From 1968 until the late 1990s, the relationship between stock prices and bond yields was characterized by a persistent negative correlation. That is, higher interest rates were typically associated with lower stock prices. Since 1997, however, the correlation has turned positive whereby rising interest rates are usually linked to gains in the stock market. What does the relationship between stocks and bonds signify and why did the correlation change so significantly since the late 1990s?
We think the correlation between stock prices and bond yields reflects investor attitudes about potential inflation/deflation risks. A negative correlation (i.e., when rising interest rates are associated with falling stock prices) results when inflation is the primary consensus fear. In this case, improved economic numbers often hurt both bond and stock prices since they are perceived as harbingers of increased inflationary potential. Conversely, when deflation is the central focus, the correlation between stock prices and interest rates is positive, since better economic reports simply signify less risk of a depressionary collapse (raising both interest rates and stock prices).
During the 1970s, investors learned to fear inflation, and this market focus remained dominant for almost two decades after the inflationary spiral peaked in the early 1980s. The persistently negative correlation between stock prices and bond yields during this period reflected widespread imbedded inflation anxieties. Any news of improved economic growth was quickly followed by escalating inflation fears pushing interest rates higher and pressuring stock prices.
However, in the early 1990s, Japan entered a deflationary economy followed by the 1997 Asian deflationary abyss, the 1998 Russian deflationary debacle, the 2000 dot-com deflationary meltdown, and the “Great Deflationary Fear-session” of 2008. This series of events awakened, and has since sustained, “deflation risk” as the predominant investor fear. This is reflected in Exhibit 1 by a 1997 surge in the correlation between stock prices and bond yields, which has since continued to remain mostly positive.
Why Monitor the Stock/Bond Correlation??!?
The correlation between stock prices and bond yields and how this correlation changes over time is significant for policy officials and investors for three main reasons. First, this correlation provides a new and unique estimation of inflation expectations. Second, historically, the effectiveness of various economic policies differ, substantially depending on whether the correlation is positive or negative. Finally, the magnitude and directional impact of changes in bond yields on the stock market differs significantly depending on the existing correlation between the stock and bond markets.
A Different Inflation-Expectations Measure!!?
Contemporary inflation-expectation monitors (e.g., Tips, yield curve or surveys) record the “rate” of expected inflation and whether this “expected rate” is rising or falling. Conversely, the stock/bond correlation is not concerned with the rate of expected inflation, but rather assesses whether “inflation” or “deflation” is the predominant financial market concern. Both measures provide important, but diverse, information. The impact of a rising “expected-inflation rate” depends on whether the economic culture is inflation-focused or deflation-focused. Conventional measures of inflation expectations do not record the “inflation/deflation culture” captured by the stock/bond correlation. For example, accelerating inflation expectations during the inflation-anxious 1970s entails entirely different economic policy and investment issues than does rising inflation expectations in today’s deflation-focused world.
