Has the 18-year relationship between bond yields and stocks turned sour?
“We’re a long way from neutral at this point” – Jay Powell, 3 October.
There is a lot of confusion presently as to why the decline in global equity markets accelerated in October. But, in our view, the fact that US equities finally gave way as Treasury yields threatened to break out of their 37-year downtrend is not a coincidence.
Furthermore, it is becoming increasingly clear that central bankers, most notably Federal Reserve (Fed) chair Jerome Powell, are no longer in the business of actively encouraging asset price inflation.
Don’t fight the Fed
While equity market performance has historically tended to vacillate with the profit cycle, there have also been times when monetary policy dominates.
This equity bull market has been influenced more than most by monetary policy and is expensively priced on many metrics as a consequence. We consider these valuation gains to be at risk of reversing as bond yields rise.
A year ago, on 1 October, the Fed started reducing the size of its balance sheet by $10bn per month. So far it has declined by 6.5% give or take. As of this quarter, the annualised pace of shrinkage has increased to $600bn. In the last 12 months, the Fed has also raised short-term interest rates by a total of 1%. With a further hike pencilled in for December, the fed funds rate is expected to hit 2.5% by year-end, and perhaps 3.5% by the end of 2019.
Bonds at critical juncture
We have written previously of how the combination of higher inflation, rising short-term interest rates, a flat yield curve providing no incentive to take duration risk, quantitative tightening (QT) and massive new debt issuance to fund trillion-dollar deficits leaves the bond market looking cyclically challenged.
Once again, the question has been when this would begin to matter for other asset classes. Yields arguably hit a secular low over two years ago in July 2016, but despite more than doubling, have yet to see a major breakout. It would appear we are now at that critical juncture.
Stocks down; bonds down?
Indeed, what was interesting about October is that in spite of the plunge in equity prices, 10-year Treasury yields actually edged up over the month, not down. (Rising bond yields means falling bond prices, of course).
US equities and Treasury yields in October
In other words, you received very little (if any) diversification benefit from what we have all been conditioned to believe is the safety asset in conventional portfolios. This is important.
The classic 60/40 stock/bond portfolio has worked brilliantly for most of the past 18 years: Stocks up; bonds down. Stocks down; bonds up. More recently, stocks up; bonds up!
It’s essential to realise, however, that the world has not always worked out this conveniently. Indeed, from the 1960s to the late 1990s, more often than not it was stocks down; bonds down and vice versa. The negative correlation we have enjoyed between these two asset classes this century has largely been a consequence of the deflationary price regime.
We have warned for a couple of years now how this cycle was turning more inflationary, since when President Trump has eased fiscal policy at a time when the output gap has closed, and threatened the breakdown of global supply chains. If it is indeed the case that our future is more inflationary than the recent past, we should expect the equity/bond relationship to evolve less favourably for portfolios wedded to a traditional asset mix.
Please find our full quarterly Multi-Manager View as a pdf below.
We discussed the state of the equity market in last week's article Mind the GARP – Growth At a Ridiculous Price.
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