Fixed Income

Now that the French pension reforms have been passed, President Macron’s focus will be on the international stage. Where are the risks and opportunities for French assets created by this pivot?

The Reserve Bank of New Zealand hiked rates this week to 5.5%. There are many reasons to expect that to be the last rate hike for this cycle – a development that is positive for New Zealand bonds but bearish for the New Zealand dollar.

The Reserve Bank of New Zealand hiked rates this week to 5.5%. There are many reasons to expect that to be the last rate hike for this cycle – a development that is positive for New Zealand bonds but bearish for the New Zealand dollar.

US bond investors should increase portfolio duration from “at benchmark” to “above benchmark” on a cyclical (6-12 month) investment horizon. We also recommend exiting Treasury curve flatteners and closing short positions in the February 2024 fed funds futures contract.

Once the debt ceiling soap opera ends, investors will likely turn their attention to some of the tailwinds supporting stocks. These include stronger earnings growth, diminished bank stresses, better housing data, early signs of an upleg in the manufacturing cycle, the prospects of an AI-driven productivity boom, and the fact that labor slack has managed to increase without rising unemployment. Investors should resist turning bearish on stocks for now but look to become more defensive later this year.

The US stock price / bond yield (SBY) correlation shifted into negative territory over the past year, significantly departing from the positive correlation regime of the past two decades. The inflation regime is the primary macro driver of the SBY correlation. History suggests that the inflationary threshold for the SBY correlation is nontrivially above the Fed’s target, suggesting that a shift back to a positive correlation is likely in the lead up to and during the next US recession. Whether the SBY correlation remains positive during the subsequent economic recovery will depend – importantly – on the magnitude of the recessionary effect on inflation, and whether investors will have reason to believe that the responsiveness of inflation to the output or jobs gap has permanently increased. A severe US recession does not appear necessary to bring inflation below the positive/negative SBY correlation threshold, but only so long as long-term inflation expectations remain anchored. Generally-speaking, cross-asset performance has not been unduly impacted by the shift in the US SBY correlation, with the exception of the performance of tech versus ex-tech or growth versus value, precious metals, and the yen. Our conclusions, alongside our economic expectations detailed in Section I of our report, support defensive portfolio positioning over the coming 6-12 months, with long-maturity government bond yields as the diversifying asset. They also imply the outperformance of growth versus value or broadly-defined tech versus ex-tech stocks within a global equity portfolio, and the outperformance of the yen within the currency space. The fact that inflation was far more elevated last year than many investors expected led to negative performance from both stocks and bonds. That was a major departure from the better part of the past two decades, when government bonds provided portfolio protection during risky asset selloffs. Quantitatively, this shift manifested itself as a decline in the US stock price / 10-year government bond yield (SBY) correlation from positive to negative territory. While the SBY correlation has become less negative over the past several months, it has not yet durably reverted into positive territory. In this report, we present our best estimate of the inflationary threshold that results in a positive or negative SBY correlation, and whether inflation is likely to approach this level over the coming one-to-two years. We also examine the performance of major financial assets since the US SBY correlation turned negative last year, to understand the investment implications of a potential shift back to a positive SBY correlation. We conclude that core US inflation does not likely need to return to the Fed’s target in order for the SBY correlation to return to positive territory, which is good news for multi-asset investors. Additionally, some simple estimations of the modern-day Phillips curve suggest that a severe recession is not required to bring inflation back to its target. That that may be increasingly less true, however, the longer it takes for a recession to occur, as it risks the emergence of backward-looking inflation expectations. Cross-asset performance has not been unduly impacted by the shift in the US SBY correlation, with the exception of the performance of tech versus ex-tech or growth versus value, precious metals, and the yen. From an investment strategy perspective, our conclusions support defensive portfolio positioning over the coming 6-12 months, with long-maturity government bond yields as the diversifying asset. They also imply the outperformance of growth versus value or broadly-defined tech versus ex-tech stocks within a global equity portfolio, and the outperformance of the yen within the currency space. Precious metals remain a wildcard, but we are sticking with a low-conviction recommendation to be overweight/bullish previous metals. The Inflationary Threshold Of The SBY Correlation Chart II-1Visualizing The Stock Price / Bond Yield Correlation Visualizing The Stock Price / Bond Yield Correlation Visualizing The Stock Price / Bond Yield Correlation Chart II-1 presents the rolling 1-year correlation between the S&P 500 and US 10-year Treasury yields. The chart illustrates that the SBY correlation was persistently negative from the mid-1960s until the late-1990s, when it shifted durably into positive territory. The SBY correlation was also modestly positive