Stranger times ahead
While the challenges cited above have been with us for several years, a new wrinkle has emerged more recently. As investor anxiety has shifted from growth and geopolitical shocks to the Fed, the correlation between stocks and bonds has started to rise, and it’s likely to continue rising as a Fed rate hike nears. As a result, typical duration-heavy bond funds may not provide as effective a hedge against equity risk as they used to. Adding to the challenges, volatility is likely to rise as the Fed begins to normalize monetary conditions.
Market Realist: Correlation between stocks and bonds is on the rise
The graph above shows the correlation between the SPDR S&P 500 ETF Trust (SPY), the iShares Barclays 20+ Year Treasury Bond ETF (TLT), and the iShares Barclays Aggregate Bond ETF (AGG) with respect to weekly returns over the past ten years.
SPY has a relatively low correlation with the other two. The correlation between SPY and TLT in that period was -0.42, while the correlation between SPY and AGG was 0.13. Low correlation means that adding bonds or bond ETFs to a portfolio containing only stocks is greatly beneficial.
Meanwhile, stock (IVV) and bond (BND) investors have been wary of the fact that interest rates could rise. Also, both stocks and bonds are trading at high valuations. This outlook has caused their performance to converge. Stock and bond volatility have risen simultaneously this year on a number of occasions.
The correlation between SPY and TLT increased to -0.19 in 2015, considering weekly returns. While this correlation is still negative, you can expect it to increase over the coming months if the Fed raises rates. The increasing correlation is bad news, as bonds aren’t providing what they usually do: diversification benefits.