When love and hate correlate

Fredrik Wilander
18-05-15 15:00 | Markets and investments | Fredrik Wilander

Financial markets have over the past few weeks seen increased tension and volatility, especially in bond markets. Yields on safe government bonds such as German, Swedish and US, have increased sharply albeit from low levels. At the time of writing, the upturn in yields seems to have moderated or even reversed. Despite this, investors are likely left with a feeling of having witnessed an uncomforting trend shift, although many of us have also been uncomforted by the continuous fall in bond yields. 

Due to the ever lower yields, the safest government bonds have become something of a hate/love relationship for investors. Either because the investor regrettably and prematurely sold off the bonds and put the money in cash (maybe loudly also warning for an imminent bond market crash), or retained his or her position and has therefore received an almost unreasonably high return given the risk while knowing that at some point surely the party must end. 

Except for the period investors now refer to as the “taper tantrum” during the summer of 2013, when markets became concerned that the Federal Reserve would be too quick to scale back on its bond purchases, short-term returns to government bonds and equities have been negatively correlated (the longer-term return trend have obviously been positive for both asset classes). Fear of either double-dip recessions, Euro Zone financial crisis, falling earnings, deflation etc. have from time to other pushed investors out of equities and into safe haven bonds, causing prices to diverge. When things have looked up, bonds have sold off and equities have rallied. Recently however, the correlation between bond and equity returns has been on the rise again. 

Why have correlations risen? One plausible explanation, which can also serve to explain why the US dollar uncharacteristically has fallen along with equity markets recently (often also the dollar moves opposite risk appetite), is investor positioning. Popular and profitable active positions among asset allocators have been long dollar (and short euro), long duration (more bonds than cash), and overweight equities. All of these positions have likely benefitted from the ECBs program of quantitative easing. As one of these “crowded trades” – long duration - starts to move against investors, it is not unthinkable to see a gradual unwinding of other active positions where there are still profits to take home. The fact that dollar, bond prices and equity prices have fallen in tandem could simply be an unwinding of positions taken by managers who might for instance have betted on quantitative easing in the Euro zone.  

No place for government bonds anymore?

Does this recent rise in correlations imply that government bonds no longer deserve a place in an investment portfolio as protection against equity risk? We do not think so. However, how much protection an investor gets will likely depend on why equity markets are falling. Reduced expectations of supportive monetary policy and/or the view that inflation is on the rise could harm both equities and bonds, leading to little support. Risk of a new economic and corporate profit recession, renewed deflationary pressure, turbulence in the financial system for example due to a “Grexit” – then safe haven government bonds will again be an investor’s friend in need and equity and bond prices being negatively correlated. More like “When love and hate collide” as a power ballad rock group of the 80s put it.  

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