The post-crisis era has been dominated by a risk-on/risk-off trading environment where risk assets such as stocks and safe assets such as bonds move in opposite directions. That may no longer be true.
Some have dismissed the recent spike in volatility as an isolated derivatives debacle rather than a regime shift in trading patterns. Yet, these gyrations are the results of rising inflation fears that are fueling concern that central banks may exit the markets sooner than anticipated.
From 1954 to 1966 and since 2001, the rolling five-year correlation between stock and bond prices was negative. These periods were dominated by a deflationary mindset.
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Stock and bond prices moved in opposite directions. Deflation fears depressed yields (boosted bond prices) and pressured stocks lower. When deflation fears dissipated, yields rose and stocks rallied. Wall Street refers to this as risk-on/risk-off.
During the period from 1966 to late 2001, stock and bond prices were positively correlated. That was when inflation was a primary concern in financial markets. If inflation was deemed too high, bond yields rose while stocks prices fell. Whenever inflation subsided, bond yields fell along with stocks.
Although the correlation between stocks and bonds is currently minus 32 per cent, there is reason to believe this relationship is changing back to an inflationary mindset, marking the demise of the risk-on/risk-off trade.
Looking at charts since the stock market peak on Jan. 26, 2018 shows that trading has been usual over the last 15 days. Stocks and bonds have not declined in unison like this since the dysfunctional days of the global financial crisis in late 2008. Something has bothered the market so much that it has changed trading patterns for the first time in a decade.
We believe the catalyst is inflationary fears, which are on the rise because of strong growth, low unemployment and small business optimism. U.S. 10-year inflation breakeven rates are trading near a four-year high.
Wages and prices paid forecasts from an aggregate of the regional Fed surveys point to a level of inflation not seen during the post-crisis era.
Composites of economic data, manufacturing sentiment, and small business sentiment since 1994, show that tax cuts, regulation cuts and fiscal stimulus have pushed these measures to levels not seen in decades.
The markets have responded to these signs of inflation by altering the relationship between stocks and bonds. Carefully crafted trading strategies built on the risk-on/risk-off mantra, which specifically assumes both stocks and bonds won’t decline together, have suffered as a result.
If inflation concerns continue to linger, we may be entering a period where both types of assets move in unison. Those who were around in the 1970s will remember this well, but many will have a difficult time adapting to such a regime change.
Jim Bianco is the President and founder of Bianco Research, a provider of data-driven insights into the global economy and financial markets.