A New Correlation Regime For Stocks And Bonds

by: Evariste Lefeuvre
Summary

Sovereign bond yields have risen across the board, mostly driven by the surge in oil prices.

There is more yet. The correlation regime between stock returns and bond yields has also changed drastically.

I explore the causes and show that as long as uncertainty remains on the conduct of monetary policy in the U.S., this regime should remain.

The sharp increase in long term yields has much to do with the huge reversal noticed in oil prices and hence the associated increase in the inflation term premium embedded in the long ends of sovereign bonds yield curves. The move has been so strong that some previous regularities have vanished. For example, yields for the German 10-year bund no longer react to the news flow associated to Greece (see below).

More importantly, the chart below shows that eurozone core Sovereign bonds (here France and Germany) are no longer safe haven - or at least have clearly switched into a rare correlation regime.

Non-core stock indexes have shown a negative correlation with their domestic sovereign bonds for a while. It suggests that both encompass a country risk: any rise in risk aversion leads to a fall in both equity and Treasury prices (index down, yields up). The arbitrage was still alive in France and Germany up to recently: lower stock prices would come along with lower yields and conversely. It is no longer the case.

This pattern is over as all markets are posting a negative correlation. U.S. Treasuries are showing the same pattern with U.S. stock indexes. We clearly see two things:

1. There is no link between those correlation breaks and the overall level of risk aversion (VIX here);

2. We have had similar regime switches in the recent past. They were temporary and generally linked to the uncertainty pertaining to the Fed policy (the long lasting break in mid-2013 was clearly related to the tapering fear).

It is not a big surprise then that the correlation switch may be related to the U.S. dollar. Interestingly enough, correlation breaks are not dependent on the direction of the dollar but rather the changes in the direction of the U.S. dollar (when orange bars below turn from (+) to (-) or the other way around, the stock bond correlation tends to switch).

Those changes are clearly highly sensitive to the news flow pertaining to the Fed policy as can be seen below. Given that the expectations on the date of the first move by the Fed will linger, we might expect that the regime switch will last more than a few weeks.

This pattern is not new and the chart below clearly highlights to what extent correlation breaks occur in period of uncertainty on the Fed policy (not that much the future direction but the future move).

Given that the Fed's timing remains uncertain and that my econometric model of the UST10 yield suggests that long yields still have room to rise further (chart below), the current correlation regime could last a little while.

Bottom Line: A rising yield environment might not be detrimental to stock returns as long as it reflects sound economic conditions. Since the early 2000s, the stock/bond yield correlation is structurally positive. Correlation breaks generally occur at times of uncertainties on the future path of monetary policy. Not so much the direction than the timing. Given the high dependency of the Fed's next move on the economic news flow, I would not be surprised if the regime switch would last several weeks more. I would not change drastically my call on equity returns for 2015 but just stress that the way up to my year-end target 2150 for the S&P 500 might be bumpier.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.