Unnatural Acts: When stocks and bonds trade together

We always watch bonds closely. In the beginning of this blog’s history some readers might have called our fixation obsessive, so we diversified but never stopped watching. A while ago we pronounced that the bubble to watch wasn’t the stock market, it was the bond market. As of today we maintain this viewpoint, more so than before.

One indicator we like to follow is the correlation between stocks and bonds. Orthodoxy dictates that stock and bond prices should move in opposite directions, but in reality that is not always the case. For instance, the following chart plots the rolling 20 day correlation between SPY and TLT, a measure which tracks the broad correlation between US debt and equities:

rolling_corAs we elaborated upon back in December of last year, when short term correlations between stocks and bonds go positive, its usually because price action is being dominated by Central Banks. By this we mean: right now the market is primarily responding to the prospect of tightening by the FOMC.

We have been living with the probability of higher interest rates for some time now, but we haven’t seen people heading for the exits en masse. The decline in long bond prices earlier in the year wasn’t catastrophic, but it wouldn’t take much to reignite the flames. In previous episodes of high stock-bond correlation, quick declines in stock prices have tended to bring correlations back in line (i.e. correlations go negative again, volatility spikes, thus re-inflating the bond bubble).

Given the backdrop of a rising dollar and the removal of US monetary stimulus, rising correlations are most likely the result of the market preparing for the initial shock of a rate increase. What is troubling is the idea that stocks and bonds could go down together. Given the simultaneous levitation of both asset classes since the Fed embarked on QE in 2008-2009, is it that far fetched to consider a simultaneous decline? Or will the stock market rally and recovering economy force the Fed to pop the bond bubble with a prolonged tightening period?

During this phase monetary expansion we saw stock prices increase overall, but the process was characterized by sharp declines. These drops were the result of rapid declines in the market’s faith in our monetary experiment. During these episodes, money rushed into bonds for safety. When a crisis receded, it seemed as though some money never left the bond market: yields on government bonds became very compressed. Each crisis ratcheted bond prices a little higher while each recovery took stock prices to a new high. In the case of monetary tightening, perhaps the ratchet will work in the opposite direction.

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Lead image CC BY-SA 3.0 – Markus Schweiss

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