Bonds are Negatively Correlated to Equities?

Posted in Wealth
30/08/2013 Level One

Risk on, risk off. Equities rise and bonds fall, or bonds fall and equities rise – that is, bonds are negatively correlated to equities – and that makes bonds a great diversifier despite their low yields.

For the past few years, this idea has been absolutely correct. However, to hear some commentators, you would think that this negative correlation is a fundamental law of nature. It is not. The idea that bonds and equities are always negatively correlated is simply wrong. As the graph below clearly shows, government bonds and equities have gone through long periods where correlations are negative (since 2001) but even longer periods where correlations are positive (1963 to 2001).

Figure 1: Rolling 5-year correlations US equities and bonds (Jan 1920-Feb 2013)

In fact, there are many influences on how bonds and equities are correlated. In the 1970s, 80s and 90s, inflation was the market’s greatest fear. When inflation expectations rose, so did interest rates and, more to the point, real interest rates rose such that a 1% increase in inflationary expectations might spark a 2% increase in bond rates. Rising interest rates are not good for sharemarkets; rising real rates are a disaster, not only for equity markets but for bond markets as well.

The past six years has turned all that on its head. The greatest fear has been a deflationary collapse of the banking system. The more nervous investors got the more equity markets sold off and the more Central Banks lowered interest rates. Hence, for now, the correlation between the two assets is negative. Why correlations went negative post the Tech Wreck (early 2000’s) is harder to explain. Perhaps the Fed’s fear of a downturn was greater than its fear of inflation and, so, interest rates were kept artificially low. A spike in inflation didn’t cause a spike in real rates and equities were spared.

Going forward, it is difficult to be sure of just how the relationship will pan out. But one thing is clear – banking on a continued negative correlation to justify an investment in low returning bonds is nuts. And you can clearly see its nuts.

This is an article written by Tim Farrelly. Tim developed and operates Farrelly’s Investment Strategy.


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