by Nikolaos Panigirtzoglou, J.P. Morgan
Highlights
This year’s shift in bond-equity correlation seems even more persistent than the one seen during the taper tantrum of 2013 and raises questions about whether the shift in bond-equity correlation in the current conjuncture is a temporary one, as it turned out to be in 2013, or a more structural shift.
• In our opinion the persistency of the current shift in the bond-equity correlation into positive territory would likely be a function of the persistency in inflation surprises, given the impact of the latter on market expectations concerning Fed policy.
• Given we see a high risk that positive inflation surprises continue, this shift in bond-equity correlation could also persist for much of the remainder of the year.
• A more persistent positive bond-equity correlation would reduce the diversification benefit of holding government bonds, which could push multi asset investors, including risk parity funds, balanced mutual funds and pension funds, to look at other more expensive ways of hedging equity risk, such as buying equity puts, perhaps inducing more elevated vol and skew premia in the equity option space.
• This month’s bond market rally appears to have been driven by a combination of risk parity funds and macro hedge funds ex CTAs increasing duration exposure, as well as CTAs adding longs in 10y USTs and taking profit on bearish exposure in 10y Bunds.
• In our opinion the shift in Bitcoin futures into backwardation is a bearish signal echoing 2018.
After shifting abruptly at the beginning of the year, the bond-equity correlation remains firmly in positive territory as shown in Figure 1. The shift in the 6- month rolling correlation in particular seems even more persistent than the one seen during the taper tantrum of 2013 and raises questions about whether the shift in bond-equity correlation in the current conjuncture is a temporary one, as it turned out to be in 2013, or a more structural shift. In our opinion, the persistence of the current shift in the bond-equity correlation to positive territory would likely be a function of the persistence in inflation surprises, given the impact of the latter on market expectations concerning Fed policy. As we highlighted in our monthly publication Global Asset Allocation earlier this week, we believe that inflation surprises are likely to be persistent over the medium term for three reasons: the strength in growth acceleration coupled with supply bottlenecks, the strong serial correlation seen historically in consensus inflation forecast revisions, and further upside in commodity prices. Therefore, our guess is that this shift in bond-equity correlation could also persist for much of the remainder of the year.
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