Bonds and stocks may return to their usual ratio, a plus for investors with a traditional mix of assets in their portfolios amid fears that the US is facing a recession this year.
“The bottom line is that the correlation has now shifted back to a more traditional one, where stocks and bonds don’t necessarily move together,” Kathy Jones, head of fixed income strategy at Charles Schwab, said in a telephone interview. “It’s good for the 60-40 portfolio because the point of it is to have diversification.”
The classic portfolio, consisting of 60% stocks and 40% bonds, was hammered in 2022. It’s unusual for both stocks and bonds to move so steeply, but they did last year when the Federal Reserve quickly raised interest rates in an attempt to curb the rise . inflation in the United States
While inflation remains high, it has shown signs of easing, raising investors̵[ads1]7; hopes that the Fed can slow the aggressive pace of monetary tightening. And with most rate hikes potentially over, bonds appear to be returning to their role as safe havens for investors fearing gloom.
“Slower growth, less inflation, that’s good for bonds,” Jones said, pointing to economic data released in the past week that reflected those trends.
The Commerce Department said on Jan. 18 that U.S. retail sales fell a sharp 1.1% in December, while the Federal Reserve released data the same day showing that U.S. industrial production fell more than expected in December. Also on Jan. 18, the US Bureau of Labor Statistics said the producer price index, a measure of wholesale inflation, fell last month.
Stocks fell sharply that day on fears of a slowing economy, but government bonds rose as investors sought safe-haven assets.
“The negative correlation between Treasury yields and US stocks stands in stark contrast to the strong positive correlation that prevailed for most of 2022,” Oliver Allen, senior market economist at Capital Economics, said in a Jan. 19 note. “The shift in the US equity bond correlation may be here to stay.”
A chart in his note illustrates that monthly returns from US stocks and 10-year Treasuries were often negatively correlated over the past two decades, with 2022’s strong positive correlation being relatively unusual over that time frame.
“The rebound in inflation has a lot longer to run,” while the U.S. economy could “take a turn for the worse,” Allen said. “It informs our view that Treasuries will extract further gains over the coming months, even as US stocks struggle.”
iShares 20+ Year Treasury Bond ETF TLT,
has climbed 6.7% this year through Friday, compared with a 3.5% gain for the S&P 500 SPX,
according to FactSet data. iShares 10-20 Year Treasury Bond ETF TLH,
rose 5.7 per cent in the same period.
Charles Schwab has “a pretty positive view of fixed income markets now,” even after the bond market’s recent rally, according to Jones. “You can lock in an attractive return for several years with very low risk,” she said. “It’s something that’s been missing for a decade.”
Jones said she likes U.S. Treasuries, investment-grade corporate bonds and investment-grade municipal bonds for people in high tax brackets.
Read: Vanguard expects a “renaissance” for municipal bonds, as investors should “drool” at higher yields
Keith Lerner, co-chief investment officer at Truist Advisory Services, is overweight fixed income relative to stocks as recession risks are elevated.
“Keep it simple, stick to high-quality” assets like U.S. Treasuries, he said in a telephone interview. Investors are starting to “gravitate” toward long-term Treasuries when they have concerns about the health of the economy, he said.
The bond market has signaled concern for months about a potential economic slowdown, with the inversion of the US Treasury yield curve. That’s when short-term interest rates are above long-term interest rates, which has historically been seen as a warning sign that the U.S. may be headed for a recession.
But more recently, two-year government bonds yield TMUBMUSD02Y,
caught the attention of Charles Schwab’s Jones, as they moved below the Federal Reserve’s benchmark interest rate. Typically, “you only see the two-year yield go below the Fed Funds rate when you go into a recession,” she said.
The yield on the two-year Treasury note fell 5.7 basis points in the past week to 4.181% on Friday, in a third straight weekly decline, according to Dow Jones Market Data. That compares with an effective federal funds rate of 4.33%, in the Fed’s target range of 4.25% to 4.5%.
Two-year Treasury yields peaked more than two months ago, at around 4.7% in November, “and have declined since,” Nicholas Colas, co-founder of DataTrek Research, said in a Jan. 19 emailed note. confirms that the markets have strong faith that the Fed will be done raising interest rates very soon.”
In terms of long-term interest rates, the yield on the 10-year Treasury bond is TMUBMUSD10Y,
ended Friday at 3.483%, also falling for three consecutive weeks, according to Dow Jones Market data. Bond yields and prices move in opposite directions.
“Bad sign for stocks”
Meanwhile, long-dated Treasuries maturing in more than 20 years “have only increased by more than 2 standard deviations over the past 50 days,” Colas said in the DataTrek note. “The last time this happened was in early 2020, going into the pandemic recession.”
Long-term Treasuries are at “a critical point right now, and the markets know it,” he wrote. “Their recent rally hits the statistical boundary between general recession fear and sharp recession prediction.”
A further rally in the iShares 20+ Year Treasury Bond ETF would be “a bad sign for stocks,” according to DataTrek.
“An investor may rightly question the bond market’s pullback-tilting call, but knowing it’s out there is better than being ignorant of this important signal,” Colas said.
The US stock market ended strongly on Friday, but the Dow Jones Industrial Average DJIA,
and the S&P 500 each posted weekly losses to snap a two-week winning streak. The tech-heavy Nasdaq Composite erased its weekly losses on Friday to end with a third straight week of gains.
In the coming week, investors will weigh a wide range of fresh economic data, including manufacturing and services activity, jobless claims and consumer spending. They will also get a reading from the Personal-Consumption-Expenditure-Price Index, the Fed’s preferred gauge of inflation.
“The Back of the Storm”
The fixed income market is on the “backside of the storm”, according to Vanguard Group’s first quarterly report on the asset class.
“The upper right quadrant of a hurricane is called the ‘dirty side’ by meteorologists because it is the most dangerous. It can bring high winds, storm surges and spin-off tornadoes that cause massive destruction when a hurricane makes landfall, Vanguard said in the report.
“Similarly, last year’s fixed income market was hit by a storm,” the firm said. “Low initial interest rates, surprisingly high inflation and a rate hike campaign by the Federal Reserve led to historic losses in the bond market.”
Now, prices may not move “much higher,” but concerns about the economy persist, according to Vanguard. “A recession looms, credit spreads remain uncomfortably narrow, inflation remains high, and several key countries face fiscal challenges,” the asset manager said.
Read: The Fed’s Williams says “far too high” inflation remains his biggest concern
Given expectations that the U.S. economy will weaken this year, corporate bonds are likely to underperform Treasuries, Chris Alwine, Vanguard’s global head of credit, said in a telephone interview. And when it comes to corporate debt, “we are defensive in our positioning.”
That means Vanguard has lower exposure to corporate bonds than it normally would, while also looking to “upgrade the credit quality of our portfolios” with more investment grade than high-interest, or so-called junk, debt, he said. In addition, Vanguard favors non-cyclical sectors such as pharmaceuticals or health care, Alwine said.
There are risks to Vanguard’s view of interest rates.
“While this is not our main case, we could see a Fed, faced with continued wage growth, forced to raise a Fed Fund rate closer to 6%,” Vanguard warned in its report. The rise in bond yields already seen in the market will “help ease the pain”, the firm said, but “the market has not yet started to price such an opportunity”.
Alwine said he expects the Fed to raise its benchmark interest rate to as high as 5% to 5.25%, then leave it at around that level for possibly two quarters before starting to ease monetary policy.
“Last year, bonds were not a good diversifier of stocks because the Fed raised interest rates aggressively to address inflation concerns,” Alwine said. “We think the more typical correlations will return.”