Stocks And Bond Yields Are Positively Correlated, Right? Not So Fast!

Includes: IEF, SPY
by: Soos Global Capital

(Click to enlarge)

There's quite a bit going on in the chart above, and some readers might have already moved on wishing not to engage in what they feared might be a complicated mind game of multiple technical contortions!

Fear not!

For those left standing, and reading, there's actually a not too difficult story here regarding the historical relationship between stock price movements and bond yields. Consideration of some of the historic and current relationships might help guide investors in the coming days/weeks/months as "tapering talk" continues, and markets respond accordingly.

First, a tour through the chart. Some of this might be pretty basic to old hands in bond/stock analysis, but a simple review never hurt. The green line represents the price movements of the S&P 500 index over the past 15 years. The black line represents the yield on 10 yr U.S. Treasury Notes. To be clear, when the black line goes up, it means bond yields are rising and bond prices are falling. A quick scan of the past 15 years shows that in general, when stocks have gone up (green line going up), bond yields (black line) have also gone up (and in turn, bond prices, not shown in the chart, have fallen). So when people refer to the correlation between stocks and bonds, with regard to bond yields, the relationship is positively correlated, and with regard to bond prices, the relationship to stocks is negatively correlated.

Now, while the upper part of the chart that we've been referring to so far makes it look like those correlations exist, to be technically accurate, take a look at the lower portion of the chart where you'll see a line representing the relative price movements of 10 yr Treasury yields to S&P stock prices. As you can see, in the time periods identified as "A" and "B", the relationship in price movements was pretty steady, implying that when stocks moved in one direction, yields moved similarly.

Section "C", however, marks a notable difference showing a declining line which indicates that stocks were rallying during this period at a much faster pace than yields were rising. In fact, during the latter half of time period C (see D on the chart), yields were actually falling as stock prices were rising, a clear divergence from the usual historical relationship. Only in the past month (see E), since tapering talk hit full stride, have yields started to climb and begin to close that diverging move.

The key question now for investors is whether that divergence will continue to close, and if it does, will it happen due to stock prices falling? Or will it happen through rising yields? Both? This question is particularly relevant to investors who automatically assume that the way to 'hedge' their equity exposure in the portfolio is to buy bonds, on the presumption that, historically at least, when stocks falter, bonds rally and yields fall. The chart above, however, should, at a minimum, be reason for caution in that it suggests that it is certainly possible that stocks could suffer a setback without yields moving much at all, and we'd still be normalizing the historical trend! The market's clear concern over Fed 'tapering' could keep investors away from bonds even if those same investors have concerns about equity valuations being too high.

So, you may ask, where would an equity investor go with money that comes out of equities if not into bonds? In the "old days", the answer would likely be "money markets", but nowadays, with rates at or close to zero, that's not an appealing option for investors. What then does that leave? Cash! Cash is often overlooked as a legitimate asset class in its own right. In this low-to-no interest rate environment, not to mention one of relatively low inflation, cash is clearly in the lineup of investment choices when capital preservation is challenged by a view that both equities and bond prices could stumble.

With the Fed's FOMC meeting this week, along with their statement that will be released on Wednesday afternoon, we're sure to get more 'taper talk' that will impact stock and bond prices. The chart above is worthy of close monitoring throughout the week (and beyond) as a way of assessing the relative price movements of stocks and bonds, and in turn, the relative value of each as a position in an overall portfolio. The Pavlovian response of "sell stocks, buy bonds" may just not be the best formula this time around.

Stay tuned for updates as the week progresses.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. While no specific stocks were mentioned in this article, I do own many stocks and ETF's that are part of the S&P 500 Index. Positions may change at any time without notice.

(Please note: This article is solely meant to be thought provoking and is not in any way meant to be personal investment advice. Each investor is obligated to opine and decide for themselves as to the appropriateness of anything said in this article to their unique financial profile, risk tolerances and portfolio goals).

Disclaimer: Please read and consider important information related to all communication made by Soos Global on this site by clicking here. Currently long many stocks/ETFs. Positions may change at any time without notice.