Will Stocks And Bonds Decouple?

So far this year stocks and bonds have been fairly tightly correlated. Not necessarily on a daily basis, but on a quarterly time frame it’s been near lockstep. Treasuries led the way down, getting smashed first with stocks following closely behind. In recent days that has tightened further to an almost one-to-one directional correlation even daily. Short term at least, there has been no diversification benefit from holding both.

The action underlying this activity isn’t immediately obvious, but when you also consider that everything else has been displaying the same pattern, including gold, copper, other commodities and realty, all arrows point to one thing: changes in the dollar itself – the common unit of measure we’re quoting prices in – are directly responsible. An increase in the market value of a dollar means that it takes fewer dollars to buy anything. Otherwise we’re left having to cobble up some spooky metaphysical conspiracy theory to explain why such disparate assets colluded to decide they would all join hands and jump off a cliff together.

Synthetic Systems thinks that’s about to change. Stocks and bonds go their separate ways, with stocks falling while bonds rise. But is there is fundamental case? 

An appreciating dollar is exactly what the Fed needs in order to counter a depreciating dollar. The trouble is changes in the value of the dollar are not manifest in all prices at the same time. In broad strokes, they show up first in asset prices that are set in real time, tick-by-tick, such as stocks and bonds, and only later filter into consumer prices. We saw for example rampant price inflation in assets from 2008-2020, followed by a veritable explosion higher in 2020-2021, which finally catalyzed the spilling over into consumer prices in a big way towards the end of the latter crime frame. 

It works the same way in reverse. We have to see evidence of dollar appreciation in the asset markets before consumer prices follow suit.

But for stocks and bonds to decouple, the sequence has to manifest between assets as well. What would cause that? Whereas changes in the time value of money have been the dominant factor so far, affecting both stocks and bonds, something has to affect stocks differently for them to decouple. That something is likely to be corporate profits.

There’s every reason to suspect that’s just what we’ll see. Unit labor costs are surging on a historically tight labor market, with labor demand far outstripping supply. At the same time, tight money is beginning to constrain revenues, and higher rates mean higher carrying costs of corporate debt accumulated over years of much lower rates. If I am right, analysts’ estimates of corporate earnings will decline sharply, likely in the coming quarter.

This will put additional downward pressure on stock prices. It will also be amplified by corporate leverage … stocks embed an effective short position in bonds. So once the decoupling gets rolling, it’s likely to be profound. This will ultimately provoke the Fed pivot prematurely anticipated last month, with bond yields falling and prices rising. The Fed Put, having been suspended in favor of a Fed Call, will eventually be reinstated.

That leaves the question of timing. Don’t expect the resurrection of the Fed Put to immediately resuscitate stocks. Recall in 2008 the Fed had actually started to cut rates in September 2007, before stocks topped, let alone before they bottomed. The best we can do there is SS, which sees this decoupling develop around the end of this month. That there is an FOMC announcement due September 21 may or may not be a coincidence.

 

7 thoughts on “Will Stocks And Bonds Decouple?

  1. jk says:

    great post, bill.
    the fall in equities discounted the rise in interest rates; the next leg will discount the fall in profits. wall street is carrying crazy earnings expectations. i think the consensus is $225-230 for the s&p. there will be a rude awakening.

  2. kbird says:

    Bonds still falling…I think QT if it happens is going to break the SS model prediction, which might mean that QT will soon enough become QE as the Fed panics that the debt service costs of the U.S. government are rising too quickly.

  3. Bill Terrell says:

    Regarding QT, see here: https://financology.net/2022/08/29/weekly-update-20220827/#comment-2241

    Regarding SS, several points bear repeating. SS is not dollar denominated … it plots asset classes relative to each other. The major trend change expected is that bonds will outperform stocks. And we’re not there yet … the inflection point is penciled in for some time around the end of the quarter. Even then that’s putting too fine a point on it. I’ve emphasized since inception that SS isn’t a short term tool. Put best, SS will have added value if bonds outperform stocks over the next few quarters. Finally, SS is always wrong … there are hundreds of precise forecasts embedded in each chart … the odds of getting them all right are in the vicinity of winning the lotto jackpot and being struck by lightning on the same day. But if you find a source of better forecasts, please share it with its us!

Leave a Reply

Your email address will not be published.