during the mid to late 1960s. Over the past year, the SBY correlation has been at its most negative since it moved durably into positive territory in the late-1990s and early-2000s. It has been a long-held view at BCA that the correlation between US stock prices and long-maturity US government bond yields turned positive in the late-1990s due to a shift in the inflation regime, and, it is thus not surprising to us that well above-target inflation has caused the SBY correlation to move back below the zero line. For example, our US Investment Strategy service presented a detailed analysis of the macro drivers of the SBY correlation in a 2012 special report,1 and more recently our Emerging Market Strategy service warned of a likely shift in the SBY correlation back to negative territory.2 Both reports underscored the importance of the inflation regime as the major driver of the SBY correlation with high (low) inflation associated with a negative (positive) correlation. It is not difficult to rationalize why the inflation regime is the primary driver of the SBY correlation. A negative correlation means that rising bond yields are bad for stocks, which was clearly the case from the late-1960s until the mid-1990s – because rising bond yields during this time reflected the Fed’s attempt to rein in inflation. In the parlance of fixed-income investors, this was the era when the inflation component of bond yields rather than the real component was the dominant driver of yields. This also explains why the correlation was modestly positive in the early-to-mid 1960s, given that core inflation averaged just 1.4% percent during that time. Chart II-2Inflation Expectations Did Not Stabilize Until The Late-1990s Inflation Expectations Did Not Stabilize Until The Late-1990s Inflation Expectations Did Not Stabilize Until The Late-1990s What changed in the late-1990s? We believe two factors were at play. First, while the idea of the “Greenspan put” had been around since the 1987 “Black Monday” stock market crash, the notion that the Fed would be quick to ease monetary policy in response to slowing economic growth was strongly reinforced by its reaction to the LTCM crisis – shown as the vertical line in Chart II-1 – as well as the 2001 recession. Second, while actual core PCE inflation essentially fell back to target levels by the early-to-mid 1990s, measures of long-term inflation expectations, such as the University of Michigan’s median 5-10 year household inflation expectation series, as well as our adaptive expectations model did not truly stabilize until the late-1990s (Chart II-2). That implies that investors were not truly convinced that inflation had reached low and stable levels until that point. Looking forward, the core question for investors is not whether the inflation regime will be the main determinant of the SBY correlation, but rather whether inflation needs to fall all the way back to the Fed’s 2% target in order for the correlation to turn durably positive again. This question is relevant to address not just whether investors can expect portfolio protection from falling long-maturity bond yields during the next recession, but also whether the SBY correlation is likely to be positive or negative on average over the coming few years. Looking at the empirical record, we address this question in two ways. First, we use a logistic regression approach to test for the inflationary threshold, using either headline or core CPI or the PCE deflator, that has the best power to predict when the rolling 1-year SBY correlation has been negative (Chart II-3). And second, using a quarterly SBY correlation (calculated using daily data), we simply calculate how often a negative correlation occurs alongside core inflation above a given value (Chart II-4). The results of Charts II-3 and II-4 are clear, and paint a somewhat positive picture for multi-asset investors over the coming year or two. Chart II-3 highlights that the core inflation regime is a more reliable predictor of a negative SBY correlation than headline, and that core CPI is a more important predictor than core PCE inflation. This likely reflects the fact that, typically, investors more closely follow the CPI data, given that it is released earlier than the PCE data. Chart II-3The Inflationary Threshold For A Negative SBY Correlation Is Higher Than The Fed’s Target… June 2023 June 2023 Chart II-4…And Is Possibly As High As 3.5% June 2023 June 2023 But, more importantly, Chart II-3 shows that the core inflation rate consistent with a negative SBY correlation has historically been higher than 2%, roughly between 2.5-3%. Chart II-4 echoes this point, by showing that negative quarterly SBY correlations have been more often associated with annualized core inflation rates of up to 3.5%. To us, this underscores that a negative SBY correlation does not reflect investor expectations of target inflation, but rather whether inflation is at a sufficiently high level that it becomes the dominant driver of monetary policy decisions. Charts II-3 and II-4 highlight that investors appear to believe that the inflationary threshold for the SBY correlation is nontrivially above the Fed’s target, suggesting that a shift back to a positive correlation is likely in the lead up to and during the next US recession. Whether the SBY correlation remains positive during the subsequent economic recovery will depend – importantly – on the magnitude of the recessionary effect on inflation, and whether investors will have reason to believe that the responsiveness of inflation to the output or jobs gap has permanently increased. Will The SBY Correlation Durably Shift Back Into Positive Territory? Determining the likely impact of the next US recession on inflation and the likely inflationary impulse of the subsequent recovery are analytically challenging exercises. The degree to which core inflation surged over the past