Your portfolio’s missing puzzle piece is finally back
The negative correlation between stocks and bonds returned during August’s market unrest.
One side effect of the disruptive, violent price action across financial markets in August: it seems to have restored some normality to a key relationship in the investment universe.
Stocks and bonds aren’t moving in the same direction any more.
The 21-session correlation between the daily change in the S&P 500 and long-term US Treasury bonds is now at its most negative since the second quarter of 2023, when the stock market was rebounding following the mini-crisis in regional banks.
Through most of the past two years, stocks and bonds have been moving in tandem. Surprisingly, persistently hot inflation was putting upward pressure on interest rates, and traders bet that these higher borrowing costs (along with high prices!) would eventually put enough pressure on businesses and consumers that the economy would tip into recession.
Lower rates, meanwhile, were a signal that either inflation was decelerating and the Fed would be able to relent on rate hikes or pivot towards rate cuts, providing more confidence that the economic expansion would continue and corporate profits would keep rising.
That’s obviously good news when both are rallying together, but a real pain when both are falling in tandem. A key part of the rationale underpinning the traditional 60 (stocks)/40 (bonds) portfolio structure is that the safe, boring fixed income instruments are there to provide a cushion when stocks fall.
That typical relationship got ridiculously distorted in 2024. At one point this year, the stocks in the market – that is, holding an equally-weighted version of the S&P 500 – were a better diversifier for the S&P 500 than owning bonds, the first time that had happened in about 25 years.
After the surprisingly soft July non-farm payrolls report landed in early August and sparked a big selloff in stocks and bond rally, I hypothesized:
This likely marks an end to the positive stock-bond correlation that’s persisted for most of the two years.
Why have we reached a limit on how much lower rates can be viewed as a positive for the stock market? Because the bond market has already priced in a lot of interest rate cuts from the Fed – more than 100 basis points through year-end and nearly 175 basis points over the next 12 months.
For the Fed to cut rates more than traders currently expect, we’d likely need to see more ugly macroeconomic data, and the kind of damage to the labor market that would get investors even more worried about the outlook for consumer spending and corporate profits.
That seems to be what’s transpired.
The data have, by and large, been less bad, especially relative to expectations. The Citi US Economic Surprise Index, which measures how US data come in relative to economists’ estimates, has risen from -40 as of August 2 (the day the July jobs report landed) to -24 by the end of the month.
So too has the Citi Economic Data Change Index, which tracks incoming figures relative to their one-year average, in rebounding from -150 to -128 over this period.
