Bonds and stocks may return to their usual relationship, which is a plus for investors who have a traditional mix of assets in their portfolios amid fears that the United States will face a recession this year.
“The bottom line is that the correlation has now morphed into a more traditional relationship, where stocks and bonds don’t necessarily move together,” Cathy Jones, senior fixed income analyst at Charles Schwab, said in a phone interview. “It’s good for a 60-40 portfolio because the point is diversification.”
This classic portfolio, consisting of 60% stocks and 40% bonds, is out in 2022. It’s unusual for both stocks and bonds. The tank is steepbut they did last year as the Federal Reserve quickly raised interest rates in an effort to tame spiraling inflation in the United States
While inflation remains high, it has shown signs of abating, raising investors’ hopes that the Fed may slow its aggressive pace of monetary tightening. With the bulk of interest rate hikes likely to be over, bonds appear to be returning to their role as a safe haven for investors fearing the gloom.
“Slower growth, lower inflation, and that’s good for bonds,” Jones said, pointing to economic data released last week that reversed those trends.
The Ministry of Commerce said on January 18 that retail In the US it fell 1.1% sharply in December, while the Fed released data showing that same day American industrial production It fell more than expected in December. Also on January 18, the US Bureau of Labor Statistics said that the Producer Price Index, a measure bulk inflationfell last month.
Stock prices fell sharply that day on fears of a slowing economy, but Treasury bonds rose as investors sought safe-haven assets.
“This negative correlation between Treasury yields and US equities stands in stark contrast to the strong positive correlation that prevailed for most of 2022,” Oliver Allen, chief market economist at Capital Economics, said in a statement. Note January 19th. It may be that “the shift in the correlation of US stocks and bonds remains.”
The chart in his note shows that monthly returns from US stocks and 10-year Treasurys have been mostly negatively correlated over the past two decades, with a strong positive correlation for 2022 being relatively unusual during this time frame.
“The decline in inflation should continue for much more,” Allen said, while the US economy may “take a turn for the worse.” “This illustrates our view that Treasuries will post further gains over the coming months even as US stocks struggle.”
iShares 20+ Year Treasury Bond ETF TLT,
It is up 6.7% this year through Friday, compared to a gain of 3.5% for the S&P 500 SPX,
According to FactSet data. iShares 10-20 Year Treasury Bond ETF TLH,
It increased by 5.7% over the same period.
Charles Schwab has “a very positive view of the fixed income markets now,” even after the recent rally in the bond market, according to Jones. “You can secure an attractive return for a number of years with very low risk,” she said. “This is something that has been missing for a decade.”
Jones said she likes U.S. Treasurys, investment-grade corporate bonds, and investment-grade municipal bonds for people in higher tax brackets.
Read: Vanguard expects a municipal bond “renaissance” as investors should “drool” at the higher yields
Keith Lerner, chief investment officer at Truist Advisory Services, has an increase in fixed income over equities with a higher recession risk.
“Keep it simple, and stick to high-quality assets,” such as US government securities, he said in a phone interview. He said investors start to “gravitate” toward long-term Treasury bonds when they have concerns about the health of the economy.
The bond market has signaled concerns for months about a potential economic downturn, with reflection from the US Treasury Market yield curve. That’s when short-term rates are higher than long-term returns, which has historically been seen as a warning sign that the US may be heading into a recession.
But recently, the two-year Treasury yield TMUBMUSD02Y,
It caught the attention of Charles Schwab-Jones, as they moved below the Fed’s benchmark interest rate. Normally, “you only see the two-year yield fall below the fed funds rate when you go into a recession,” she said.
The yield on two-year Treasury notes fell 5.7 basis points over the past week to 4.181% on Friday, the third straight weekly decline, according to market data from Dow Jones. Compare with effective federal funds rate 4.33% is in the Fed’s target range of 4.25% to 4.5%.
“This further confirms that markets strongly believe the Fed will finish raising interest rates very soon,” Nicholas Colas, co-founder of DataTrek Research, said in a note emailed Jan. 19.
For long-term rates, the yield on the 10-year Treasury note is TMUBMUSD10Y,
It ended Friday at 3.483%, also down for three consecutive weeks, according to Dow Jones market data. Bond yields and prices move in opposite directions.
‘Bad sign for stocks’
Meanwhile, long-term Treasury notes maturing in more than 20 years have “just gone up more than two standard deviations over the past 50 days,” Colas said in a Data Trek note. “The last time this happened was early 2020, as I entered a pandemic recession.”
He wrote that the long-term treasury is at “a tipping point right now, and the markets know it.” “Their recent rally hits the statistical boundary between general recession fears and predictions of a severe recession.”
A further rally in the iShares 20+ Year Treasury Bond ETF would be a “bad sign for stocks,” according to DataTrek.
“An investor could rightfully wonder about the bond market’s call for a recessionary tilt, but knowing it’s there is better than not being aware of this important signal,” Colas said.
US stock market It ended sharply on Fridaybut the Dow Jones Industrial Average DJIA,
and the Standard & Poor’s 500 each booked weekly losses to snap a two-week winning streak. The high-tech Nasdaq Composite erased its weekly losses on Friday to end its third consecutive week of gains.
In the coming week, investors will weigh a wide range of new economic data, including manufacturing and services activity, unemployment claims and consumer expenses. They will also get a reading from the Consumer Price Index and Personal Expenditure, which is the Fed’s preferred measure of inflation.
Back of the storm
The fixed income market is in the “tail of the storm,” according to Vanguard Group’s first-quarter report on the asset class.
Forecasters call the upper-right quadrant of a hurricane the “dirty side” because it is the most dangerous. It can bring high winds, storm surges, and occasional tornadoes that cause massive destruction as the hurricane makes landfall, Vanguard said in the report.
“Similarly, last year the fixed income market was hit by the brunt of the storm,” the company said. “Low primary rates, surprisingly high inflation, and a drive to raise interest rates by the Federal Reserve have led to historic losses in the bond market.”
Now, rates may not move “much higher,” but concerns about the economy remain, according to Vanguard. “A recession looms, credit spreads remain uncomfortably tight, inflation remains high and many important countries face fiscal challenges,” said the asset manager.
Read: The Fed’s Williams says that “very high” inflation remains his number one concern
Given the outlook for US economic weakness this year, corporate bonds will likely underperform government fixed income, Chris Alwyn, head of global credit at Vanguard, said in a phone interview. And when it comes to corporate debt, “we’re on the defensive.”
That means Vanguard has less exposure to corporate bonds than it normally does, while looking to “upgrade the credit quality of our portfolios” with more investment grade than high-yield debt, or so-called junk debt. Additionally, Vanguard favors non-cyclical sectors such as pharmaceuticals or healthcare, Alwine said.
There are risks to Vanguard’s price forecasts.
“While this is not our base case, we could see the Federal Reserve, faced with persistent wage inflation, forced to raise the federal funds rate to close to 6%,” Vanguard warned in its report. The company said that the rise in bond yields already seen in the market should “help ease the pain,” but that “the market has yet to begin pricing in such a possibility.”
Allwyn said he expects the Fed to raise its benchmark interest rate to 5% to 5.25%, then leave it at that level for perhaps two quarters before it starts easing its monetary policy.
“Last year, bonds were not a good way to diversify stocks because the Fed was aggressively raising interest rates to address inflation concerns,” Alwyn said. “We think the most typical associations return.”