two years underscores the inherent difficulty in estimating the magnitude of inflation over a cyclical time horizon, especially when unique circumstances – such as the supply chain impacts of the COVID-19 pandemic and its aftermath – are present. We noted in our January 2021 Special Report that the modern-day version of the Phillips curve expresses actual inflation as a function of expected inflation, economic or labor market slack, and other atypical shocks to prices. For headline inflation, these atypical shocks very often occur from sharp changes in food and energy prices. In core space, price shocks typically stem from changes in imported goods prices and the US dollar, as well as core feed-through effects from large or long-lasting shocks to food and energy prices. Despite the fact that pandemic-related effects are clearly still exerting an impact on core PCE inflation in the US, it is still worthwhile to estimate core inflation using the first two terms of the modern-day Phillips curve to gauge what kind of labor market adjustment may be required to bring inflation back to the Fed’s target. Chart II-5 presents a variety of estimates based on a linear regression of core inflation on different measures of inflation expectations, as well as the unemployment rate gap as defined by the CBO's estimate of NAIRU. We present the results of the regression calculated over two different estimation periods; in all cases, the inflation expectations component is the most significant driver, but the unemployment rate gap shows up as highly significant in all six models. Chart II-5As Long As Inflation Expectations Remain Forward-Looking, Only A Mild Or Average US Recession Will Be Needed To Bring Inflation Back To Target June 2023 June 2023 Chart II-5 indicates that the range of unemployment rate estimates that would be required to return core PCE inflation to the Fed’s 2% target is very large. Still, it highlights a very important point, which is that ostensibly forward-looking measures of inflation expectations (such as those reported by the University of Michigan’s Surveys of Consumers) imply a considerably lower unemployment rate needed to return core inflation back to the Fed's target. This is strongly consistent with academic research showing that the monetary policy response to a rise in inflation must be significantly greater the more that inflation expectations are adaptive (i.e., backward-looking). For investors hoping that long-maturity government bonds will once again provide some form of protection to a balanced portfolio during periods of falling equity prices, Chart II-5 is encouraging. It suggests that because households recognize a large part of the surge in inflation over the past two years was uniquely driven by pandemic related effects, a large rise in the unemployment rate will not be needed to bring inflation back to the Fed’s target. However, Chart II-5 does show that a recession will likely be needed for inflation to return to target given that even the smallest unemployment rates shown imply a recessionary shock to the labor market, unless disinflation or outright deflation from housing and goods inflation is more pronounced over the coming year than we currently expect. It also reinforces a crucial point about why we think a recession is likely over the coming year: the greater weight on inflation expectations from the models shown in the chart underscores that the Fed must prevent household inflation expectations from becoming backward-looking, or else it would require a much more severe recession in order to return to low and stable inflation. Chart II-6Some Concerning Signs Of A Renewed Rise In Household Inflation Expectations Some Concerning Signs Of A Renewed Rise In Household Inflation Expectations Some Concerning Signs Of A Renewed Rise In Household Inflation Expectations Disinflation from energy prices and global supply chain factors have bought the Fed some time in this regard, but Chart II-6 highlights that we have recently seen a concerning rise in both one-year and five-to-ten year expected inflation. To the extent that a recession would simply accelerate the housing and goods-related disinflation that is either already occurring or will soon, the Fed is likely to prefer a recession sooner rather than later – were they to conclude that an economic contraction is unavoidable in order to bring inflation back to 2%. So, while we agree that the SBY correlation is likely to turn positive over the coming 6 to 12 months, this will very likely occur in the context of falling stock prices. To us, the greater weight of inflation expectations in the models shown in Chart II-5 also supports the idea that a shift in the SBY correlation back into positive territory will likely be a durable one if a recession occurs over the coming year, as we expect. We acknowledge that demographic effects are likely to impact the US labor market structurally for years to come, and agree that US inflation may be above target on average over the course of the next economic recovery. However, unless long-term inflation expectations become unmoored, the implication is that US core inflation will probably grow at a 2-3% annual rate during the next economic recovery – which is below the negative SBY correlation threshold that we identified in Charts II-3 and II-4. This reflects our belief that the greatest threat to very elevated structural inflation in the US does not come from the demographic outlook, but rather from a tepid monetary policy response from the Fed to the currently elevated rate of inflation. This tepid response would likely be inadvertent, as we believe the Fed is truly serious about bringing inflation back down to target levels. Rather, it would stem from the Fed’s misguided views about the neutral rate of interest, which we have noted in past reports could cause the Fed to cut interest rates before the job of