US Treasury bonds at ‘critical point’: Equity-bond correlation shifts as fixed income market flashes for recession warning

Bonds and equities may return to their usual relationship, a plus for investors with a traditional mix of assets in their portfolios amid fears that the US could face a recession this year.

“The bottom line is that the correlation has now shifted back to a more traditional one, where stocks and bonds don’t necessarily move together,” said Kathy Jones, chief fixed income strategist at Charles Schwab, in a telephone interview. “It’s good for the 60-40 portfolio because it’s about having diversification.”

That classic portfolio, consisting of 60% stocks and 40% bonds, was hammered in 2022. It’s unusual for both stocks and bonds to fall so suddenly, but they did last year when the Federal Reserve quickly raised interest rates in an attempt to tame rising interest rates. inflation in the US

While inflation remains high, there are signs of easing, giving investors hope that the Fed could slow its aggressive pace of monetary tightening. And now that most of the rate hikes may be over, bonds appear to be returning to their role as safe havens for investors fearing gloom.

“Lower growth, less inflation, that’s good for bonds,” Jones said, pointing to economic data released last week that reflected trends.

The Commerce Department said on January 18 that US retail sales fell a sharp 1.1% in December, while the Federal Reserve released data that same day showing US industrial production fell more than expected in December. Also on Jan. 18, the U.S. Bureau of Labor Statistics reported that the producer price index, a measure of wholesale inflation, fell last month.

Stock prices fell sharply that day on fears of a slowing economy, but government bonds rallied as investors sought safe havens.

“That negative correlation between Treasury returns and U.S. equities is in stark contrast to the strong positive correlation that prevailed through most of 2022,” Oliver Allen, a senior market economist at Capital Economics, said in a Jan. 19 note. The “shift in the correlation between stocks and bonds in the US may be here to stay.”

A graph in his note illustrates that monthly returns of US stocks and 10-year Treasury bonds have often been negatively correlated over the past two decades, with the strong positive correlation of 2022 being relatively uncommon during that period.

CAPITAL ECONOMY NOTE OF JAN. 19, 2023

“Inflation’s pullback has yet to go much further,” while the U.S. economy may “get worse,” Allen said. “This confirms our view that government bonds will continue to gain in the coming months, even if US equities struggle.”

The iShares 20+ Year Treasury Bond ETF TLT,
-1.62%
is up 6.7% through Friday this year, compared to a 3.5% gain for the S&P 500 SPX,
+1.89%,
according to FactSet data. The iShares 10-20 Year Treasury Bond ETF TLH,
-1.40%
increased by 5.7% over the same period.

According to Jones, Charles Schwab “has a fairly positive view of fixed income markets right now,” even after the bond market’s recent rally. “You can lock in attractive returns for a number of years with very low risk,” she said. “That’s something that’s been missing for a decade.”

Jones said she likes U.S. Treasuries, investment grade corporate bonds and investment grade municipal bonds for people in high tax brackets.

Read: Vanguard expects a “renaissance” in municipal bonds as investors should “drool” at higher yields

Keith Lerner, co-chief investment officer at Truist Advisory Services, is overweight fixed income versus equities as recession risks are higher.

“Keep it simple, stick to high-quality assets,” like U.S. Treasury bonds, he said in a phone interview. Investors are beginning to be “attracted” to longer-term government bonds when they are concerned about the health of the economy, he said.

The bond market has been signaling concerns over a possible economic contraction for months, with the inversion of the US Treasury market yield curve. That’s when short-term interest rates are higher than long-term interest rates, historically seen as a warning sign that the US may be headed for recession.

But more recently biennial Treasury bill yields TMUBMUSD02Y,
4.126%
caught the attention of Charles Schwab’s Jones when they fell below the Federal Reserve’s benchmark interest rate. Typically, “you don’t see the two-year yield below the Fed Funds rate until you get into a recession,” she said.

