News about growth, inflation and monetary policy influence bond and equity markets. For bonds, the relationship is straightforward: news about faster growth, more inflation or higher official interest rates tend to push bond yields higher and bond prices lower. For equities, the relationship is more complex. Sometimes they react negatively to the prospect of higher interest rates but sometimes investors focus on the positive earnings outlook that follows from a good growth environment that forces central banks to raise their policy rate.
Therefore, the correlation between bond prices and equity prices fluctuates over time. As shown in this chart with data since 1995, the 60-day rolling correlation between daily changes in bond prices and daily changes in equity prices has fluctuated in a wide range of positive and negative numbers.
Since 2000 it has been predominantly negative, especially when official interest rates were at the zero lower bound. A negative correlation means that when equity prices decline, bond prices rise (and hence bond yields decline). An investor who is invested in both asset classes will benefit from a diversification effect: one asset decline in value but the other increases and cushion the impact of the other. This effect underpins the demand for bonds, even when yields are very low.
During the recent Federal Reserve tightening cycle, the correlation has turned positive again. This is reminiscent of what happened during the rate hike cycle of 2004-2006. This is not a surprise: higher official interest rates cause an increase in bond yields and a decline in bond prices. Higher rates lower the net present value of future earnings, can cause a downward revision of these future earnings, and can weigh on the risk appetite of investors. For all these reasons, equity prices may decline, leading to a positive correlation with bond prices, which have also declined. Investors no longer benefit from a diversification effect.
Based on past experience, one would expect that, as the Federal Reserve starts cutting rates later this year, the bond-equity correlation would turn negative again. This could reflect a benign scenario of equities rising due to lower policy rates, whereas bond markets have already anticipated the policy easing and start to focus on the positive impact of rate cuts on the growth outlook. A less benign scenario would consist of a rallying bond market because the economy turns out to be weaker than expected -hence causing equities to decline-, necessitating swifter rate cuts by the Fed. However, this scenario is in our view less likely.
