One of the investment themes that was widely publicized early this year was the "rebalancing" between bonds and stocks. The expected outperformance in equity markets would arrive amidst higher Treasury bond yields as the result of:
- Traditional portfolio arbitrages;
- The return of retail investors to the equity market; and
- The possibility that the forward guidance of the Fed could hint towards lower accommodation ahead.
The chart below shows that no such thing happened: soaring stock prices came along with lower Treasury yields (or higher bond prices).
Interestingly enough, the correlation between weekly returns of the S&P 500 and weekly changes of U.S. Treasury yields has increased and remained highly positive: high stock returns => positive change in bond yields.
We get the same conclusion using a total return index for U.S. Treasuries. Over the last few months higher stock prices came along with higher bond prices, while stock returns have been negatively correlated with bond returns.
How do we explain such a paradox? If bond and stock prices move in the same direction, the correlation between stocks and bond returns should not be expected to be positive?
This is mostly due to the fact that correlation is not calculated with data directly but with their deviation from the mean: two assets with trends of opposite signs can have returns with positive correlations if both have identical deviations of their prices to the mean.
In the short run, there is still as strong link between stock returns and bond yield changes as can be seen in the chart below. 3-month returns of the SP 500 come along with 3-month changes in UST 10-year yields. This explains the return correlation seen above.
On the other hand, the ongoing decline in bond yields while stocks are poised to reach 1700 in early 2014, is linked to the ongoing trend of monetary policy. The disconnect between bond yields and stock prices occurred during Operation Twist, which was balance-sheet-neutral and continued while the Fed improved its rate guidance.
The recent move has been accentuated by speculation that the BOJ's ultra-accommodative policy could spur strong portfolio outflows from Japan, a phenomenon that should not be overstated.
The disconnect came along with a decline in the inflation premium (10-year UST Breakeven).
Conclusion: The great rebalancing did not materialize. For reasons linked to the BOJ policy, the fall in the inflation premium, and Fed's communication, bond yields did not increase while the stock market gained momentum. This explains why the trends diverged between bond yields and stock prices.
Yet, the short-run relationship between bond and stock returns has not changed. This is neither a statistical oddity, nor inconsistent with the fact that the yields of asset prices remain driven by the economic cycle in the short run.
For the TLO investor the lesson is simple: play the trend and forget the short-run relationship between stocks and bonds.