US Treasuries at 'Tripping Point': Stocks-Bonds Correlation Shifts as Fixed Income Market Posts Recession Warning

US Treasuries at ‘Tripping Point’: Stocks-Bonds Correlation Shifts as Fixed Income Market Posts Recession Warning

Bonds and stocks may be returning to their usual ratio, a boon for investors with a traditional mix of assets in their portfolios amid fears that the United States faces a recession this year.

“The bottom line is that the correlation has now gone back to being more traditional, where stocks and bonds don’t necessarily move together,” Kathy Jones, chief fixed-income strategist at Charles Schwab, said in a phone interview. “It’s good for the 60-40 portfolio because the goal is to have diversification.”

That classic portfolio, which is 60% stocks and 40% bonds, took a hit in 2022. It’s unusual for both stocks and bonds to crash so precipitously, but they did last year when the Federal Reserve rapidly raised interest rates in an effort to control the rise. inflation in usa

While inflation remains high, it has shown signs of easing, raising investor hopes that the Fed can ease its aggressive pace of monetary tightening. And with most of the interest rate hikes potentially over, bonds appear to be returning to their role as a safe haven for investors fearing the blues.

“Slower growth, less inflation, that’s good for bonds,” Jones said, pointing to economic data released last week that reflected those trends.

The Commerce Department said on January 18 that US retail sales fell 1.1% in December, while the Federal Reserve released data the same day showing US industrial production fell more than expected in December. Also on January 18, the US Bureau of Labor Statistics said the producer price index, a proxy for wholesale inflation, fell last month.

Stock prices fell sharply that day amid fears of an economic slowdown, but Treasuries rallied as investors searched for safe havens.

“That negative correlation between Treasury yields and US stocks stands in stark contrast to the strong positive correlation that prevailed through most of 2022,” Oliver Allen, a senior markets economist at Capital Economics, said in a May 19 note. from January. The “change in the correlation between US stocks and bonds may be here to stay”.

A chart in his note illustrates that monthly returns for US stocks and 10-year Treasuries have often been negatively correlated over the past two decades, and the strong positive correlation of 2022 was relatively unusual during that period. of time.

ECONOMY OF CAPITAL NOTE OF JAN. 19, 2023

“Reversing inflation has a lot more to go,” while the US economy could be “getting worse,” Allen said. “That informs our view that Treasuries will gain more in the coming months, even as US stocks struggle.”

The iShares TLT 20+ Year Treasury ETF,
-1.62%
is up 6.7% this year through Friday, compared with a 3.5% gain for the S&P 500 SPX,
+1.89%,
according to FactSet data. The iShares TLH 10-20 Year Treasury ETF,
-1.40%
rose 5.7% in the same period.

Charles Schwab has “a fairly positive view of fixed income markets right now,” even after the recent rally in the bond market, according to Jones. “He can secure an attractive return for several years with very little risk,” he said. “That’s something that’s been missing for a decade.”

Jones said he likes US Treasuries, investment-grade corporate bonds and investment-grade municipal bonds for high-tax brackets.

Read: Vanguard expects muni ‘renaissance’ as investors should ‘salivate’ at higher yields

Keith Lerner, co-chief investment officer at Truist Advisory Services, is overweight fixed income relative to equities as recession risks are high.

“Keep it simple, stick to high-quality assets,” like US government securities, he said in a phone interview. Investors start to “gravitate” to longer-term Treasuries when they have concerns about the health of the economy, she said.

The bond market has signaled concerns for months about a possible economic contraction, with the US Treasury market inverting the yield curve. That’s when short-term rates are above long-term yields, which has historically been seen as a warning sign that the US may be heading for a recession.

But more recently, the two-year Treasury yield TMUBMUSD02Y,
4.193%
caught the attention of Charles Schwab’s Jones as they moved below the Federal Reserve’s benchmark interest rate. Typically, “you only see the two-year yield drop below the fed funds rate when you go into a recession,” he said.

