, CIPM

Another strong gain in US producer prices in August revived inflation fears and sent stock and bond markets into a synchronous tailspin. While moderate growth in consumer prices is usually seen as evidence of a healthy, recovering economy, persistently strong price increases would steadily erode the present value of future interest payments, dividends, and corporate earnings. A sustained period of elevated inflation expectations would also likely prompt central banks to tighten monetary conditions, which could further depress asset valuations. The resulting rise in bond and earnings yields could then drive a co-movement of the two, as they start competing for investors’ money.

In our latest whitepaper, Inflation and Its Impact on the Stock-Bond Correlation, we examined the historical interaction of equity and bond-market returns over the last 60 years to identify the main triggers of shifts in their relative directions—especially situations that might prompt the two asset classes to persistently move together. We identified three possible scenarios.

Scenario 1: Inflation surges and remains well above 2.5% for a prolonged period

Figure 1 illustrates the relationship between inflation and the interaction of stock and bond prices since 1960. The green area in the left chart shows the total-return correlation of US large-cap stocks and long-term government bonds, based on monthly returns over a rolling 5-year window. The dark blue line depicts the year-on-year percentage changes in the US consumer price index (CPI), excluding food and energy, with the dotted light blue line representing the 5-year trailing average. The scatter chart on the right is based on the same data, plotting the stock-bond correlation (green area from the right) over the corresponding average inflation (dotted light blue line) The colored dots represent the distinct periods of mostly positive, negative, or low correlation.

Figure 1. US inflation and stock-bond correlation

Sources: Morningstar Direct, FRED®, U.S. Bureau of Labor Statistics, Qontigo

The charts show a connection between the average level of inflation and the relative movements of stock and bond prices. Whenever the former seems to deviate too far from the 2% central-bank target, the two asset classes appear to move in tandem. The chart on the right suggests a corridor from 1.6% to 2.4%. This seems to be supported by the fact that over the past 18 years, the 10-year US Treasury breakeven rate has been between 1.5% and 2.5% for 80% of the time (90% between 1.4% and 2.6%), and that the stock-bond interaction tended to turn positive when inflation expectations moved outside of these boundaries.

Scenario 2: The Federal Reserve tightens monetary policy beyond what is justified by economic growth

The fact that recent US breakeven inflation rates have mostly remained anchored at just under 2.4%, despite the current surges in consumer and producer prices, highlights the importance of monetary-policy expectations. Most major central banks nowadays have some sort of inflation target, usually around 2% over the medium to long term, which they try to achieve primarily through either open-market operations (buying and selling securities), or setting interest rates at which banks can borrow or deposit funds. The appropriate level of the central-bank rate largely depends on how far inflation and real GDP growth deviate from their long-term targets and linear trends, respectively.

Figure 2. Monetary policy and the stock-bond correlation

Sources: Morningstar Direct, FRED®, U.S. Bureau of Economic Analysis, Board of Governors of the Federal Reserve System (US)

One such indicator is the so-called “Taylor Rule”[1]—named after former American economist and presidential advisor John Taylor—depicted by the light blue line in Figure 2. The dark blue graph shows the actual effective Federal Funds rate, with the light blue area representing the deviation from the rule-based rate. A positive or negative gap implies monetary policy that is either contractionary or expansionary, respectively. The green area once again denotes the stock-bond return correlation.

Looking at only the last 40 years, one might conclude that a policy rate above what is prescribed by the Taylor Rule (contractionary monetary policy) is conducive to a co-movement of stock and bond prices, whereas an expansionary stance goes hand-in-hand with a negative stock-bond correlation. Yet, the effective Fed Funds rate was also trailing the rule-based rate in the 1970s, when stocks and bonds sold off together. What was different then, though, was that consumer prices grew at double-digit rates, while in the past two decades, inflation expectations stayed close to 2%, despite extended periods of ultra-low interest rates.

Scenario 3: Long US Treasury yields rising significantly to compete with equity earnings yields

The overall level of interest rates and bond yields also seems to have a role to play. During the three decades of positive stock-bond correlation before 2000, the effective Fed Funds rate was generally higher than in the past 20 years. The same was true for sovereign yields, as can be seen in Figure 3. In fact, for much of the 1970s, ‘80s, and ‘90s, the 10-year US Treasury rate (light blue line) was at a similar level or even slightly higher than the average earnings yield for large-cap equities (dark blue line). Plotting one against the other in a scatter chart further highlights that the periods in which the relationship was strongest and most positive (the green dots) were when Treasury and earnings yields were above 5%.

Figure 3. Treasury yields, earnings yields, and the stock-bond correlation

Source: Robert J. Shiller, data used in Irrational Exuberance

Of the three drivers presented above, inflation is probably the most significant and important, as it tends to impact the other two. So, looking ahead, any shifts in the stock-bond correlation will likely depend on how consumer prices develop over the next year or two. Thus far, market-implied inflation expectations appear to be buying into the Fed’s narrative that the current spike is only transitionary. As long as it stays that way, multi-asset class investors should be able to continue relying on sovereign debt for risk diversification and downside protection.

[1] The Taylor Rule states that the target rate should be set at the current rate of inflation, plus a real yield of 2%, and that the central bank should raise or lower the rate by 50 basis points for each percentage-point deviation from either the 2% inflation target or from potential GDP growth.

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