wringing out excess inflation from the system is complete. We have noted in past reports that monetary policy rules that are commonly-cited by Fed officials could justify a fed funds rate below our estimate of neutral if core PCE inflation falls below 3%, given that the Fed’s view of the neutral rate of interest is meaningfully below ours. For now, this is a plausible but not probable scenario. Were we to see mounting evidence of this scenario, we may shift our 6-12 month investment recommendations more in favor of a pro-risk stance, as interest rate cuts into easy territory would stimulate economic activity and meaningfully push out the onset of a recession. But as noted above, this would also significantly raise the odds of elevated structural inflation, suggesting that the SBY correlation would only briefly turn positive during the next US recession in such a scenario. Asset Performance And A Negative SBY Correlation Given the very large change in the SBY correlation over the past two years, one natural question for investors to ask is whether we have seen highly atypical cross-asset performance owing to this correlation shift. However, the surprising reality is that most of the examples of atypical asset performance since the beginning of 2022 have occurred for reasons other than the decline in the SBY correlation – besides some well-known performance dynamics like the failure of US stocks to outperform in the face of falling global stock prices. When analyzing this question, we use an admittedly quantitative approach, but one that we feel is still accessible and relatively easy for investors to understand. Essentially, we examine the beta of a variety of assets relative to global stocks since the beginning of 2022, and also look at beta-adjusted performance. Assets whose performance has been significantly driven by the shift in the SBY correlation into negative territory should have experienced a sharp change in their beta versus global stocks and beta-adjusted out/underperformance that is logically consistent with the asset’s relationship to inflation. Charts II-7 and II-8 present the results of our approach, and highlight several points. Chart II-7Only A Few Major Asset Classes… June 2023 June 2023 Chart II-8…Have Had Their Performance Materially Affected By The Shift In The US SBY Correlation June 2023 June 2023 First, while it is true that several assets experienced a significant change in their beta to global stock prices since 2022 versus the five years prior to the onset of the COVID-19 pandemic, several of these changes were related specifically to Russia's invasion of Ukraine or China's zero-COVID policy. This is especially true when examining the performance of euro area, UK, and emerging market equities, emerging market sovereign bonds, and oil and base metals prices. Chart II-9Core Services Ex-Shelter Inflation Drove The SBY Correlation Into Negative Territory, And Its Rise Preceded The War In Ukraine Core Services Ex-Shelter Inflation Drove The SBY Correlation Into Negative Territory, And Its Rise Preceded The War In Ukraine Core Services Ex-Shelter Inflation Drove The SBY Correlation Into Negative Territory, And Its Rise Preceded The War In Ukraine China’s decision to pursue strict lockdown and control measures for most of 2022 had nothing to do with above-target inflation in the developed world, so it is clear that the underperformance of China-related assets since the beginning of last year has not been connected to a shifting US SBY correlation. And while it is clearly the case that Russia's invasion of Ukraine and its impact on the global energy market made the global inflation situation worse, it was the rise in core services ex-housing inflation that was the root cause of the shift in the US SBY correlation into negative territory, which was already well underway prior to the war (Chart II-9). To us, Charts II-7 and II-8 highlight just three major asset classes or investing styles whose performance appears to have been materially affected by the shift in the US SBY correlation from positive to negative territory: the performance of tech versus ex-tech or growth versus value, precious metals, and the yen. In the case of tech/growth stocks and the yen, we have seen beta-adjusted underperformance since the beginning of 2022, whereas in the case of precious metals it has been the opposite. The abnormal performance of these three assets does appear to have been driven by the same factors that pushed the US SBY correlation into negative territory: The fact that bond yields were rising in conjunction with falling stock prices had an outsized impact on tech or growth stocks because of the perception by investors that these are comparatively longer duration assets. As we highlighted in Section I in last month’s report, this perception is still in effect given that the relative performance trend of tech versus ex-tech stocks continues to be strongly negatively correlated with long-maturity government bond yields. Given the US equity market’s heavy weight toward growth/tech stocks, it is thus unsurprising that US equities have failed to outperform global stocks since the beginning of 2022. Chart II-10The Yen's Decline Has Been Related To A Shift In The US SBY Correlation The Yen's Decline Has Been Related To A Shift In The US SBY Correlation The Yen's Decline Has Been Related To A Shift In The US SBY Correlation As the most prominent major country that has historically struggled with below target core inflation, Japanese interest rate differentials collapsed versus other DM economies last year as investors priced in a much more aggressive monetary policy response in the US and euro area than in Japan (Chart II-10). This resulted in significant underperformance of the yen on a broad trade-weighted basis (panel 2), despite the fact that the yen is typically a risk-off currency. Over the past year, gold has massively