In 2019, much of the news flow was dominated by the stock markets’ longest – and best ever – bull market in history. But arguably, bonds have been on a general upward trend for much longer (the global bond bull market began in 1985). Despite a few significant setbacks, bond prices have risen, and yields have declined for the best part of four decades.
During this time, low interest rates (major central banks reversed course last year and are once again in easing mode), subdued inflation and muted global growth have prompted investors, searching for ways to generate income in the low-yield environment, to buy longer, riskier durations and rely on diversification for protection. And although this backdrop is unlikely to change just yet, vigilance is necessary. That’s because if the market enters periods of tumult in the future multiple lines of defence – not just rates and duration – will be needed to navigate it successfully.
Over the past century, there have been many stock-bond correlation regimes: the rolling three-year correlation was positive from the mid-1960s to 1998, but it has been almost entirely negative since the late 1990s (see figure 1a).
This regime change has been driven by a subdued inflation environment over the past 25 years. Indeed, this can be demonstrated by comparing the correlation of bonds and equities and inflation-linked bonds (real rates) and equities (see Figure 1b). Owing to an environment of low interest rates and disinflation, investors wishing to hedge their credit exposure have used rates, accepting much longer, riskier durations in exchange for yield.
Even though longstanding predictions of the end of the bull market (which started after former Federal Reserve Chair Paul Volcker quashed inflation in the 1980s) have not materialised, it can’t last forever. As such, actively managing duration is therefore important, but investors should not rely on the relationship between interest rates and risk assets to provide protection. This would be a threat to capital in a rising-rating environment.
Figure 1: The yin and yang of financial markets