A pattern of stocks and bond yields rising and falling in parallel held for most of this century, until last year. PHOTO: ANDREW KELLY/REUTERS
The bad news is, there are plenty of reasons to think it may not last
It’s early days, but in the past couple of weeks investors have begun moving away from their obsession with inflation, shifting markets into a new regime where good news on the economy is again good news for stocks.
This is a big change from the rally that lifted the S&P 500 from just after Christmas until mid-January, which was accompanied by falling bond yields as inflation fears receded. Since then stocks have switched from rising when bond yields fall, to rising when bond yields rise—a return to what counted as normal for most of this century.
Put another way, economic growth is good because it means higher profits, rather than growth being bad because it means higher inflation. Unfortunately for investors hoping that they can return to business as usual, there are plenty of reasons to think this might not last.
Before getting into them, look more closely at the shift. In the 10 trading days up to Friday, stocks and bond yields moved in the same direction on all but one day, the tightest link since the brief recession panic in May 2022. The correlation between the two, a mathematical measure of how closely they are in sync, leapt to 80%, after being negative for most of last year. (On Monday and Tuesday they moved in opposite directions again.)
This pattern of stocks and bond yields rising and falling in parallel held for most of this century, until breaking decisively last year. It made life much easier for investors, dampening volatility while making money. The standard 60% stock, 40% bond portfolio smoothed returns as stocks and bond prices tended to move in opposite directions on a day-to-day basis, while over the long run both made money. Last year the approach was crushed, as prices moved together—that is, stocks fell when bond yields rose, and vice versa—and both fell heavily over the year. It would be great if the old pattern was back.
It might be wishful thinking, though. True, there are clear justifications for stocks to be higher and bond yields lower than a few months ago, as inflation has come down, China has reopened and Europe’s mild winter has eliminated fears of energy shortages.
But the shift in the stock-bond link requires a belief that inflation has been vanquished. The market is well ahead of the economic evidence, and it’s easy to see how the new regime could be upset.
The first test comes on Wednesday, with the first Federal Reserve rate rise of the year. It’s widely expected to lift rates only 0.25 percentage point, down from past 0.5-point hikes, so the key will be the tone of Chairman Jerome Powell‘s press conference. Will he nod to the idea that inflation pressures are abating?
The biggest doubt is about wages, the heart of the Fed’s concern about self-sustaining inflation. Wage growth has moderated and job openings fallen, supporting the argument that there’s less to fear. But unemployment remains at 50-year lows, there are still 4 million more jobs on offer than there are unemployed workers, and while wages are rising more slowly than they were, they’re still rising far too fast for Fed comfort. They are also rising faster than the Fed’s preferred measure of inflation, which could eat into corporate profit margins.
All of this affects how we should think about the good news for the world economy, which on Tuesday led the International Monetary Fund to upgrade its growth forecasts. That comes on top of China’s reopening.
A stronger economy should only be good for stocks if stronger growth doesn’t mean more inflation. For now, investors believe it doesn’t, or at least that any extra inflationary pressure will be manageable. This is why cyclical stocks sensitive to the economy have been outperforming defensive ones solidly since late December.
Maybe we will magically get inflation-free growth. Maybe the effect of last year’s rate rises, which tend to hit the economy after a significant lag, will precisely counter the upward pressure of unexpectedly strong growth. But it seems more plausible that inflation fears will return in the not-too-distant future, and stocks and bond yields will start moving in opposite directions again.
Featured article licensed from The Wall Street Journal.