RAPID REACTION STOCK - BOND CORRELATION

Background

The correlation between stocks and bonds has dramatically risen, causing concern among investors. Trailing 1-year correlation began rising in the middle of 2021 and has stayed elevated throughout 2023 while medium term, trailing 5-year, correlation flipped positive late last year. Stocks and bonds have been negatively correlated over the last two decades, however, that was a materially different environment than from the mid-1970s to 1999 when correlation was consistently positive.

New research suggests that the correlation between stocks and bonds tends to increase when inflation is volatile, and growth is not. Importantly, the research suggests that the absolute level of inflation is not an important factor, but rather the volatility and uncertainty regarding it.

Looking Ahead

While strong positive correlation is not likely to persist over the long term, strong negative correlation may not return soon either. Inflation volatility will eventually subside and may be showing signs that it peaked earlier this year, however, this may happen gradually over the next year. As it does, the relationship between stocks and bonds may return to more normal levels and allow the long-term diversification benefits of holding bonds to resume.

For the most conservative investors with anxiety concerning the current environment, money market funds may be an attractive temporary holding, even though money market funds can have significant opportunity costs as a long-term holding. Conversely, longer-duration bonds may also be attractive in this environment as yields may be likely to come down as inflation (and inflation volatility) trend down.

HISTORY OF STOCK-TREASURY BOND CORRELATION

Based on monthly total returns, December 1976 to September 2023