Photographer: Eric Thayer/Bloomberg

Stocks and Treasuries Haven't Moved Together Like This Since China's Yuan Devaluation

The five-day correlation between stocks and long bonds has become strongly positive.

It's almost as if cats and dogs are living together.

The five-day correlation between the daily change in the iShares 20+ year Treasury Bond ETF (known as TLT) and the S&P 500 Index rose to its strongest level in over a year on Tuesday.

Source: Bloomberg

The last time stocks and bonds moved in the same direction to this extent was in August 2015 after Chinese policymakers devalued the yuan, with strategists heralding the onset of "quantitative tightening."

In stark contrast to the recent experience, modern portfolio construction has typically been predicated on a negative correlation between stocks and bonds, lowering the overall volatility of the portfolio and producing better risk-adjusted returns.

"The correlation between stocks and bonds has been increasing as stocks have been driven more and more by the chase for yield but that shift from negatively correlated to positively correlated will play havoc for portfolio level risk management (and risk parity)," writes Peter Tchir, head of macro strategy at Brean Capital LLC.

The risk parity strategy, which, in very basic terms consists of a levered long position in Treasuries and a long position in stocks, has been on fire in 2016. Bank of America Merrill Lynch Head of Global Rates and Currencies Research David Woo has warned that tough times could be in store for this strategy if investors heading into the U.S. presidential election begin to price in the possibility of fiscal easing in the U.S., anticipating a clean sweep at the polls by either party.

The correlation started to wane just before noon on Wednesday, with stocks moving to their lows of the day while bonds found support. However, this recent five-session stretch could be a precursor of a long-term trend in the relationship between stocks and bonds. Toby Nangle, head of multi-asset allocation at Columbia Threadneedle Investments, has suggested that demographic trends — a scarcity of labor as baby boomers retire — could flip the sign on the correlation between stocks and bonds from negative to positive, changing the game for asset allocators.

Source: Bloomberg

 

The diversification benefits of a traditional 60/40 (stocks/bonds) portfolio would disappear in such an environment, causing portfolio managers to scramble and search for a new hedge.

Norwegian hedge fund Sector Asset Management has already moved to keep a large share of its assets in cash, citing lofty valuations in both stocks and bonds as the correlation between the two has increased.

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