The yield on the two-year Treasury note fell 5.7 basis points over the past week to 4.181% on Friday, in a third straight weekly decline, according to Dow Jones Market Data. That compares with an effective federal funds rate of 4.33%, in the Fed’s target range of 4.25% to 4.5%.

Two-year Treasury yields peaked more than two months ago, at around 4.7% in November, “and have been on a downward trend ever since,” Nicholas Colas, co-founder of DataTrek Research, said in a note sent by email on January 19. he confirms that markets strongly believe the Fed will stop raising rates very soon.”

As for long-term rates, the yield on the 10-year Treasury note TMUBMUSD10Y,
3.479%
it ended Friday at 3.483%, also falling for three straight weeks, according to Dow Jones Market data. Bond yields and prices move in opposite directions.

‘Bad sign for stocks’

Meanwhile, long-term Treasuries with maturities of more than 20 years “have simply rallied by more than 2 standard deviations in the last 50 days,” Colas said in the DataTrek note. “The last time this happened was in early 2020, going into the pandemic recession.”

Long-term Treasuries are at “a critical point right now, and the markets know it,” he wrote. Its recent rally is hitting the statistical line between general recession fears and sharp recession prediction.”

A further rally in the iShares 20+ Year Treasury ETF would “bode badly for stocks,” according to DataTrek.

“An investor may rightly question the bond market recession call, but knowing it exists is better than not being aware of this important signal,” Colas said.

The US stock market ended sharply higher on Friday, but the Dow Jones Industrial Average DJIA,
+1.00%
and S&P 500 posted weekly losses to snap a two-week winning streak. The Nasdaq technology composite erased its weekly losses on Friday to end a third straight week of gains.

In the coming week, investors will weigh in on a wide range of new economic data, including manufacturing and services activity, jobless claims and consumer spending. They’ll also get a reading of the personal consumption expenditures price index, the Fed’s preferred indicator of inflation.

‘Back of the Storm’

The fixed-income market is at “the rear of the storm,” according to Vanguard Group’s first-quarter report on the asset class.

“Meteorologists call the upper right quadrant of a hurricane the ‘dirty side’ because it is the most dangerous. It can bring strong winds, storm surge and spinoff tornadoes that cause massive destruction when a hurricane makes landfall,” Vanguard said in the report.

“Similarly, last year’s fixed income market was hit by the brunt of a storm,” the firm said. “Low starting rates, shockingly high inflation, and a rate hike campaign by the Federal Reserve led to historic losses in the bond market.”

Now, rates may not go up “much more,” but concerns about the economy remain, according to Vanguard. “A recession is looming, credit spreads remain uncomfortably tight, inflation remains high and several major countries face fiscal challenges,” the asset manager said.

Read: Fed’s Williams says ‘too high’ inflation remains top concern

‘Defensive’

Given expectations that the US economy will weaken this year, corporate bonds will likely underperform government fixed income, Chris Alwine, global head of credit at Vanguard, said in a telephone interview. And when it comes to corporate debt, “we are defensive in our positioning.”

That means Vanguard has lower exposure to corporate bonds than it normally would, as it seeks to “improve the credit quality of our portfolios” with more investment grade than high-yield, or so-called junk, debt, he said. In addition, Vanguard is favoring non-cyclical sectors such as pharmaceuticals or healthcare, Alwine said.

There are risks to Vanguard’s outlook on rates.

“While this is not our base case, we could see a Fed, faced with continued wage inflation, forced to raise a fed funds rate closer to 6%,” Vanguard warned in its report. The rise in bond yields already seen in the market “would help ease the pain,” the firm said, but “the market has not yet begun to price in that possibility.”

Alwine said he expects the Fed to raise its benchmark rate to between 5% and 5.25%, then leave it there for possibly two quarters before starting to ease monetary policy.

“Last year, bonds were not a good diversifier from equities because the Fed was aggressively raising rates to address inflation concerns,” Alwine said. “We think the more typical correlations are coming back.”

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