US Treasuries ‘at critical juncture’: Stocks, bonds shift correlation as fixed-income market flashes recession warning

Bonds and stocks may return to their normal relationship, a plus for investors with a traditional mix of assets in their portfolios amid fears that the U.S. will face a recession this year.

“The bottom line is that the correlation is now a more traditional one where stocks and bonds don’t necessarily move together,” Kathy Jones, chief fixed-income strategist at Charles Schwab, said in a phone interview. “A 60-40 portfolio is good because the goal is to have diversification.”

This classic portfolio of 60% stocks and 40% bonds was hit in 2022. It’s unusual for both stocks and bonds to rally so quickly, but they did last year as the Federal Reserve quickly raised interest rates to tame growth. Inflation in the United States

Inflation remained high but showed signs of easing, raising investors’ hopes that the Fed will slow the aggressive pace of monetary tightening. With the bulk of interest rate hikes potentially over, bonds are returning to their role as safe havens for investors fearful of the gloom.

“Slower growth, less inflation, that’s good for bonds,” Jones said, pointing to economic data released last week that reflected those trends.

The Commerce Department released data on Jan. 18 that showed U.S. retail sales fell a sharp 1.1% in December, while the Federal Reserve released data the same day that showed U.S. industrial production fell more than expected in December. Also on January 18, the US Bureau of Labor Statistics reported that the producer price index, a measure of wholesale inflation, fell last month.

Stocks fell sharply on the day amid fears of an economic slowdown, but Treasuries rose as investors sought safe havens.

“This negative correlation between Treasury and US equity yields is in stark contrast to the strong positive correlation that has dominated much of 2022,” Oliver Allen, chief market economist at Capital Economics, said in a Jan. 19 statement. “US equity-bond correlation swings may be here to stay”.

The chart in his note shows that monthly yields on US stocks and 10-year Treasuries have often been negatively correlated over the past two decades, and that 2022’s strong positive correlation has been relatively unusual over that period.


“Inflation has more to come,” Allen said, while the U.S. economy “could take a turn for the worse.” “This signals our view that Treasuries will continue to gain more in the coming months, even as US stocks struggle.”

iShares 20+ Year Treasury Bond ETF TLT,
The S&P 500 is up 6.7% this year through Friday, compared with a 3.5% gain for the SPX.
According to FactSet data. iShares 10-20 Year Treasury Bond ETF TLH,
increased by 5.7% in the same period.

According to Jones, Charles Schwab is “pretty bullish on fixed income markets,” even after the recent bond market rally. “You can get attractive returns over a few years with very low risk,” he said. “It’s something that’s been missing for a decade.”

Jones said he likes U.S. Treasuries, investment-grade corporate bonds and investment-grade municipal bonds for people in higher tax brackets.

Read: Vanguard expects a municipal bond “renaissance” as investors salivate over higher yields.

Keith Lerner, chief investment officer at Truist Advisory Services, has an overweight fixed income over equities as downside risks rise.

“Keep it simple, stick to high-quality assets,” like U.S. government securities, he said in a phone interview. Investors start to “gravitate” to long-term Treasuries when they have concerns about the health of the economy, he said.

The bond market has been pointing to concerns about a potential economic contraction with the inversion of the U.S. Treasury market’s yield curve for months. This is when short-term rates are above long-term yields, which is historically seen as a warning sign that the US is headed for recession.

But more recently, the two-year Treasury TMUBMUSD02Y,
Charles Schwab caught Jones’ attention because they fell below the Federal Reserve’s benchmark interest rate. Typically, “you only see the two-year yield fall below the federal funds rate when you go into a recession,” he said.

The yield on the two-year Treasury note fell 5.7 basis points over the past week to a third weekly low of 4.181% on Friday, according to Dow Jones Market Data. That compares to an effective federal funds rate of 4.33%, within the Fed’s target range of 4.25% to 4.5%.

Two-year Treasury yields peaked more than two months ago, at about 4.7% in November, and have continued to decline since then, Nicholas Colas, co-founder of DataTrek Research, said in an emailed note on Jan. 19. confirming that the markets believe that the Fed will raise interest rates very soon.

As for long-term rates, the yield on the 10-year Treasury note TMUBMUSD10Y,
It ended Friday at 3,483%, according to Dow Jones Market data, while also declining for three straight weeks. Bond yields and prices move in opposite directions.

“Bad Sign for Stocks”

Meanwhile, long-dated Treasuries maturing over 20 years “rose by just over 2 standard deviations over the past 50 days,” Colas said in a DataTrek note. “This last happened in early 2020 heading into the Pandemic recession.”

Long-dated Treasuries are “at a critical juncture right now and the markets know it,” he said. Their recent rally defies the statistical boundary between general recession fears and the recession forecast.

Another rally in the iShares 20+ Year Treasury Bond ETF would be a “bad sign for stocks,” according to DataTrek.

“An investor may rightly question the bond market’s bearish call, but knowing it’s there is better than not being aware of this important signal,” Colas said.

The U.S. stock market ended Friday sharply higher, but the Dow Jones Industrial Average DJIA,
and the S&P 500 each posted weekly losses to snap two-week winning streaks. The tech-heavy Nasdaq Composite ended a third straight week of gains on Friday, erasing weekly losses.

Next week, investors will assess a wide range of fresh economic data, including manufacturing and service activity, jobless claims and consumer spending. They will also get a reading from the personal consumption-expenditure-price index, the Fed’s preferred inflation gauge.

“Back of the Storm”

The fixed income market is “on the backside of the storm,” according to Vanguard Group’s first-quarter asset class report.

“The upper right quadrant of a hurricane is what meteorologists call the ‘dirty side’ because it is the most dangerous.” It can bring strong winds, storm surges and tornadoes that cause mass destruction as the hurricane makes landfall,” Vanguard said in the report.

“Similarly, last year’s fixed income market was affected by the storm,” the firm said. “Low prime rates, surprisingly high inflation and the Federal Reserve’s interest rate hike campaign have led to historic losses in the bond market.”

Rates may not be “too high” now, but concerns about the economy persist, according to Vanguard. “A recession is looming, credit spreads remain worryingly tight, inflation is still high and several key countries are facing fiscal challenges,” the asset manager said.

Read: The Fed’s Williams says “too high” inflation remains its No. 1 concern


Given expectations that the U.S. economy will weaken this year, corporate bonds will likely underperform government fixed income, Chris Alwine, head of global credit at Vanguard, said in a telephone interview. As for corporate debts, “we defend our position”.

That means Vanguard has less exposure to corporate bonds than it normally would, while also seeking to “enhance the credit quality of our portfolios” with more investment grade than high-yield or so-called junk debt. In addition, Vanguard favors non-cyclical sectors such as pharmaceuticals or healthcare, Alwine said.

There are risks to Vanguard’s outlook on rates.

“While this is not our primary concern, we could see the Fed forced to move the federal funds rate closer to 6%, facing continued wage inflation,” Vanguard warned in a report. The rise in bond yields already seen in the market “will help ease the pain,” he said, but “the market has yet to begin to appreciate that possibility.”

Alwine said he expects the Fed to raise its benchmark rate to a range of 5% to 5.25%, then likely hold it at that level for two quarters before starting to ease monetary policy.

“Bonds have not been a good diversification of stocks in the past year as the Fed has aggressively raised rates to address inflation concerns,” Alwine said. “We believe more typical correlations will return.”

Source link