March 17, 2021

Buttonwood – Why people are worried about the bond-equity relationship | Finance & economics

Mar 6th 2021 MOST PEOPLE have little time for quants. They find the language of…

MOST PEOPLE have little time for quants. They find the language of quantitative finance far from illuminating. Even fairly numerate people struggle to grasp what comes easily to pointy-headed number-crunchers. Take the idea of correlation, the co-movement of two or more variables. Such relationships vary with the period over which they are measured. The direction can shift. Things quickly become confusing.

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Yet the quant argot is useful when considering perhaps the biggest fear stalking financial markets: a sustained rise in inflation that would be bad for both equities and bonds. A quant might describe this as a flip in the bond-equity correlation from negative to positive. That is none too elegant, though. A better choice is a term used in geopolitics as well as econometrics: regime change.

It is helpful in this matter to start with two stylised facts. The first is that in recent years, bond and equity prices have tended to move in opposite directions over the business cycle. When recessions hit, bond prices tend to rise sharply (their yields fall) and equity prices usually crash. When the economy recovers, bonds tend to fall in price and equity prices go up again. You can think of this in terms of risk appetite. Government bonds are safe assets. People rush into them when they fear for the future. Equities, by contrast, are risky assets, so people shun them in troubled times.

The second stylised fact concerns a secular relationship rather than a cyclical one. Since the early 1980s bond and equity prices have moved in the same broad direction—upwards. If you look at low-frequency data over a long period, the bond-equity correlation is positive. This is best understood in terms of yields rather than prices. For the past four decades, there has been a secular decline in government-bond yields, reflecting a secular decline in interest rates. The earnings yield on equities has fallen, too, as have yields on other assets, such as corporate bonds and property. This should not be a surprise. Yields are a gauge of expected returns. Bonds and equities compete for investors’ capital. Over the long haul the prices and yields of each will respond to those of the other.

These two facts may seem at odds, but a third fact makes them consistent. In each business cycle, interest rates tend to rise as the economy gathers strength (so bonds and equities diverge over short periods). But each business-cycle peak in interest rates is lower than the previous one (so bonds and equity prices converge over the long run). That in turn is a response to the secular decline in inflation.

Indeed, inflation is central to the bond-equity relationship. It is here that things become trickier, and the notion of regime change matters. Bonds promise fixed cash payments in the future. Those cashflows are worth less when inflation unexpectedly rises. By contrast, equities have generally outpaced inflation over the long haul. But the relationship between inflation and equity prices is not stable. A study by Sushil Wadhwani, a former member of the Bank of England’s rate-setting committee, in 2013 found that higher inflation generally helped to boost stockmarket returns in Britain in the two centuries before 1914. But by the last half of the 20th century a negative relationship had emerged. You might best explain this finding in terms of monetary regimes. Under the pre-1914 gold standard, inflation was mean-reverting: if it was high one year, it would fall the next. But in the era of fiat money, especially in the 1970s, the checks on inflation were less binding.

In the past few decades central banks were given inflation targets, and the monetary regime switched again. Now, yet another regime change may be afoot. Fiscal stimulus is back in favour, which has an unsettling 1970s feel to it. Fiscal policy fell out of fashion because it was not well suited to fine-tuning aggregate demand; politicians are reluctant to cut spending or raise taxes when the economy threatens to overheat. And the old-style central banker—reared in academia, aloof from politics, paranoid about inflation—is now almost extinct. The new breed talks about climate change and inequality and is sanguine about inflation risks. This feeds a general sense of lost policy discipline.

Sooner or later, warn the hawks, this will end in tears. Many of the people who predict the return of 1970s-style inflation used to deride the old-school, bookish rate-setter, with his fancy econometrics and lack of market smarts. It is no small irony that they now feel so nostalgic for the pointy-headed central banker.

This article appeared in the Finance & economics section of the print edition under the headline “Lament for the pointy-heads”