Stock and Bond Divergence Continues to Puzzle Investors: Will it Widen or Narrow?

The decline in Treasuries since the 8th of March has been mostly attributed to the massive increase in supply, following hawkish testimony from Fed Chair Jerome Powell and safe-haven concerns over smaller US banks after a Fed-arranged rescue of Silicon Valley Bank.

Despite the rising duration risk, equity markets - particularly mega-cap tech companies - have displayed an alarming level of disregard for these developments. In fact, the Nasdaq index surged by 32% in H1 2021, its strongest first half since 1983, when it rose by 37%.

This year, there has been a noteworthy divergence between the Nasdaq and Treasuries, with the previously lockstep relationship appearing to be inversed. This amplified divergence is a cause for concern among investors and analysts alike, as it could indicate that the market may not be fully accounting for the risks associated with rising treasury yields.

The correlation between stock and bond prices has undergone a significant shift over time, with the positive correlation that was more persistent in the 20th century being replaced by a negative one. There are several reasons for this change, including the fact that bonds are generally considered less risky investments than stocks. This is particularly true of US Treasuries, which are viewed as risk-free.

As bond interest rates increase, investors tend to demand more bonds, leading to a fall in demand for stocks. This results in a negative impact on stock prices. Moreover, companies' borrowing costs increase as interest rates rise, leading to higher costs and lower profits, putting additional pressure on stock prices.

The increasing cost of doing business due to inflation and higher borrowing costs is expected to impact the performance of companies (stocks).

The correlation between stocks and bonds has undergone several changes over the years. Between 1998 and 2019, the correlation was negative, but with inflation on the rise in 2020, it again turned positive.

The question now is whether this positive correlation will continue.

Recent trends suggest that the divergence between stocks and bonds has been increasing since April, with indications that it may persist. Historically, when inflation levels have been high, stocks and bonds often move in similar directions. Moreover, when real interest rates are a driving force in the market, as we have seen in the last year, it can hurt both stock and bond returns since higher interest rates reduce future cash flows for these investments.

The recent trend indicates that inflation levels may be stabilizing, which could signal a positive economic outlook. Investors appear more willing to take on risk, leading to potential boosts in equity prices. If this trend continues, it could offer more opportunities for investors as the assets provide a hedge for each other.

However, while these developments are encouraging, it is important to note that market conditions can change rapidly and unpredictably. Therefore, investors should continue to monitor market trends closely and remain vigilant. It is essential to have a sound understanding of the risks associated with investing in equities and other securities and to devise appropriate investment strategies accordingly.

According to J.P. Morgan, there is dissonance between the bond market and equity market expectations for rate cuts this year and the Federal Reserve's rhetoric of not seeing any rate cuts. The gap between these markets is likely to close, with equities potentially taking the biggest hit.

Michael Kramer, Founder of Mott Capital Management, has stated that financial conditions will need to tighten further, and real rates will have to increase due to resilient core inflation rates and a potential setup for renewed commodity inflation. These factors are expected to widen the divergence between equities and treasuries.