outperformed what its historical relationship with real government bond yields and the dollar would have implied (Chart II-11). Part of this outperformance may have been caused by a negative SBY correlation, in the sense that some investors may have flocked to gold as an alternative to stocks and bonds while both were falling in value. It is also likely that gold has benefited from a significant increase in central bank gold reserves (in lieu of US dollars) in the aftermath of Russia’s invasion of Ukraine and the US’ freeze on Russia foreign currency reserves. At the same time, it is also possible that gold is starting to benefit from fears of an eventual fiscal crisis in the US, given that US federal government interest payments are exploding higher as a share of GDP. This explosion in payments is the result of the sharp rise in the fed funds rate over the past year (Chart II-12). While it is true that the government’s interest expense will fall during the next US recession as the Fed cuts the policy rate, the key point is that investors have become more aware of the US government’s eventual interest burden based on normalized interest rates and may have increased their structural allocations to gold over the past year in response. Chart II-11Gold Has Significantly Outperformed What Real Interest Rates And The Dollar Would Have Implied Gold Has Significantly Outperformed What Real Interest Rates And The Dollar Would Have Implied Gold Has Significantly Outperformed What Real Interest Rates And The Dollar Would Have Implied Chart II-12Gold May Be Benefitting From Fears Of An Eventual US Fiscal Crisis Gold May Be Benefitting From Fears Of An Eventual US Fiscal Crisis Gold May Be Benefitting From Fears Of An Eventual US Fiscal Crisis Investment Strategy Conclusions Our analysis highlights several conclusions about the US SBY correlation: The historical evidence suggests that the US SBY correlation will shift back into positive territory once US core inflation falls back or below 3%. A full return to target inflation is not likely required. We expect that US core inflation will fall below 3% at some point over the coming year or two, but it is only likely to occur in the context of a recession. A severe US recession does not appear necessary to bring inflation below the positive/negative SBY correlation threshold, but only so long as long-term inflation expectations remain anchored. Generally-speaking, cross-asset performance has not been unduly impacted by the shift in the US SBY correlation, with the exception of the performance of tech versus ex-tech or growth versus value, precious metals, and the yen. From an investment strategy perspective, our conclusions support defensive portfolio positioning over the coming 6-12 months, with long-maturity government bond yields as the diversifying asset. They also imply the outperformance of growth versus value or broadly-defined tech versus ex-tech stocks within a global equity portfolio, and the outperformance of the yen within the currency space. Precious metals remain somewhat of a wildcard, and we are conflicted about the outlook for gold and silver prices over the coming year. On the one hand, precious metals have significantly outperformed over the past year as the US SBY correlation has fallen into negative territory, implying a potential reversal of performance if the correlation becomes positive again. In addition, the real price of gold is extremely elevated relative to history, suggesting that precious metals are quite expensive. On the other hand, we expect real interest rates to fall meaningfully at some point over the coming 6-12 months as the US economy slips into recession, which has historically been bullish for precious metals. On balance, we are sticking with our recommendation to be overweight/bullish previous metals, but investors should note that this is a relatively low-conviction view. Investors who are heavily overweight precious metals should respond to increasing evidence of 1) an impending US recession and 2) a major technical breakdown in precious metals prices as a sign to reduce their exposure significantly. Finally, even though structurally elevated inflation has recently fallen off investors’ radars as a major source of concern, investors should continue to monitor long-term inflation expectations closely for further signs of a renewed breakout. While we strongly believe that the SBY correlation will turn positive during the next US recession regardless of its severity, a strong breakout in long term inflation expectations would increase the probability of a negative SBY correlation during the next economic recovery. It would also significantly raise the odds of a more severe recession than we expect. That would still justify conservative portfolio positioning, but it would imply meaningfully higher long-maturity government bond yields over the nearer term, and thus would delay the point at which long duration positions would be warranted. As noted in Section I of our report, fixed-income investors would lose money on 10-year Treasury positions over the coming year if yields rise above 4.2%, something that could occur if the odds of the “no landing” scenario increase further over the near-term. We are sticking with our view that investors should wait for meaningful labor market weakness or a rise in 10-year yields above 4% to shift to a long duration stance, but investors should be prepared to extend duration quickly and significantly in response to either of these events. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1  Please see “Shifting Sands: Why Are Stocks And Bond Yields Positively Correlated, And When Will This Change?”, US Investment Strategy, March 12, 2012, available at usis.bcaresearch.com 2  Please see “A Paradigm Shift In The Stock-Bond Relationship”, Emerging Markets Strategy, February 25, 2021, available at ems.bcaresearch.com