The Two-Year Trend Has Reversed... Bonds Are Back

Editor's note: The past couple of years have been tough for the bond market. But according to Rob Spivey – director of research at our corporate affiliate Altimetry – now might just be a great time to get back into this part of the market...

In today's Weekend Edition, we're taking a break from our usual fare to share one of Rob's essays, from a recent issue of the free Altimetry Daily Authority e-letter. In it, Rob explains why a multiyear trend is reversing... and why bonds are back to being a hedge against volatility.

Stocks generally outperform bonds...

This isn't a hard concept to understand. More risk means more return – and stocks are much riskier than bonds.

But it's really about when you'll need your money.

See, stocks are the only asset class that has beaten inflation in every 20-year period over the past 100 years. So the longer you plan to be invested, the more you should lean toward equities.

Bonds are more for short-term financial needs... like money you'll want in the next two to five years. Since bonds are less volatile than stocks, they make for much safer investments in the near term.

While this limits their upside potential, it's also why bonds are often used as a "hedge" against falling stock prices.

Historically, bonds and stocks have had a negative correlation – meaning bond prices rise when stocks fall, and vice versa.

However, this relationship has broken down since early 2022. When the Federal Reserve started raising interest rates, both stock and bond prices declined at the same time.

Normally, if the government or corporations offered higher rates for bonds, it would attract risk-averse investors. But if bonds weren't going to act defensive, investors weren't interested.

As I'll explain today, that's all changing now...

In the first three trading days of August, investors witnessed a market bloodbath.

The S&P 500 Index fell 7% due to weak manufacturing activity and rising unemployment data. The Nasdaq Composite Index slid more than 10%.

Meanwhile, demand for bonds went up. The U.S. Treasury market saw gains of around 2% over the same span.

In other words, the broken trend we've seen in the relationship between bond and stock prices over the past couple years is going back to normal.

As was the case before the Fed started its rate-hiking campaign, bonds are once again seen as a hedge against stock volatility.

According to Bloomberg, between 2000 and 2021, the correlation between stocks and bonds was negative.

It flipped to positive in 2022, when higher rates caused both bonds and stocks to crater. And it had stayed that way until last month... when it went back to negative.

This signaled that bonds are returning to their typical market role as a way to offset losses from stocks.

It's also a sign that investors are growing increasingly worried about a potential recession...

And they're not entirely wrong to be concerned.

Last month, part of the reason stocks fell was the worse-than-expected unemployment data for July. That economic report triggered one well-known recession indicator – the Sahm Rule.

According to the Sahm Rule, when the three-month rolling-average unemployment rate rises 0.5 percentage points above its low from the previous year, it signals the beginning of a downturn.

The unemployment rate jumped to a three-year high of 4.3%, and job growth slowed.

However, it's important to determine whether unemployment data is "good" or "bad" by looking at weekly initial jobless claims.

Initial jobless claims came in lower than expected for the week ending August 3, and they have dropped almost every week since. So the situation isn't as dire as it seems.

All macro-related data is under a spotlight today – especially jobs data. And right now, we're dealing with a mixed bag of results.

In this uncertain environment, investors want to protect their hard-earned money. And now, bonds are an attractive option. They've regained their hedging power against stocks.

This could lead to a surge in demand for both corporate and government bonds.

It won't be long before interest rates fall from their two-decade highs...

The Fed cut interest rates at its September policy meeting last week. And it's sure to announce more cuts to aid the economy by the end of the year.

We can't be sure how quickly this rate-cutting cycle will continue... But regardless, recession-fearing folks are likely to start buying bonds to protect their investments. Now that the trend of the past two years has reversed, it's the perfect place to park their cash.

Meanwhile, savvy investors have a chance to get into the bond market early and lock in high-yielding bonds... before their prices rise even more.

Regards,

Rob Spivey

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