Blog

Inflation Expectations and Markets: When the Bond Tail Wags the Equity Dog

The rise in bond yields and concurrent shakiness in equity markets may emanate from a subtle but important shift in risk sentiment on inflation.

The rise in bond yields and concurrent shakiness in equity markets may emanate from a subtle but important shift in risk sentiment on inflation. This has important ramifications for stock and bond investors.

In the U.S., both actual inflation and inflation expectations are accelerating. While the increase has been modest so far ­– the core Consumer Price Index (CPI) moved from 1.8% year-over-year in October 2017 to 2.1% year-over-year in March 2018, and breakeven inflation (or BEI, which is the spread between nominal and real (i.e., adjusted for inflation) U.S. Treasury bond yields of the same maturity) for 10-year Treasuries moved from 1.85% to 2.15% over the same time frame – many market participants worry that U.S. inflation could accelerate further. They can point to the large deficit-induced fiscal spending, the likelihood of tariffs on imports and geopolitical turmoil in the Middle East, among other causes.

The important point here is not just the rise in inflation, but an inflection point in investors’ assessment of inflation risk: It is shifting from deflation or too little inflation to too much inflation.

This explains why bond yields have been rising recently while equity prices have been falling, a combination that is confusing many investors who have come to depend on the “reliable” negative correlation between stock and bond prices to reduce the volatility of their portfolios. Over the last several years, if an investor was worried about having too much equity risk, all one had to do was increase bond market exposure, and voilà, the equity risk was hedged. If this strategy no longer works, then investors turn to the next logical step to reduce equity risk: They sell equities! This explains some of the recent confusing price action in equity markets. The bond tail is wagging the equity dog.

A longer-term view of the stock-bond correlation

None of this is necessarily unexpected. As we discussed in our annual Asset Allocation Outlook,Singles and Doubles,” rising inflation, rising volatility and unusual stock-bond correlations were risks investors should be prepared for in 2018. As the chart below shows, U.S. stock-bond correlations were positive for three decades until the turn of the 21st century, and became negative only after the Federal Reserve managed to anchor inflation expectations.

It is important to note that no matter what the near-term correlations are between stocks and bonds, high quality U.S. government bonds have been good performers in nearly all recessions over the past 60 years. For a deeper dive into this issue, please read the recent PIMCO Viewpoint,Treasuries, Stocks and Shocks,” by Jamil Baz and Steve Sapra.

Long-term investors who buy high quality bonds for income or for a hedge against recessions will likely find those objectives fulfilled. However, those who buy high quality bonds to hedge every zig and zag in the equity markets may have more surprises in store.

Enjoyed this article? Subscribe to receive updates to the PIMCO Blog.

SUBSCRIBE

Disclosures

London
PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

Dublin
PIMCO Europe GmbH Irish Branch,
PIMCO Global Advisors (Ireland)
Limited
3rd Floor, Harcourt Building 57B Harcourt Street
Dublin D02 F721, Ireland
+353 (0) 1592 2000

Munich
PIMCO Europe GmbH
Seidlstraße 24-24a
80335 Munich, Germany
+49 (0) 89 26209 6000

Milan
PIMCO Europe GmbH - Italy
Corso Matteotti 8
20121 Milan, Italy
+39 02 9475 5400

Zurich
PIMCO (Schweiz) GmbH
Brandschenkestrasse 41
8002 Zurich, Switzerland
Tel: + 41 44 512 49 10

PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Irish Branch (Company No. 909462), PIMCO Europe GmbH UK Branch (Company No. BR022803) and PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Italian Branch, Irish Branch, UK Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority; and (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2) . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.

XDismiss Next Article
PIMCO

LU

unidentified

[change]

Subscribe
Please input a valid email address.