The Price Correlation Between Stocks And Bonds

I turned 55 a couple of weeks ago, but at times I feel even older than that. Not in a physical sense, although a glance at my profile picture will quickly indicate that fitness training is not a big hobby of mine, but in the way I look at things. I started my career in trading just over thirty years ago, and at that time I was taught certain immutable truths about the way that markets moved and the relationships between them. A casual glance at what is going on now, though, could easily lead one to conclude that those relationships have completely broken down. It is a confusing world for an old man, but logic suggests that these are temporary phenomena, and those that have come to trading and investing in the last few years and know nothing else are in for a rude awakening when order reasserts itself.

The most obvious distortion of a “rule” is in the relationship between stocks and bonds. Conventional wisdom has it that when stock prices go up, bond prices go down. In other words, bonds and stocks have an inverse relationship. The logic behind this is simple. Investors have to choose between the safety, but relatively low return, of bonds, or the risky nature, but relatively high return, of stocks. If they are fully invested they have to sell one in order to buy the other, though, so bond prices tend to drop when stocks are rising and vice versa. As logical as that sounds, the exact opposite has occured on many occasions over the last few years; stocks and bonds have risen and fallen in tandem.

This strange behavior, however, can be explained in just two words: The Fed. I am not a Fed basher; I genuinely believe that the policies that the central bank has pursued since the recession were forced on them by circumstances, and that in those circumstances they have been remarkably successful. That doesn’t mean, however, that I am not a realist, and the fact is that those policies have not been without problems. With the benefit 20/20 hindsight, it is possible to say that some mistakes were made.

The biggest of those mistakes was in not giving enough consideration to an exit strategy when interest rates were being lowered to an effective rate of zero and the Fed started to purchase assets in what is known as QE. I don’t think anybody expected those policies to last as long as they did and it was that longevity that created the problem. Markets became accustomed to lots of free or cheap capital, and taking that away risked a major disruption, the like of which could easily derail a fragile recovery.

Continued easy monetary policy therefore became the only viable course, but after a while we moved from “priming the pump” to flooding the system. In the first few post-recession years that liquidity helped to get stock valuations back to normal, and in doing so increased confidence in the economy. Once we got to reasonable valuations, however, the continuing flood of money started looking for a return, and 1.75% on the U.S. 10 year didn’t cut it. Money was forced into a fully valued stock market and we got to where we are now, when stocks are still going up, even in the face of what looks like soon becoming six straight quarters of negative earnings growth for the S&P 500.

Obviously, if it is Fed policy that has, at least to some extent, created that situation, then stock prices will respond to any change, or perceived chance of a change, to that policy. What has created the distortion in the relationship between stocks and bonds, though, is that bonds will do the same, and every other indicator has given way to interest rate sensitivity. If there is a chance of an interest rate hike then bonds will be sold, but so will stocks, and vice versa. Both markets therefore move together.

What we do know, though, is that the Fed seems increasingly determined to return to a more normal interest rate environment, and that that will happen fairly soon. As that process goes on bond prices will presumably fall, but in a fairly orderly fashion. The price adjustment in stocks, however, could be anything but orderly. The fact that we are at above average multiples of earnings that have been falling for a year and a half indicates that the Fed’s easy money policy has been the main supporter of the market. When that goes away the adjustment must come. When that happens, us old folks will be nodding our heads as bond prices go up and stocks drop and saying, “See, I told you that is just the way of things," and lecturing you youngsters about how it used to be in the good old days.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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