When all markets rise at once, think twice

Unusual cross-asset correlations likely won’t last and can leave portfolios overexposed when inflation expectations finally heat up.


Modern portfolio theory is based on the idea that bond prices tend to zig when equity prices zag. This inverse relationship is fundamental to the 60/40 stock-bond portfolio, which reduces volatility—compounding to likely higher returns in the long run.

But what if bond prices don’t move? What if it’s all one trade?

During months of equity volatility, interest rates have barely budged and bond volatility over the past six months reached historic lows. In a recent piece, we explained that as the Federal Reserve (Fed) has cut rates close to zero in response to the pandemic, bonds may be losing some of their characteristics as portfolio protection for those times when equities fall.  

The Federal Reserve (Fed) has a new policy framework that has dampened bonds’ volatility and altered many traditional cross-asset correlations, so bond prices have not fallen even as equities have appreciated. As a result, many investors have begun looking at alternative assets to provide that protection, such as gold.

In this piece, we discuss the consequences of these conditions. And because we don’t believe they will last forever, we look ahead to when Fed rate expectations, and growth and inflation expectations, revert to their traditional relationships and Fed policymakers begin thinking about raising rates. We conclude that cross-asset correlations in client portfolios are likely higher than many realize, which could leave investment portfolios exposed. We explain why, at current levels, clients’ marginal dollar might be best spent on pro-cyclical assets (those that do well during an upcycle or economic recovery) such as value stocks and credit, rather than the market sectors and trades that have benefitted the most in recent months, including growth stocks and gold.

Unique times for bond investors

In normal times, we expect two drivers to induce bond yields to rise or fall: expectations for where policy rates set by the Fed should be in a few years’ time; and expectations for economic growth and inflation. The majority of the time, these drivers move together. As growth and inflation expectations rise, expectations that the Fed will hike policy rates in the future tend to follow.

However, the Fed changed the game recently, shifting to a new framework. Under it, before the Fed will even consider hiking rates, policymakers are now promising to wait for inflation to reach their 2 percent target and for inflation expectations to modestly exceed that target for a period of time.1

This change has important implications for investors and the market. Over the last six months, as the Fed made known that this framework shift was coming and market participants adjusted, yields in the U.S. barely moved, while the U.S. economy showed surprising strength. Despite expectations for better growth and higher inflation, investors believe that the Fed will keep policy rates on hold for years to come.

As a result of this new situation, “real” or inflation-adjusted yields—that is, expected yields on U.S. government bonds after taking inflation into account—have declined to record lows. This dynamic is very rare, occurring only a few times in the last 10 years.

As inflation expectations rise—rates aren't keeping up

Source: Bloomberg. Data as of September 30, 2020. Nominal yields do not take inflation into account; real yields do, by removing inflation’s effects. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

Falling real yields lift all boats

As these rare conditions have persisted, correlations across asset classes have changed. In fact, assets that generally aren’t correlated with equities—and that traditionally serve as portfolio diversifiers, such as gold—have been moving more in tandem with equities, as they react to the same thing (lower real yields). Inflation and growth expectations have risen, yet yields didn’t follow. That’s created a rising tide that has boosted a number of assets.

Not only has the economy’s outlook gotten better; investors’ compensation, after inflation, for holding the safest dollar-denominated assets has been declining. This made higher-yielding instruments, like stocks and corporate credit, more attractive, and also weighed on the value of the U.S. dollar DXY (which increases the attractiveness of foreign assets to U.S. investors) and supported gold prices at the same time. These correlations could leave investors overexposed to assets now moving in tandem should real yields move higher.

In a rare period of correlation, once-divergent markets are rising

Source: Bloomberg. Data as of September 30, 2020. Breakevens are the level of inflation that Treasury Inflation Protected Securities (TIPS) are pricing over the life of the bond. Russell Growth vs. Value measures the relative performance of Russell 1000 Growth to Russell 1000 Value. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

When conditions normalize—will you be ready?

Investors have been betting that the economy will continue to recover and that growth and inflation will follow, but that the Fed will still keep rates low. We agree, but only to an extent and not forever. At some point, the Fed will have to let interest rates rise alongside an improving economy or risk allowing inflation to move far above its 2% objective.

For now, inflation is below 2 percent, as are market-based measures of expected inflation over the coming years—as Fed Chair Jerome Powell has famously quipped, the Fed “isn’t even thinking about thinking about” raising interest rates. But inflation expectations are trending toward the Fed’s target as the economy improves—so investors are expecting higher inflation in the future. In our view, as inflation expectations get closer to its target, the Fed will feel comfortable at least “thinking about thinking about raising rates.”

At that point, traditional correlations will likely return and the tide lifting all boats might look more like rocky shoals to navigate. On average, in the past, the six months after real yields and inflation expectations became positively correlated (after a period of negative correlation), gold and equity returns moderated and the dollar appreciated a bit. High yield bonds, however, continued to appreciate.

Implications for investors

The Fed’s new policy framework has dampened bonds’ volatility and altered many traditional cross-asset correlations. However, this set of conditions won’t last forever and could leave investment portfolios more exposed when inflation expectations finally become sufficient for policymakers to start considering raising rates.

Looking ahead to when rate, growth and inflation expectations all revert to their traditional relationships, clients should consider adding marginal dollars to pro-cyclical assets (that typically do well during the business cycle’s up phase or recovery), such as value stocks and credit, and rein in return expectations for sectors and trades—such as growth stocks and gold—that have benefitted most from recent unusual conditions.

1. The new framework is called “flexible average inflation targeting.”







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