Why stocks and bonds are moving in the same direction – down

An increasingly stagflationary environment has reversed the traditional relationship between the two asset classes, with both bond and stock markets struggling amid high inflation, slowing growth, rising interest rates and a hawkish Federal Reserve

Marcella Chow

Published: 4:30pm, 20 May, 2022

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The year so far has been challenging for global markets. Growing concerns about an overly hawkish US Federal Reserve and intensifying growth headwinds in China have led to equity sell-offs while the rise in US Treasury yields has weighed on fixed income markets given the inverse relationship between bond prices and interest rates.

While historically stock and bond performances have tended to move in opposite directions, both asset classes have seen negative returns in the year to date with an increasingly positive correlation.

Much of the downward pressure on equities has stemmed from stickier than expected US inflation. The US April consumer price index has reinforced sentiments that high inflation may persist throughout the next quarter, leading to concerns about the Fed over-tightening as it attempts to tame inflation by increasing interest rates.

Higher interest rates mean increased borrowing costs which cools economic activity by weighing on business capital expenditure and consumer spending, and may further slow down growth. Investors are worried that interest rates may be increased too much too quickly, which could tip the economy into a recession.

After the Fed announced an interest-rate increase of half a percentage point earlier this month, markets expect the Fed funds rate to reach 2.7-2.9 per cent at the end of the year, indicating three more half-point jumps and two more quarter-point increases. Market participants will look for clues in the upcoming meetings, especially the June meeting, to get a better sense of the Fed’s policy plans.

The headquarters of the US Federal Reserve in Washington on May 3. The recent rate increase was the biggest jump in over 20 years. Photo: Kyodo

Having said that, we believe that inflation in the United States can moderate without a recession as the Fed will do its utmost to engineer a soft landing for the country’s economy. Economic growth will inevitably slow this year but inflation should moderate as reopening demand subsides and supply chain pressure alleviates over the course of the year.

This would allow the Fed to moderate its hawkish tone, thereby supporting both the US equity and fixed income markets. In the near term, however, market volatility may continue before there’s more clarity on the Fed’s tightening plans.

The second driver of volatility stems from a tepid outlook on global economic growth. In particular, the resurgence of Covid-19 in China and its zero-Covid policy have dragged on domestic economic activity and tightened global supply chain bottlenecks. While Covid-19 cases have peaked and mobility indicators suggest a moderate pickup in economic activity, April’s data showed a bigger-than-expected drop in China’s economic activity, with both retail and property sales and industrial production declining.

Concerns are also mounting in China’s labour market, with its unemployment rate rising to 6.1 per cent last month. The health of its labour market will be a top-line agenda as China evaluates its pandemic control strategy. More effective policy easing is needed to provide some relief to the Chinese economy.

Tax rebates and reductions for businesses have been deployed, but the effects have been fleeting as companies have mostly been loss-making during the lockdown. After the recent reduction in the minimum mortgage rate for first-time homebuyers, we expect the People’s Bank of China to roll out more targeted relending in the near term. There have also been more calls for cash handouts from the central government.

To soften the impact of equity market volatility, investors traditionally relied on the negative relationship between stock and bond performances to diversify their risks. The average correlation between the weekly returns of S&P500 and Bloomberg US Aggregate Bond Index has been -37 per cent over the past two decades, meaning as equities underperformed, fixed income typically outperformed, and vice versa.

However, an increasingly stagflationary macroeconomic environment – characterised by high inflation, slowing growth and rising real interest rates – has led to a reversal of this relationship. As equities and fixed income products fell at the same time, the correlation between S&P500 and Bloomberg US Aggregate Index weekly performances reached a peak of 25 per cent at the beginning of this month.

We expect such a trend to continue in the near term as both asset classes continue to digest high inflation and hawkish monetary policy, which tends to drive stocks and bonds in the same direction. As the rise in real interest rates stabilises and inflation moderates, the stock-bond relationship may gradually return to negative.

Marcella Chow is a global market strategist at J.P. Morgan Asset Management