When stock volatility first erupted in February, something unusual happened: bonds declined along with stocks. This was a clear break from the pattern of the last several years–the post-crisis environment–a period when stocks and bonds have generally moved in opposite directions, a reliably negative correlation.
However, since the spring, the stock-bond correlation has reverted to form (see Chart 1). But as I discussed last year in, The geekiest (and most important) number nobody is discussing, this is not a foregone conclusion. Stocks and bonds sometimes move together. When that happens, investors find that their most reliable hedge suddenly becomes a liability.
The long view
While investors have become accustomed to stocks and bonds mostly moving in the opposite direction, in the 1980s and 1990s stocks and bonds tended to move together. Between 1980 and 2000 stock-bond correlations were positive, averaging about 0.4 (based on a rolling 60-month calculation). But as some investors will remember, that was a very different time.
The ’80s and ’90s more resembled the post-WW II norm of faster growth, both nominal and real (i.e. growth after the rate of inflation). Between 1946 and 2000 real U.S. GDP averaged around 3.6%. Since then it has averaged approximately 2.3%. Nominal GDP has slowed even more, from an average of 7.3% to barely 4%. Much of that change is due to slower inflation. From 1960 to 2000 U.S. core inflation averaged 4%; since then it has averaged just 1.70%.
Given faster growth and more robust inflation, the Federal Reserve was a less benign force in prior periods than it is today. Between 1980 and 2000 the real federal funds rate–calculated as the effective fed funds rate minus the one-year change in the consumer price index–averaged 3.4%, well above today’s barely positive levels.
Slower and steadier
Things changed around the turn of the century, when both growth and inflation slowed. This allowed for structurally easier monetary conditions. In January of 2000 the fed funds rate was 2.75%. Within 18 months it was barely above the rate of inflation. Since 2002 the real fed funds rate has averaged close to -1%. During this same period, the average stock-bond correlation has been approximately -0.10. In more qualitative terms: A less threatening Fed has allowed bonds to play the role of equity hedge.
The price you pay and the hedge you need
The stock-bond correlation impacts portfolios through at least two channels. First, it can affect the rate investors receive on bonds. There is evidence that a bond’s term premium, i.e. the higher interest investors get for holding longer-maturity bonds, moves with stock-bond correlations. Investors are more willing to accept a lower premium for a long-duration bond if they believe that the bond will provide a hedge against equity risk.
Beyond its impact on yield, the stock-bond correlation has an even larger significance. If bonds are a less reliable hedge, investors looking to mitigate portfolio risk need to maintain a much larger cash balance or find another hedge.
Nonetheless, monetary conditions are still easy and concerns over growth exist. This suggest bonds can still perform one key function: a hedge.