Breakdown of Stocks-Bonds Link Leaves Investors Nowhere to Hide

(Bloomberg) -- Money managers may have nowhere left to hide.

Bond yields and stocks have spent much of the past decade being positively correlated, but that trend of rising and falling together has broken down. The shift makes it harder for investors to hedge equity risk, meaning that perhaps “the bond tail is wagging the equity dog,” according to Pacific Investment Management Co.’s Mihir Worah.

“Bond yields have been rising recently while equity prices have been falling, a combination that is confusing many investors who have come to depend on the ‘reliable’ negative correlation between stock and bond prices to reduce the volatility of their portfolios,” Pimco’s chief investment officer for asset allocation wrote in a blog post Friday. “The rise in bond yields and concurrent shakiness in equity markets may emanate from a subtle but important shift in risk sentiment on inflation.”

Breakdown of Stocks-Bonds Link Leaves Investors Nowhere to Hide

Both actual measures of inflation and market expectations have been rising. The breakeven rate signaled by 10-year inflation-linked Treasuries this month reached its highest since 2014. The central bank’s preferred gauge of inflation rose to 2 percent in March, government data showed Monday. It was the first time it hit the Federal Reserve’s target since February 2017

Rising price pressures are also encouraging the Fed to press ahead with gradual policy tightening, which is weighing on both stocks and bonds. After raising rates in March, officials are expected to hold steady this week, and have previously signaled two more hikes in 2018 as likely.

Jury’s Out

Some say the jury is still out on the stock-bond connection.

“The historic relationship between stocks and yields is far from stable,” Citigroup Inc. strategists Mark Schofield and Jeremy Hale wrote in a note Monday. “The speed and magnitude of the rates move seems likely to be a determining factor in the equity response.”

The 10-year Treasury yield rose above 3 percent this month for the first time since 2014, while the S&P 500 index is down about 7 percent from a record high set in January. So in recent months, prices of both have moved largely in the same direction.

“Long-term investors who buy high quality bonds for income or for a hedge against recessions will likely find those objectives fulfilled,” Worah said. “However, those who buy high quality bonds to hedge every zig and zag in the equity markets may have more surprises in store.”

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