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Market Extra

Feb. 26, 2021, 1:37 p.m. EST

Cracks in this multidecade relationship between stocks and bonds could roil Wall Street

By Sunny Oh

With bonds and stocks taking hits this week, investors are facing the ugly possibility that the multidecade relationship between the two assets are on the precipice of breaking down.

Since 1997, stocks and bond yields have exhibited a positive correlation, according to analysis by Montreal-based BCA Research. In other words, whenever risky assets came under pressure, yields would fall, pushing bond prices higher.

For Americans balancing their assets between stocks and bonds to manage their brokerage accounts and retirement savings, this relationship has allowed investors to reap strong returns while cushioning the losses from equity drawdowns.

Yet this once-reliable correlation has shown signs of crumbling, spelling trouble for investors who rely on government bonds as ballast for portfolios. Even as the fall in government bond prices lifted the 10-year Treasury yield BX:TMUBMUSD10Y around 13 basis points this week to 1.50%, equities have also come under pressure.

The S&P 500 SPX and the Dow Jones Industrial Average DJIA are both on pace to record losses this week, pulling back from record highs.

This simultaneous selloff is pushing the stock-bond correlation closer to negative territory, this chart from BCA Research shows.

BCA’s analysts say this positive correlation between stocks and bonds disappears when investors perceive sea changes in the macroeconomic landscape, especially if inflation risks are gaining ground.

Inflation can pose risks to both equities and debt because they raise the possibility of more monetary tightening down the road, leaving investors with few hiding places during a stock-market selloff.

That’s the fear brewing in Wall Street. Market participants were starting to price in the small risk of a strong bounce in inflation after the pandemic, as the reopening of the economy and trillions in fiscal relief spurred a rush of spending on restaurants, hotels and travel later this year, ING strategists said.

Read : The traditional stock-bond correlation disappeared in 2018, spelling trouble for investors

By itself, correlation breakdowns could fuel further selling in both bonds and equities, according to Robert Tipp, chief investment strategist at PGIM Fixed Income.

He noted fast-moving quantitative traders like risk-parity funds or commodity trading advisors who toggled their exposure to stocks and government bonds based on this relationship were particularly exposed.

In the face of a breakdown in correlations, these traders would sharply slash their overall positions to limit the risks they were taking. But in doing so, they could create a vicious spiral of tumbling values for both risky and haven investments.

“The correlation breakdown is unhealthy and the longer it goes on the worse it feels. The good news is that these breakdowns do not last long, but they can cause valuation damage while they persist,” wrote Mark Holman, CEO and portfolio manager for TwentyFour Asset Management.

Link to MarketWatch's Slice.