·May 30, 2023
Harvard University, Harvard Business School, and Harris School of Public Policy at the University of Chicago
For most of the past 20 years, stock prices and bond prices have tended to move in opposite directions. Purchasing 10-year Treasury bonds therefore constitutes a good hedge for investors seeking to protect their portfolio from falling stock prices. But when the Federal Reserve began raising interest rates to combat inflation in 2022, stock prices And bonds fell simultaneously. This was more like the norm in the 1980s and 1990s, when stock and bond prices tended to rise and fall in tandem. Recent research in economics has looked at the co-movement of stocks and bonds and what it indicates about the risk characteristics of U.S. Treasuries, as well as market expectations about the U.S. macroeconomic outlook.
Long-term Treasury bonds protect portfolios against falling stock prices over the past 20 years. But stocks and bonds don’t always move in opposite directions.
- Although U.S. Treasury bonds have very little default risk, they are not risk-free assets. Changes in interest rates have a substantial short-term impact on long-term U.S. Treasury bond prices, as many investors regularly see. Rising interest rates lower the price of existing bonds (and the opposite is true for falling interest rates). Even investors who hold their bonds to maturity can suffer losses in real terms if inflation becomes unexpectedly high.
- An additional measure of the risk of holding bonds in a portfolio is to compare how they perform relative to other assets. We can calculate beta – the financial asset pricing model’s standard measure of systematic risk – for long-term Treasury bonds by comparing their yield with the stock market as a whole. This metric assesses the extent to which Treasury bonds move like stocks over time – or not (see chart).
- The performance of Treasuries relative to stocks has changed significantly over time. During the 1980s and 1990s, U.S. Treasuries had a positive beta relative to stocks: when stocks fell, bonds fell; when stocks went up, bonds went up. But at the turn of the millennium, this co-movement changed sign and became negative: bonds moved opposite to stocks and served to balance portfolios. (Note that each point on the chart reflects five years of quarterly data, reflecting how bonds have performed relative to stocks over the previous five years).
- The change in how bonds move relative to stocks is related to the nature of inflation. The nominal interest rates that determine Treasury bond prices reflect both inflation expectations and real interest rates: when these are high, bond prices tend to be low. Stocks move with the strength of the economy: When the market expects lower growth and lower corporate profits in the future, stock prices fall. So, a scenario in which high inflation and high real interest rates occur simultaneously with a recession is one in which Treasury bonds and stocks are both likely to decline.. Campbell, Sunderam, and Viceira (2017) relate changes in bond betas to the changing nature of inflation in the economy and formally model the implications for short- and long-term interest rates over time . Long-term interest rates play a central role in the economy; for example, mortgage rates tend to increase when long-term bond rates are higher. When bonds are risky and move like stocks, investors will naturally charge a higher long-term interest rate.
- The changing nature of shocks to the economy and the Federal Reserve’s stance on inflation offer a potential explanation for why stocks and bonds tend to move together. In the early 1980s, the Fed’s monetary policy prioritized combating inflation at a time when inflation was peaking above 14%, even though this caused disruptions in economic activity and an increase in unemployment. In situations like this, or if inflation rises due to an energy crisis or war, the Fed will suppress inflation by raising interest rates even if it causes a recession. This is bad for bonds and bad for stocks, and the prices of both will fall, resulting in positive bond beta. In this century, until recently, the situation has been different. The Fed had good credibility in its commitment to fighting inflation and no major supply shocks changed inflation expectations. Under these conditions, in the event of a recession, the Fed will reduce interest rates to stimulate the economy. Recession is bad for stocks. Low interest rates are good for bonds. Bond and stock prices move in opposite directions, resulting in negative bond beta. Pflueger (2023) offers a formal model showing that bond betas should be more strongly positive when supply shock-induced inflation is present and the Fed risks a recession in its efforts to stabilize inflation.
- The perception of bonds as “safe assets” can play a reinforcing role in conditions where bonds are used as a hedge against stocks in market downturns. Campbell, Pflueger, and Viceira (2020) question whether the attractive security aspect of Treasury bonds after the year 2000 is due to changes in the cyclical behavior of inflation and real interest rates, or whether Investors tend to flee to the safety of bonds when there are risks. is bad news. The answer is both, and they are related. In the early 21st century, low and stable inflation made nominal bonds a safe haven, to which investors fled in times of bad news, driving up their prices and further improving the bonds’ hedge value. But this amplification mechanism now serves as a warning to investors questioning the continued safety of bonds, as even a slight change in the macroeconomic environment can be enough to dramatically shift bonds from asset safe havens for risky assets.
- Do current conditions—high inflation, war in Ukraine, high and volatile energy prices—indicate that the U.S. economy is likely to return to the regime of the 1980s and 1990s, when stocks and bonds moved in lockstep? Although it is probably too early to tell, bond betas suggest that while the current situation has some similarities to the 1980s and 1990s, there are also important differences. Recent data shows positive beta for TIPS – bonds whose prices are linked to inflation and which, unlike regular Treasuries, do not suffer when inflation rises. Additionally, the beta of regular Treasuries (or nominal bonds) has remained lower than the beta of TIPS. Both the nature of the shocks – supply shocks as in the 1980s or demand shocks as in the 2000s – and the perceived reaction of monetary policy play a role for the economy and bond betas. Pflueger’s (2023) model suggests that recent empirical trends can arise when the economy is subject to strong inflationary supply shocks, such as those experienced in the 1980s, but unlike in the 1980s, markets expect what the Fed achieves a “soft landing”. “. The most recent increase in nominal and inflation-indexed bond betas into positive territory occurred just as the monetary policy response was strengthening, further highlighting the importance of monetary policy for betas obligations.
The co-movement of Treasuries and stocks is an important indicator for both policymakers and long-term investors. Positive co-movement between nominal Treasury bonds and stocks, as in the 1980s, means that nominal bonds amplify the volatility of stock investors’ portfolios. This trend tends to occur when investors anticipate inflation accompanied by a recession, which often results from an adverse supply shock – pushing up prices – and a rapid and forceful rise in interest rates – pushing the economy into a recession. The importance of the co-movement of Treasury bonds and Treasury stocks is increasingly recognized in policy circles as an important policy indicator of supply-induced inflationary pressures and the risk of monetary policy-induced stagflation (see for example the President’s Economic Report, March 2017). 2023, p. 61-62). Policymakers also recognize the importance of bond-stock co-evolution for the attractiveness of Treasuries to investors and the term premiums they demand to hold these bonds – the government would find it more expensive to borrow if long-term Treasury bonds were no longer available. considered useful hedges against equity risk. So far, post-pandemic risks for Treasuries look markedly different from those of the 1980s despite energy supply disruptions, suggesting investors are anticipating a less aggressive Fed response and a soft landing . Going forward, nominal T-bill risks will be a useful tool for tracking market expectations of stagflation risk and its sources.
Financial markets / Stock markets