Stop Panicking About Stock-Bond Correlations

(Bloomberg Opinion) -- When U.S. stocks tumbled on Wednesday by the most since February, a number of theories were posited for the sell-off, from concerns about the trade war with China to the lack of share repurchases.

But the one that seemed to get the most traction was pinning the blame on bonds. Benchmark Treasury yields had climbed too far, too fast, the argument went, and traders could no longer count on ultra-low interest rates, the crucial underpinning of the long bull run in equities. That’s definitely part of it. But some strategists took it a step further, concluding that when bonds and stocks fall in unison, equities ultimately crumble. That was based on the 52-week correlation between the S&P 500 and the 10-year U.S. Treasury over the past 20 years. That figure is now around zero.

Stop Panicking About Stock-Bond Correlations
I’m skeptical of that theory. First, it’s unclear how an analysis of that length fits the swift moves that happened over the past several days. Also, a correlation around zero doesn’t necessarily mean that bonds and stocks are destined to rise or fall together — that would be a correlation of one. It just means that their relationship isn’t as easy to predict as it might have been before.

Treasury trading on Wednesday put that dynamic in stark relief. Clearly, markets were ready to push the narrative that higher U.S. yields were taking a bite out of stocks, given that the 10-year Treasury reached 3.24 percent just before the stock market opened. By the end of the day, the yield had fallen to 3.16 percent in the biggest two-day rally since early August. Investors found a place to hide after all.

That’s right: bonds rallied and stocks declined. No more worrying about their prices moving somewhat more in unison.

Of course, it’s a bit more complicated than that. Like February’s equities rout, markets are trying to find an equilibrium between rising U.S. rates and stocks near their all-time highs. Unsurprisingly, the first reactions from Wall Street were that this slide was “slightly overdue” and not a reason to panic. And, for now, they’re right. If you’re feeling queasy, just pull your S&P 500 chart back five years — or better yet, make it a decade.

In other times, a stock tumble like this might have had traders betting that the Federal Reserve would slow its interest-rate increases. That’s certainly what President Trump wants — he told reporters on tarmac in Pennsylvania late Wednesday that the “Fed is too tight,” is “making a mistake,” and has “gone crazy.”

Central bank independence aside, this is a different era. As long as the equities carnage doesn’t spill over into the “extraordinary” U.S. economy, Chairman Jerome Powell seems likely to push forward with tightening policy. It’s not his job to make sure benchmark stock indexes hit record after record or to appease Trump. Though, to be fair, he’s also never had to deal with a sustained period of stock market weakness. For now, the eurodollar futures market signals that bond traders are just about as confident as they were earlier in the week that the Fed will stay the course, pricing in another move in December and more than two quarter-point increases in 2019.

We’ll know more in the coming days about how this tug of war between stocks and bonds will end. A resolution like February certainly seems possible: Treasury yields settling into a range while the S&P 500 swings around a bit more before finding its footing. Any number of strategists have said to expect more volatility as the Fed raises interest rates, and yet they all still seem surprised when it comes.

But don’t shed tears for risk-parity strategies in times like these. They only have themselves to blame for fighting against this more hawkish Fed. Ultimately, if things get messy, Treasuries will still be a haven.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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