December’s Consumer Price Index (CPI) report left investors a bit anxious. Core inflation ticked slightly higher, enough to lead some to question whether inflation may finally be rising from the ashes. Attention turned to the impact of higher inflation. Bond prices would be the first and obvious casualty. A second, less obvious one would be stock-bond correlations. Although “rising stock-bond correlations” is not the sort of phrase that normally induces panic, as I’ve discussed in previous blogs it matters a great deal for how you build portfolios.
For years bonds have arguably been a better hedge against risk than a source of income. This is because stock-bond correlations—while higher than they were in 2010—have been reliably negative for most of the past decade.
What could cause that dynamic to change? Historically, what has mattered the most has been the level of nominal growth and the Federal Reserve (Fed)’s reaction to inflation.
1. Nominal GDP (NGDP)
The correlation between stocks and bonds tends to move with nominal growth, the sum of real growth and inflation. For the past several years U.S. nominal GDP has averaged around 4%, roughly half the long-term average. A meaningful move higher, particularly if driven by inflation, would suggest higher stock-bond correlations. For example, based on the historic relationship, should NGDP move back towards 5%, this would suggest stock-bond correlations closer to zero than today’s modestly negative reading.
2. Fed policy
Besides growth and inflation, stock-bond correlations have also tended to move with the Fed’s reaction to inflation. More specifically, stock-bond correlations have had a positive correlation with the real-federal funds rate (effective federal funds rate minus the consumer price index). Today the upper bound for federal funds is 1.50%, 0.60% below the headline CPI. This leaves the real federal funds rate well above the 10-year average of -1.20%. To the extent the Fed is true to their guidance of at least another three rate hikes this year, the real federal funds rate is likely to climb back into positive territory. This would also imply a rise in the stock-bond correlation.
This still leaves the question of whether any of this really matters. The simple answer: A less negative stock-bond correlation (or positive) lowers the likelihood of bonds as an effective hedge against equity risk. This would suggest a lower allocation to bonds and arguably a higher allocation to other types of hedges, such as cash.
For now, however, investors can take some solace in the fact that the death of the low inflation regime may be exaggerated. The Fed’s preferred measure of inflation remains stuck at around 1.50%, well below its target, and wage growth has been modest. To the extent the post-crisis norm continues, investors should still consider bonds as a reasonable hedge in most risk-off scenarios. However, a more pronounced and prolonged pickup in inflation would necessitate a new playbook.