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I’ll admit, there are times where I point out some chart-based evidence of uncertainty in the bond market and I feel like we’re just delaying an inevitable move. The most recent sideways consolidation felt like that yesterday. Sure, yields were locked inside a nice, linear consolidation range, but with the coronavirus situation apparently improving and US stocks at all-time highs, it felt like we were merely waiting for rates to eventually break higher.
What a difference a few hours can make! Stocks are still pretty close to those all-time highs, but bonds have moved to heavily favor the lower end of the recent range. Whereas I noted that the upwardly-sloped trend line was better established yesterday, today’s gains quickly level the playing field (i.e. both of the red lines in the chart below have plenty of bounces).
For those that subscribe to the ancient and misguided notion that stock prices and bond yields must move in the same direction, this is incredibly puzzling. In their defense, we often see exactly that, but only under certain conditions. Stock/bond correlation is best seen over shorter time horizons or when the entire financial market is moving to price-in or price-out a recession or significant economic downturn. The Fed is the other x-factor as a friendly Fed generally coincides with falling rates and rising stocks.
Right now, we do indeed have a friendly Fed and we also in the midst of a lengthy and stable economic expansion with no clear signs of the need to price-in economic contraction. In other words, there’s very little to inform stock/bond correlation apart from unexpected market shocks like coronavirus. As the following chart shows, coronavirus took a clear toll on both stocks and bonds in late January. The improved outlook in early February prompted a rebound, but bonds haven’t been as quick to move back up.
If that shorter-term chart comes as a surprise, the longer-term chart won’t really help. In it, we see stocks moving almost exclusively higher at the same time that rates were moving lower a vast majority of the time. Correlations certainly emerged when the trade war hit, when trade prospects improved, and amid the coronavirus volatility. But even over this longer time horizon, we see the same sort of behavior with bonds resisting a move back to higher levels, despite stocks surging to all-time highs.
To reiterate, the Fed is a big piece of that puzzle. They’ve been able to offer the market accommodation in a few ways, but the most significant way is arguably their forward guidance. In short, they’ve been clear in saying that there is a very high bar for any more rate hikes. Strong economic data isn’t even enough for them to make such a move. They’d have to see a marked uptick in inflation, and that’s proven to be elusive time and again in recent years (so much so that policy officials openly express confusion as to why it hasn’t shown up). Additionally, the Fed repeatedly says the next economic downturn will see a reprisal of the same sort of bond buying programs that juiced financial markets during the great recovery (2011-2015).
All that to say, bonds have some reasons to avoid a quick return to recent highs, even as the stock market can justify it. Coronavirus adds to the discrepancy because bonds are accounting for the economic impact likely to be seen in the near future while stocks are fresh off a strong earnings season and generally riding the wave of ongoing US economic expansion. Bonds are also a global safe haven in times of uncertainty. The US economy is decent for now, so US stocks are forgiven for being as high as they are. But the Chinese economy will undoubtedly take a bigger hit from coronavirus–so much so that investors haven’t been nearly as quick to fuel a rebound in Chinese stocks.
Bottom lines on stock/bond discrepancy:
- A friendly Fed serves as a backdrop for generally lower rates and higher stock prices
- Coronavirus hurts the Chinese and global economies more than the US economy
- Global investors use the US bond market as a safe haven
- The US bond market always does more to price in economic expectations for the future than the stock market