Stocks up, bonds down? Not at the moment!

If, like me, you spent your entire working life in the 21st century, you may find yourself, like me, assuming that equity and bond market returns are inversely related most of the time. I don’t want to bore you with the details of the dividend discount model (a remote memory from CFA Level I) or the “Fed model”, but there are strong indications that this may not always have been the case. Anyway, if, like me, you were professionally trained in an environment of ever-lower interest rates and excessive central bank action, you will be excused for assuming, like me, that bond prices go down when equity markets go up and vice versa.

Let’s take, for instance, the so-called “Trump rally”. From the day after the presidential election (November 9, 2016) to the end of last year, the US stock market and the USD both gained 5%. Over the same period, the 10-year US Treasury yield surged more than 70 basis points from under 1.9% right before the election to a peak of 2.6% on December 15 when the Federal Reserve Bank implemented its first rate hike of the current cycle. Meanwhile, the proposed tax cuts and fiscal spending plans of the new administration raised concerns about rising inflation, and government bond implied breakeven rates increased by 30-40 basis points.

We also saw the opposite movements whenever the focus shifted towards (geo-)political risk. For example, when tensions between Russia and the West rose over Syria and President Trump decided to warn North Korea by sending an aircraft carrier fleet towards their waters in April, yields declined quite rapidly (sending bond prices up), while share prices went south. The same happened again in the middle of May when the 10-year rate dropped by 11 basis points and US stock market lost almost 2% in a single day after claims that President Trump had interfered with an FBI investigation, which led to concerns about a possible impeachment.

In the last week of June, we suddenly saw the relationship between stock and bonds shift. While mildly hawkish comments from ECB President Mario Draghi and BoE Governor Mark Carney at a central bank conference sent bond prices into a downward spiral, the equity market also suffered losses driven by a sell-off of tech stocks. Another day that stood out was July 12, when 10-year Treasury yields dropped 4 basis points and US equity indices gained 0.7%. Those moves were triggered by Fed Chair Janet Yellen’s testimony to Congress that day, in which she was mostly bullish about the US economy, but at the same time added a note of caution with regards to consumer price inflation, thus putting into question the projected path of future rate hikes.

This change in risk factor correlations had a considerable impact on the risk of Axioma’s multi-asset class model portfolio. Previously, fixed income assets would provide a good hedge for equity risk, and both asset classes moving in the same direction removed an important source of risk reduction from the portfolio. Furthermore, the recent dollar weakness combined with record highs at stock markets around the globe made equity returns across currencies seem even more correlated, adding yet more volatility to the portfolio.

We don’t know how long this “anomaly” is going to last, but if you would like to be kept up-to-date, why not sign up for our weekly equity and multi-asset class risk monitor updates here

Christoph Schon, CFA, CIPM

Christoph Schon is the Executive Director, Applied Research for EMEA at Axioma, where he generates insights into recent risk trends with a particular focus on fixed income and multi-asset class analysis. Christoph has been in the portfolio risk and performance analysis space for more than 10 years, having previously worked for Lehman Brothers/Barclays POINT and UBS Delta.