Do You Need a Correlation Break?
Updated
February 21, 2023
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Stocks and bonds have gone up and down together in recent months while stocks appear to be leading bonds.
Many assume the same dynamics are still at play, and expect bonds to recover soon. This might be a mistake.
People have forgotten that in a world where rates are not floored at zero, stocks and bonds are expected to move in opposite directions. The intuition is straightforward. With expectations of higher stock returns, people shift their asset allocations from bonds to stocks, thereby causing one to lose value while the other gains.
That’s pretty much been the rule prior to the great financial crisis. Are we finally back to a normally functioning bond market? That’s the multi-trillion dollar question. Some initial signs seem to point in that direction.
The first example of this was the monster CPI print. With an uptick of inflation to 0.5% MoM in Jan vs a revised 0.1% gain in December. At that rate, many do not believe that we’ll get inflation under 2% until well into 2024.
Compounding those concerns with wage pressures from the over 500k NFP print last month, we would have expected stocks to tumble. Hard.
At least that was the playbook for all of Tuesday morning, until markets decided that higher inflation might mean more earnings? Even bonds were only down mildly despite the much more direct impact of inflation on rates.
So perhaps a fluke of a day, but continued pressure should decimate stocks, right?
Indeed, retail sales delivered the coup de grâce. With a jump of 3% in January, it dashed all hopes of lower rates in 2023. Bonds began to capitulate across the yield curve but risk assets held strong as the prospects of sustained demand propped up stocks.
When both stocks and crypto end positive on a day with massive loss for bonds, this should have raised some eyebrows. PPI followed on Thursday with a 0.7% MoM print, handily beating expectations of 0.4%.
The same script played out on Thursday until finally comments from Fed presidents Mester and Bullard were able to take risk assets down a notch as they emphasized they would have favored a ½ percent hike instead of the ¼ percent delivered at the previous FOMC meeting.
Some may have noticed the outperformance from the crypto sector in the face of higher rates and decidedly negative news in the US regarding enforcement actions.
Some of this may be due to recent news that Hong Kong is considering opening up crypto trading to retail investors. Now this may seem to be out of proportion considering the size of the Hong Kong market. Especially since these come with additional regulatory requirements for existing exchanges and other “Virtual Asset Service Providers”, as well as networth requirements for end users similar to accredited investor rules in the US.
However, the implication is that anything that addresses such financial concerns in Hong Kong will also have the implicit backing of Beijing. This is unexpected since the relationship between China and crypto has been volatile to say the least. “China Bans Bitcoin” has been a running meme over the years and has even been memorialized into a South Park episode.
It is not lost on China however, that blockchain technology, along with its uniquely antifragile characteristics, could serve both as a potential avenue for growth as well as diversification away from the US dominated financial system. This could be the angle that brings more adoption to potentially over a billion new users.
This will not be easy however given that China still relies on strong foreign exchange controls to manage its economy. Broader access to foreign/non-sovereign investment choices could poke a hole through such controls unless managed carefully. Is this a new spring for Crypto in China or another head fake?
Correlations between markets are similar to large ships. They are fairly stable over long periods of time, they can change course slowly, but once set, they tend to be persistent for extended periods of time. It appears the correlation ships are changing course now.
Markets are no longer transfixed on the spigot that is controlling the monetary supply. Despite disagreement on the next few hikes, it’s pretty clear that we are most of the way there. For longer term investors however, the bigger challenge will be to decide whether we are going back to the “normal” inflation regime of 3-4% during the 2000’s, or the more moribund sub 2% of the post Great Financial Crisis era.
In the former scenario, a sub 4% yield on long term treasuries doesn't make much sense, and that would mean a lot more pain ahead for bond investors. In the latter scenario, investors would be getting nearly 2% real yields with the opportunity to lock them in for decades at a time. A big fork in the road.
As for risk assets, it’s fairly early, but my hunch is they are now able to stand on their own. Few can imagine the scenario of risk assets blazing higher as rates continue to go up. But we need to remember that over the long run, risk assets have typically been much better inflation hedges than bonds. When will markets wake up to this old dynamic? Perhaps next week?
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