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Markets: Stocks and Bonds May No Longer Be Moving in Unison

Say goodbye to stocks and bonds moving in opposite directions. 

Markets: Stocks and Bonds May No Longer Be Moving in Unison
A monitor on the floor of the New York Stock Exchange (NYSE) in New York, U.S. (Photographer: Michael Nagle/Bloomberg)

(Bloomberg View) -- The post-crisis era has been dominated by a risk-on/risk-off trading environment where risk assets such as stocks and safe assets such as bonds move in opposite directions. That may no longer be true.

Some have dismissed the recent spike in volatility as an isolated derivatives debacle rather than a regime shift in trading patterns. Yet, these gyrations are the results of rising inflation fears that are fueling concern that central banks may exit the markets sooner than anticipated. 

The chart below shows the S&P 500 in blue and 10-year yields in red. The green line in the bottom panel is a rolling five-year correlation of the weekly change in the price of stocks and bonds. From 1954 to 1966 and since 2001, the rolling five-year correlation between stock and bond prices was negative. These periods were dominated by a deflationary mindset. Stock and bond prices moved in opposite directions. Deflation fears depressed yields (boosted bond prices) and pressured stocks lower. When deflation fears dissipated, yields rose and stocks rallied. Wall Street refers to this as risk-on/risk-off.

The shaded area highlights the period from 1966 to late 2001 when stock and bond prices were positively correlated. That was when inflation was a primary concern in financial markets. If inflation was deemed too high, bond yields rose while stocks prices fell. Whenever inflation subsided, bond yields fell along with stocks.

Markets: Stocks and Bonds May No Longer Be Moving in Unison

Although the correlation between stocks and bonds is currently minus 32 percent, there is reason to believe this relationship is changing back to an inflationary mindset, marking the demise of the risk-on/risk-off trade. Consider the scatter graph below, which shows the 15-day percentage change of the total return of the S&P 500 (x-axis) and the total return of the 10-year (y-axis). The chart covers the period since the end of the recession on June 30, 2009.

Markets: Stocks and Bonds May No Longer Be Moving in Unison

The red circles, which denote the plots since the stock market peak on Jan. 26, 2018, show how unusual trading has been over the last 15 days. Stocks and bonds have not declined in unison like this since the dysfunctional days of the global financial crisis in late 2008. Something has bothered the market so much that it has changed trading patterns for the first time in a decade.

We believe the catalyst is inflationary fears, which are on the rise because of strong growth, low unemployment and small business optimism. As the chart below shows, U.S. 10-year inflation breakeven rates are trading near a four-year high.

Markets: Stocks and Bonds May No Longer Be Moving in Unison

The next chart shows the wages and prices paid forecasts from an aggregate of the regional Fed surveys. They are shown as z-scores, which indicate the number of standard deviations they are above or below their average. Both point to a level of inflation not seen during the post-crisis era.

Markets: Stocks and Bonds May No Longer Be Moving in Unison

The last chart provides composites of economic data (blue), manufacturing sentiment (peach), and small business sentiment (red) since 1994. Tax cuts, regulation cuts and fiscal stimulus have pushed these measures to levels not seen in decades.

Markets: Stocks and Bonds May No Longer Be Moving in Unison

The markets have responded to these signs of inflation by altering the relationship between stocks and bonds. Carefully crafted trading strategies built on the risk-on/risk-off mantra, which specifically assumes both stocks and bonds won't decline together, have suffered as a result.

If inflation concerns continue to linger, we may be entering a period where both types of assets move in unison. Those who were around in the 1970s will remember this well, but many will have a difficult time adapting to such a regime change.

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

Jim Bianco is the President and founder of Bianco Research, a provider of data-driven insights into the global economy and financial markets.

To contact the author of this story: Jim Bianco at jimb@bloomberg.net.

To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.

For more columns from Bloomberg View, visit http://www.bloomberg.com/view.

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