Inflation has been dormant in the U.S. since 1994. Through expansions and recessions, inflation hovered around 1.5-2.0% for over a quarter century after falling from much higher levels in the 1970s and 1980s. The seeming durability of low inflation has not been lost on bond investors. Yields on 10Y U.S. Treasuries have been cascading lower, from 14% in 1980 to around 9% by 1989, about 6% by 1999 to around 4% by 2009, and to 2% by 2019. Currently they are around 1.5% (Figure 1).
Recently, however, the combination of large budget deficits, quantitative easing, high savings rates, widening vaccine distribution and bottlenecks in supply chains, have given rise to concerns that inflation might make a comeback. Central banks have tried to assuage this concern by suggesting that they might not raise interest rates to pre-empt inflation as they have for much of the past quarter century. Bond yields have begun to rise, contributing to volatility in certain sectors of the equity market as investors debate over what higher bond yields and rising inflation might mean for equity valuations.
Twenty-five years of low inflation not only caused bond yields to fall (and bond prices to rise), it also changed how stocks and bonds relate to one another. This change has had a profound, and so far, generally beneficial effect on long-only investors with portfolios combining stocks and bonds.
From the late 1970s until 1998, stocks and bonds generally exhibited positive correlations (Figure 2). On days when bond prices rose (and yields fell), equity prices rose, too, and vice versa. This meant that owning both stocks and bonds simultaneously offered rather limited diversification. The reason for this was that investors primarily feared inflation. The onset of higher inflation would mean the Federal Reserve (Fed) would have to raise interest rates, which would slow growth and hurt corporate profits. Rising inflation and short-term interest rates could also pull long-term bond yields higher along with them, which would increase the discount rate on future corporate cash flows, lowering their present value and equity prices along with them.
Starting in 1998, this once durably positive correlation began to change. By 1998, the economy had been expanding for seven years, unemployment had been falling and yet inflation remained dormant amid the productivity revolution of the late 1990s. While investors were generally optimistic during this time, a new threat emerged on the horizon: deflation and financial instability.
By the summer of 1998, a debt crisis that began in Asia one year earlier had led to the collapse of commodity prices. High levels of debt and low oil prices led Russia into defaulting on debts owed domestically in roubles and internationally in U.S. dollars. Russia’s debt default sent shockwaves through global markets and to a rapid widening of credit spreads, triggering the meltdown of a highly leveraged U.S. hedge fund, Long-Term Capital Management (LTCM). In August 1998, equities plunged while U.S. Treasuries, German Bunds and other AAA-rated sovereign bond prices soared (yields fell). For the first time in living memory, the equity-bond correlation flipped to negative.
The 1998 experience of negative correlations between stocks and bonds was neither an aberration nor an anomaly; rather, it was the beginning of a structural shift in the ensuing decade. Between late-1998 and mid-2008, the correlation between equities and bonds fluctuated. Sometimes it was negative (during the 2001-2003 “tech-wreck”) and sometimes it was slightly positive (at the height of economic expansions in 1999-2000 and 2005-2007). During this transitional period, investors alternated between a 1970s and 1980s-style concern about inflation and their new-found fears about the risks of economic collapse, deflation and financial instability.
The 2008 financial crisis, when banks collapsed as the economy sank and unemployment soared, crystalized this latter set of concerns. Since 2008, the correlation between stocks and bonds has been consistently negative on a one-year rolling basis, even during the 2013 “taper tantrum” over quantitative easing and during the strongest phases of the 2010-19 economic expansion. Inflation during this period remained dormant even as unemployment fell from 10% to as low as 3.5%.
When the global pandemic struck in 2020, investors’ initial reaction sent bond prices soaring and equity prices plunging. Then, equity prices rebounded strongly to new record highs as bond yields remained near record lows. Only in the past month have yields begun to rise again, creating concerns among some equity investors.
What would a sustained rise in inflation mean for investors? For starters, it could eventually flip the stock-bond correlation back to positive. If that happened, it would much less diversification for investors holding both asset classes. To demonstrate this let’s look at three portfolios:
We then calculate a 10-year rolling information ratio for these three portfolios where the information ratio is defined as the average annualized excess return divided by their annualized standard deviation. What this shows is that a portfolio that diversified its risk equally between stocks and bonds did slightly better than either stocks and bonds individually when the stock-bond correlation was positive or mixed (pre-2008). Since 2008, however, the portfolio that evenly distributes its risk between stocks and bonds has done dramatically better than either stocks or bonds individually, owing to the combination of a negative correlation plus positive returns from both equities and fixed income since 2008 (Figure 3).
The fact that stocks and bonds both offered positive returns since 2008, combined with their tendency to move in opposite directions on any given day, led to exceptional diversification benefits. But what happens if inflation comes back? Higher inflation risks bringing an end to the 40-year trend of falling bond yields that began in 1980. This period of falling bond yields has led to soaring equity valuation levels (except from 2000 to 2009 when equities fell by 60%). Rising inflation and rising bond yields could hurt equity investors as well. Moreover, any sustained rise in inflation could also lead equities and bonds to return to a positive correlation, reducing any diversification benefit from holding both sets of assets simultaneously.
There is historical precedent for this: from 1965 to 1980 bond yields generally rose, while at the same time equity prices slid by 70% in real terms and lost about 40% when dividends were considered. Measured as a percentage of gross domestic product, the S&P 500 market cap fell from 110% in the mid-1960s to around 30% by the early 1980s. In other words, the dollar value of U.S. output grew much more quickly than the dollar value of the stock market during this time. Meanwhile, bond investors suffered significant losses on their portfolios (Figure 4). During this difficult period, it paid to invest in other assets beyond bonds and stocks. Gold prices, for example, soared in value versus equities (Figure 5).
This is not to suggest that an actual rise in inflation is in the offing. The economy of the 1970s was very different from the one today. The labor force was highly unionized, and international trade was only one third of what it is today as a percentage of GDP. Back then, when central banks created excessive amounts of much money, it quickly led to too many consumers chasing to few goods, driving consumer prices higher. Today, it seems that when central banks do the same, it instead leads to too many investors chasing too few investment opportunities, bidding up the value of whatever investments that are considered to be in trending.
That said, the positive correlation between stocks and bonds over several days in late February and early March 2021 offers a taste of how things might turn out if inflation does stage a sustained comeback.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
View more reports from Erik Norland, Executive Director and Senior Economist of CME Group.
Fed Fund futures are a direct reflection of collective marketplace insight regarding the future course of the Federal Reserve’s monetary policy.