Bonds and stocks could return to their usual relationship, a boon for investors with a traditional mix of assets in their portfolios as the United States fears a recession this year.
“At the end of the day, correlation has now reverted to more traditional correlation, where stocks and bonds don’t necessarily move together,” said Kathy Jones, chief fixed income strategist at Charles Schwab, during a briefing. ‘a telephone interview. “It’s good for the 60-40 portfolio because the goal is to have diversification.”
This classic portfolio, consisting of 60% stocks and 40% bonds, was hammered into 2022. It’s unusual for stocks and bonds to crash so precipitously, but they did last year. when the Federal Reserve quickly raised interest rates in an effort to bring the surge under control. inflation in the United States
Although inflation remains high, it has shown signs of slowing, raising hopes among investors that the Fed may ease its aggressive pace of monetary tightening. And with most of the interest rate hikes potentially over, bonds seem to be returning to their role as safe havens for investors fearful of the gloom.
“Slower growth, less inflation, good for bonds,” Jones said, pointing to economic data released last week that reflected those trends.
The Commerce Department said Jan. 1. 18 that US retail sales fell 1.1% in December, while the Federal Reserve released data the same day showing that US industrial production fell more than expected in December. Also on Jan. 18, the US Bureau of Labor Statistics said the producer price index, a gauge of wholesale inflation, fell last month.
Stock prices fell sharply on the day amid fears of a slowing economy, but Treasuries rallied as investors sought safe-haven assets.
“This negative correlation between US Treasury and equity returns contrasts sharply with the strong positive correlation that has prevailed for most of 2022,” said Oliver Allen, senior market economist at Capital Economics, in an article by Jan. 19 tickets. The “change in US stock-bond correlation may be here to stay.”
A chart in his note illustrates that monthly returns for U.S. stocks and 10-year Treasuries have often been negatively correlated over the past two decades, with the strong positive correlation in 2022 being relatively unusual over this period.
“There’s still a long way to go with declining inflation,” while the U.S. economy could “worse,” Allen said. “This informs our view that Treasuries will make further gains over the coming months, even as US equities struggle.”
The iShares 20+ Year Treasury Bond ETF TLT,
climbed 6.7% this year through Friday, compared to a 3.5% gain for the S&P 500 SPX,
according to FactSet data. The iShares 10-20 Year Treasury Bond TLH ETF,
increased by 5.7% over the same period.
Charles Schwab has “a pretty positive view of fixed income markets now,” even after the recent rally in the bond market, according to Jones. “You can secure 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, high-quality corporate bonds and high-quality municipal bonds for people in high tax brackets.
Read: Vanguard expects ‘revival’ in municipal bonds as investors set to ‘salivate’ at higher yields
Keith Lerner, co-chief investment officer at Truist Advisory Services, is overweight fixed income versus equities as recession risks are high.
“Keep it simple, stick to high-quality assets” such as US government securities, he said in a phone interview. Investors start to “gravitate” toward longer-term Treasuries when they worry about the health of the economy, he said.
The bond market has been signaling concerns about a potential economic contraction for months, with the US Treasury market yield curve inverting. This is when short-term rates are higher than long-term yields, which has always been seen as a harbinger that the United States could be heading into a recession.
But more recently, the two-year Treasury gives TMUBMUSD02Y,
caught the attention of Charles Schwab’s Jones, as they fell below the Federal Reserve’s benchmark interest rate. Typically, “you only see the two-year yield drop below the fed funds rate when you enter a recession,” she said.
The yield on the two-year Treasury note fell 5.7 basis points over the past week to 4.181% on Friday, in a third consecutive weekly decline, according to Dow Jones Market Data. That compares to an effective federal funds rate of 4.33%, within the Fed’s target range of 4.25% to 4.5%.
Yields on two-year Treasuries peaked more than two months ago, at around 4.7% in November, “and have been on a downward trend ever since,” said Nicholas Colas, co-founder of DataTrek. Research, in an emailed note Jan. 2. 19. “This confirms once again that the markets firmly believe that the Fed will be done raising rates very soon.”
As for longer-term rates, the yield on the 10-year Treasury note TMUBMUSD10Y,
ended Friday at 3.483%, also down for three consecutive weeks, according to data from the Dow Jones Market. Yields and bond prices move in opposite directions.
“Bad sign for equities”
Meanwhile, long-term Treasuries maturing in more than 20 years have “just risen more than 2 standard deviations in the past 50 days,” Colas said in the DataTrek note. “The last time this happened was in early 2020, at the start of the pandemic recession.”
Long-term Treasuries are at “critical point right now, and the markets know it,” he wrote. “Their recent rally is hitting the statistical boundary between general recession fears and pointed recession forecasts.
Another rally in the iShares 20+ Year Treasury Bond ETF would be “a bad sign for equities”, according to DataTrek.
“An investor may rightly question the bond market’s call for recession, but knowing it exists is better than ignoring this important signal,” Colas said.
The US stock market ended sharply higher on Friday, but the Dow Jones Industrial Average DJIA,
and the S&P 500 each booked 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 consecutive week of gains.
Over the coming week, investors will assess a wide range of new economic data, including manufacturing and services activity, jobless claims and consumer spending. They’ll also get a reading of the Personal Expenditure Consumption Price Index, the Fed’s preferred inflation gauge.
“The Underside of the Storm”
The fixed income market is “on the underside of the storm”, according to the Vanguard Group’s first quarter 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 tornadoes that cause mass destruction when a hurricane landfall,” Vanguard said in the report.
“Similarly, the fixed income market last year was hit hard by a storm,” the company said. “Low starting rates, surprisingly high inflation and a rate hike campaign by the Federal Reserve have resulted in historic losses in the bond market.”
Now, rates may not rise “much more,” but concerns about the economy persist, according to Vanguard. “A recession is looming, credit spreads remain uncomfortably narrow, inflation is still high and several major countries face fiscal challenges,” the asset manager said.
Read: The Fed’s Williams says “far too high” inflation remains his No. 1. 1 concern
Given expectations of a weaker U.S. economy this year, corporate bonds are likely to underperform government fixed income, Chris Alwine, global head of credit at Vanguard, said in an interview. telephone. And as far as corporate debt is concerned, “we are defensive in our positioning”.
This means that Vanguard has a lower exposure to corporate bonds than it normally would, while seeking to “enhance the credit quality of our portfolios” with more quality investment than high-yield debt. or so-called junk, he said. Additionally, Vanguard favors non-cyclical sectors such as pharmaceuticals or healthcare, Alwine said.
Vanguard’s rate outlook is risky.
“While not our base case, we could see a Fed, faced with continued wage inflation, forced to raise a federal funds rate closer to 6%,” Vanguard warned in its report. The rise in bond yields already seen in the market “would help temper the pain,” the firm said, but “the market has not yet begun to price such a possibility.”
Alwine said he expects the Fed to raise its benchmark rate as much as 5% to 5.25% and then leave it around that level for maybe two quarters before starting to ease policy. monetary.
“Last year, bonds weren’t a good way to diversify stocks because the Fed was raising rates aggressively to address inflation concerns,” Alwine said. “We think the most typical correlations are coming back.”