US Equities and Bond Yields: No Longer Positively Correlated
The sheer severity of the financial crisis and subsequent Great Recession unleashed savage deflationary forces on the world economy. The Fed’s adoption of quantitative easing was partly aimed at alleviating upward pressure on real interest rates due to declining inflationary expectations. Hitherto, the prospect of rising inflationary expectations has, for the most part, not been a major concern for either the Fed or investors. This may now be changing with the apparent breaking down of the condition known as “Gibson’s Paradox.”
Gibson’s Paradox originally referred to the positive relationship between interest rates and the ...view middle of the document...
Low levels of Fed credibility during the 1970’s also helped to reinforce the negative relationship between equity prices and bond yields. The US bond market was reluctant to sever the association between strong growth and inflation until the late-1990’s, by which time the information technology revolution had bestowed supply-side improvements on the economy. Additionally, the Fed had finally regained the respect of financial markets.
Since the early-1990’s, the vast bulk of economic and financial shocks hitting the world economy have been deflationary. These include the bursting of Japan’s bubble economy, the Asian and Russian financial crises in 1997-8, as well as the end of the information technology bubble in 2000. Furthermore, the growth of world trade due to the expansion of the World Trade Organisation has acted as an inflation safety valve for many countries. Investor concerns about inflation gave way to worries of sustained deflation. This tilt from inflationary to deflationary angst by investors in the late-1990’s helps to explain the arrival of a positive correlation between equity prices and bond yields. The variability in this correlation captures important information about where investors think the biggest risks lie: rising inflation or deflation. This will have important implications for the conduct of monetary policy, because the efficacy of changes in interest rates on real economic activity will vary depending on whether investors are focussing on inflation or deflation.
What Will the Fed Focus On?
The dual mandate of the Fed means that the unemployment and inflation data used to assess the appropriate policy stance will not be totally “real time.” The Fed will monitor wage inflation during the course of 2014 as a means of cross-checking labour market slack. Historically, the Fed has raised interest rates when the wage inflation cycle has turned upwards. Prior to the late-1990’s, this would have initiated a sell-off in equity prices, as testified by the infamous events of 1994. Against a backdrop where some residual deflationary psychology still prevails, the Fed may feel less compelled to rush into raising interest rates. If Fed inaction results in inflationary fears starting to dominate, then the correlation between equity prices and bond yields will become more negative, potentially becoming a proxy for Fed credibility. The Fed will need to focus on other real time indicators in addition to the equity-bond correlation.
Relationships between financial and economic indicators seldom remain static. They will partly depend on the psychology of investors. Both quantitative easing and deflationary psychology have distorted the valuations and signals underpinning long duration asset prices. The predictive power of the yield curve has, for example, been undermined by the Fed’s asset purchases. Prior to late-1990’s, the yield curve had robust predictive power for US economic growth. Assuming the continuation of asset tapering,...