Tuesday's Market Minute: The Positive Bond & Equity Price Correlation May Soon Fade

Today’s CPI print of 7.1% Y/Y may have kicked off the turning point between equity prices and bond yields. In 2022, the market got accustomed to a relationship between low rates and higher equity values. Traders were looking towards the 5-year, 10-year, or even the 30-year treasury for direction on where equity prices may go. As we saw rates move lower, equity markets would pop, and the opposite reaction would also occur. Throughout the year, we saw rates increase at a rapid pace as the result of FOMC actions, and bond traders were selling their positions to mitigate risk from these policy actions. 

But now, the dynamics may have changed, as the market is now under the impression the Fed may be close to peak rates as we are expecting another 50-basis point rate hike tomorrow, and possibly another 25-50 basis points at the February meeting. If the market is correct, then fixed-income traders may start shopping for rates, and who can blame them? 

As of this morning, a 2-year treasury is yielding over 4.3%, a rate the market has not seen in over 15 years. Remember, fixed-income yields trade inverse to prices. So, if cash starts to come off the sidelines, we may see inflows into fixed-income products, stabilizing rates and leaving equity traders questioning what is the next best “indicator”.

For some, this is all new, so let’s break it down. Every asset class has its own form of perceived risk or “safety” mechanism. The big “4”, and I can’t believe I’m adding crypto into the mix, are: Cash, Bonds, Equities, Crypto. Now, before we get too far ahead, I know some traders are asking: “What about commodities?” Let’s leave that out for now, because the dynamics of some commodity markets have changed over the last year. Cash provides very low yield or may not provide a yield at all, but is perceived to be the safest asset. Treasuries are next on the risk spectrum, once again, backed by the full faith and credit of the U.S. but they’re tradable and the value for this asset is more dynamic than cash. However, if you hold the product until maturity, you will receive your premium back plus interest payments depending on the treasury. Equities have more risk: you become a shareholder of a company, partake in the profits or losses, maybe receive a dividend, but ultimately the risk is if the stock goes to zero—so greater risk, greater potential for return. The last “asset” is crypto. New to the investment mix for many in the investing community, very volatile, and only appropriate for those who have the risk tolerance and understanding of the product.

Back to the relationship. As investors’ risk appetites change as uncertainty enters the market, they may adjust their portfolio to less risky assts. This reaction could create inflows into bonds, raising prices, and stabilizing or lowering yields. The outflows from risker assets like crypto and equities could result in those asset values falling or leveling out. Once again, there is an inverse relationship to risk and asset flows in a “traditional” market, and this market is far from normal or “traditional”. Enjoy the rallies, manage risk, and buckle up for an exciting 2023.

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