Negative stock-bond correlation experiences a resurgence
For more than 20 years, there has been a negative correlation between stock and bond prices, which means that while one does well, the other does not. Balanced techniques and asset allocation portfolios require this negative correlation to function properly. Investors were taken aback when the price correlation between bonds and stocks reversed to a positive value during the 2022 bear market and both asset values collapsed together.
In his article for Sun Life Global Investments, Jason Zhang, Portfolio Manager at SLGI Asset Management Inc, pointed out that when central banks tightened monetary policy to combat inflation in the 1970s and 1980s, stock and bond values fell together. At that time, interest rates dramatically increased throughout developed economies, which put pressure on both asset classes.
In 2022, the correlation between stock prices and bond prices, which has been smooth over time, turned strongly positive, a condition that international investors had not experienced in more than 20 years. This resulted from the sharp rise in interest rates seen by industrialized economies.
Due to the ongoing U.S. banking crisis, the negative stock-bond correlation experienced a significant resurgence in March. This has exposed weaknesses in the asset-liability mismatch, a practice that is prevalent in the banking sector. A slowdown or recession might arise from the U.S. banking sector acting carefully and reducing lending activity, which would restrict the amount of credit accessible to the real economy.
Recent market volatility was a result of widespread investor fear. Stocks started to decline almost immediately because of concerns about their growth prospects. Investors swiftly adjusted their estimates for how much more the U.S. Federal Reserve and other significant central banks might continue to implement tighter monetary policy. Bond prices increased as interest rate forecasts decreased. This aided the recent return of a negative correlation between bond and stock prices.
Recent market volatility was a result of widespread investor fear. Stocks started to decline almost immediately because of concerns about their growth prospects.
Investors swiftly adjusted their estimates for how much more the U.S. Federal Reserve and other significant central banks might continue to implement tighter monetary policy. Bond prices increased as interest rate forecasts decreased. This aided the recent return of a negative correlation between bond and stock prices.
To be clear, it is doubtful that we will continue to follow the policy of "stock down, bonds up," or vice versa, Zhang said. Since inflation dynamics are still somewhat unknown in the intermediate term, there is no expectation for this negative connection to endure for very long.
Because of enduring variables including structural labor market imbalances, geopolitical tensions, and international pledges to decarbonize economies, it will be difficult to return to the 2% inflation "sweet spot" even though peak inflation has passed. Stocks and bonds will probably have a positive correlation rather than a negative one until investors concentrate on the uncertainty surrounding economic development.
