Bond Stock Correlation to Turn Positive Again in Autumn?

Summary

• During April-July, bond and stock prices were positively correlated. That has been unusual since the late 1990s but was normal before then.
• The turn positive could reflect that economic shocks have become mainly real since the 1990s (as opposed to inflation shocks before then) and that bonds and stocks react to real shocks in opposite directions, but to inflation shocks similarly.
• The positive correlation during April-July could therefore reflect the decline in inflation expectations.
• Inflation expectations are set to decline further as demand strength and supply constraints are easing, meaning the bond stock correlation could turn positive again, for a limited period of time, in autumn.

Market Implications

• Positive bonds and stocks.

The Bond Stock Correlation Only Turned Negative After the Late 1990s

During April-July, the bond stock correlation turned positive. This is unusual: since the late 1990s, it has generally been negative (Chart 1). I believe the correlation largely reflects the prevailing macro regime.

The Negative Bond Stock Correlation Reflects the Low Inflation Regime

Until the 1990s, the main source of nominal GDP (and therefore earnings) volatility was inflation (Chart 3). Afterwards, inflation fell and became stabler, and the main source of nominal income volatility became real GDP. The more stable macro environment is also evidenced by the decline in the term premium – the excess yield investors need to hold a long-term bond instead of a series of short-term ones (Chart 4). The term premium tends to rise with economic uncertainty, including (but not limited to) inflation uncertainty.

Stock and bond prices both tend to be negatively correlated with inflation. By contrast, real growth is positive for stock prices and negative for bond prices. Therefore, in the inflation-driven macro environment prevailing up to the 1990s, the bond stock correlation tended to be positive. By contrast, with real growth becoming the main driver of nominal GDP since the 1990s, the bond stock correlation has turned negative.

Will Autumn See a Renewed Positive Bond Stock Correlation?

The above suggests the recent episode of positive bond stock correlation could reflect the decline in inflation expectations since April . Before that, inflation expectations had increased, but growth expectations had increased by much more, resulting in a negative bond stock correlation.

Going forward, inflation is likely to continue to surprise on the downside and prompt a further downward revision in expectations. MoM core inflation has likely peaked. Relative to February 2020, the annualized change in the price of holiday-related spending, i.e., transportation goods and services, hotels and restaurants, is peaking (Chart 6). The price of other core CPI components is also peaking on an annualized basis. And while owners’ equivalent rent (OER) inflation, which accounts for 30% of core CPI weights, has increased to 2.3% annualized relative to February 2020, residential REIT prices are falling. That suggests rents could be about to peak. Regardless, with real household incomes falling, affordability will likely cap the increase in rents.

Slowing inflation reflects mainly an easing of demand strength. The negative surprise in Julyretail sales and the collapse of August consumer sentiment, which tends to drive durable purchases, shows this for instance. Pandemic benefits have ended in red states representing about 40% of the US economy, just when Delta has slowed the recovery and inflation is eating into households’ real income. Pandemic-related benefits are set to end for all Americans in September.

Market Consequences

A downward revision of inflation expectations would be positive for stocks and bonds. This will come with a revision of growth expectations and possibly the end of the expansion next year, but any downturn would be shallow as economic normalization still has a far to go.

The positive correlation would last only while inflation expectations moved to their LT lower level. Once the expectations adjustment is over, the negative correlation will likely reassert itself as macro shocks would once more become mainly real, rather than inflation, shocks.

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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)