The yield on the two-year Treasury bill fell 5.7 basis points over the past week to 4.181% on Friday, in a third straight weekly decline, according to Dow Jones Market Data. That compares to an effective federal funds rate of 4.33%, in the Fed’s target range of 4.25% to 4.5%.

Two-year government bond yields peaked more than two months ago, around 4.7% in November, “and have been falling ever since,” Nicholas Colas, co-founder of DataTrek Research, said in an email Jan. 19. confirms that markets are very confident that the Fed will be done raising rates very soon.”

In terms of longer-term interest rates, the 10-year Treasury yield is TMUBMUSD10Y,
3.405%
ended Friday at 3.483%, also falling for three consecutive weeks, according to Dow Jones Market data. Bond yields and prices move in opposite directions.

‘Bad sign for stocks’

Meanwhile, long-dated government bonds maturing in more than 20 years have “just gone up more than 50 standard deviations in the last 50 days,” Colas said in the DataTrek note. “The last time this happened was in early 2020, as we entered the pandemic recession.”

Long-term treasury bills are currently at a critical point, and markets know it, he wrote. Their recent rally hits the statistical boundary between general recession fears and sharp recession forecasts.”

A further rally in the iShares 20+ Year Treasury Bond ETF would be “a bad sign for stocks,” according to DataTrek.

“An investor can legitimately question the recession-tilting call of the bond market, but knowing it is there is better than being unaware of this important signal,” said Colas.

The US stock market ended sharply higher on Friday, but the Dow Jones Industrial Average DJIA,
+1.00%
and S&P 500 each posted weekly losses to break a two-week profit streak. The technology-intensive Nasdaq Composite reversed its weekly losses on Friday to finish with a third straight week of gains.

Over the next week, investors will be weighing a wide range of new economic data, including manufacturing and services activity, unemployment claims and consumer spending. They also get a reading of the personal consumption expenditure price index, the Fed’s preferred inflation gauge.

‘Back of the storm’

The fixed income market is in “the back of the storm,” according to the Vanguard Group’s first-quarter asset class report.

“The upper right quadrant of a hurricane is called the ‘dirty side’ by meteorologists because it is the most dangerous. It can bring high winds, storm surges and spin-off tornadoes that wreak havoc when a hurricane makes landfall,” Vanguard said in the report.

“Likewise, the fixed income market was hit by a storm last year,” the company said. “Low initial interest rates, surprisingly high inflation and a rate hike campaign by the Federal Reserve led to historic losses in the bond market.”

Now, interest rates may not go “much higher,” but worries about the economy remain, according to Vanguard. A recession is looming, credit spreads remain uncomfortably narrow, inflation is still high and several key countries face fiscal challenges.

Read: Fed’s Williams says “much too high” inflation remains its biggest concern

‘Defensive’

With the US economy expected to weaken this year, corporate bonds are likely to underperform government fixed-rate bonds, Chris Alwine, Vanguard’s global head of credit, said in a telephone interview. And when it comes to corporate debt, “we’re defensive in our positioning.”

That means Vanguard has lower-than-normal exposure to corporate bonds as it tries to “improve the credit quality of our portfolios” with more investment-grade than high-yield debt, or so-called junk debt, he said. In addition, Vanguard favors non-cyclical sectors such as pharmaceuticals or healthcare, Alwine said.

There are risks to Vanguard’s view of the rates.

“While this is not our base case scenario, we could see a Fed, faced with continued wage inflation, forced to raise the Fed Funds rate closer to 6%,” Vanguard warned in its report. The increase in bond yields already seen in the market would “help ease the pain,” the company said, but “the market has not yet begun to assess such a possibility.”

Alwine said he expects the Fed to raise its reference rate as much as 5% to 5.25%, then leave it around that level for possibly two quarters before it begins easing monetary policy.

“Last year, bonds were not a good diversification from stocks because the Fed aggressively raised interest rates to address inflation concerns,” said Alwine. “We believe the more typical correlations are coming back.”

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