Alarming Divergence Between Stocks And Bonds

The bond market is in turmoil. Yes, the 40-year bull run on bonds is long gone, but the pain in the bond market is far beyond what many could have imagined. In fact, the bond market has experienced its worst two years in more than a century and a half. This decline in bond values has shattered the classic 60/40 portfolio and put tremendous pressure on leveraged borrowers.

In contrast, the equity market seems to be largely indifferent. Over the past three years, there has been a notable negative correlation between long-duration stocks and bonds, with the two moving in opposite directions. This massive divergence raises the question of how long-duration stocks and bonds will repair their long-term relationship. Will stocks fall to meet bonds or vice versa? Or will they meet in the middle?

The Impact Of Supply And Demand On Treasuries

One possible explanation for this historically large divergence between stocks and bonds is simple supply and demand dynamics within treasury markets. Deficit spending and debt levels in the United States have reached such a magnitude that even at currently high interest rates, there are simply not enough buyers for all the debt that needs to be issued to maintain trillion-dollar annual deficits. To make matters worse, foreign central banks have reduced their purchasing of treasuries or become net sellers. Also, the discontinuation of bond purchases by the Federal Reserve may be coming together to create a large imbalance between bond supply and interested buyers.

These supply and demand dynamics in the treasury market could potentially lead to a continued rise in yields until more investors are enticed away from risky assets like stocks in exchange for higher yields that carry much less risk. Billionaire investor Ray Dalio warned in June that the United States is beginning a “classic late, big-cycle debt crisis” marked by a lack of buyers for its bills and bonds.

According to a team of strategists led by Michael Hartnett from Bank of America
BAC
, the ongoing United States Treasury rout is the most severe bond bear market in the 247-year history of the United States. The team predicts that persistent inflation pressures will push 10-year treasury yields to 5%, a figure last observed in mid-2007.

Here lies the problem the Fed is facing. To bring down yields at the long end of the curve, they would need to lower interest rates and probably begin buying treasuries again to relieve supply pressures. Taking either of these actions has a high probability of pushing risk asset prices higher and causing inflation to accelerate to the upside once again.

Why Long-Duration Stocks And Bonds Are Correlated

Historically, growth companies, such as those found in the Nasdaq 100 stock index, have had a strong correlation with long-dated treasury bond prices. This is because the high valuations of growth stocks are justified by discounting high future expected growth back to present value.

However, the rate used to discount future growth back to present value is significantly influenced by treasury yields and the discounted value of future cashflows is very sensitive to even small changes in the discount rate. Therefore, as bond yields rise (and bond prices fall), the present value of future earnings drops, leading to a decrease in stock prices.

Potential Downside Risk For Equities

Bond yields still have upward momentum presenting significant risks to stock investors. At some point bond yields may be pushed high enough to entice stock investors to begin selling stocks to buy much lower risk, high yielding bonds while rising discount rates simultaneously devalue companies. This scenario would be a true one-two punch for stocks with both selling pressure and falling valuations pushing stocks lower. The historically large divergence between stocks and bonds validates that a scenario like this deserves consideration.

JPMorgan Chase
JPM
& Co. strategists Nikolaos Panigirtzoglou and Mika Inkinen have noted that while bond markets are pricing in a period of sustained macroeconomic uncertainty, equity markets appear to be “priced for perfection.” The question of how and if this divergence will close in the future remains uncertain. However, there are reasons to believe that stocks are at the most risk of eventually giving ground to bonds to close this gap.

he historically positive correlation between stocks and bonds is usually measured over three years or more, and the massive divergence we currently see between the two has taken three years to materialize. The closing of the gap is likely to take years, not days or months to correct and should signal to investors that stocks are riskier than usual with significant downside risk and limited upside potential.

In light of these developments, investors may wish to adjust their strategies by altering the composition of stocks they hold, reducing exposure to growth and some defensive stocks that are sensitive to interest rates. When divergences as fundamental as the relationship between long-duration stocks and bonds emerge to this magnitude, risk management becomes the name of the game.

This market environment demands careful scrutiny of portfolios, strategic adjustments, and an increased focus on risk management. Always mind market gaps in long-held cross asset relationships and patiently wait for opportunities that will certainly come from market imbalances of this magnitude.