The Case for More Cash, Fewer Treasury Bonds

Back in December, astronomy buffs were treated to a highly unusual alignment of Jupiter and Saturn, the so-called “Christmas Star,” a configuration not seen in approximately 800 years. Recent behavior in financial markets has also been anomalous. Yields are rising, stocks are surging and the correlation between stocks and bonds is shifting in a profound way.

Since August, Treasury yields have roughly doubled, albeit from an all-time low. During the same period stocks have risen more than 20%. And while a similar dynamic took place in late 2016, recent behavior is evidence of a shift in the relationship between stocks and bonds: their correlation, while still negative, is rising (see Chart 1). This dynamic has important implications for portfolio construction.

Correlation of bond and equity returns

Correlation of bond and equity returns

Source: Refinitiv DataStream, chart by BlackRock Investment Institute, Jan 21, 2021
Notes: the line shows the correlation of daily U.S. 10y Treasury returns and S&P 500 over a rolling 90-day period.

Not about the Fed

What led to this shift in market behavior? Recent changes are not about an evolution in Federal Reserve policy, but instead are a function of market expectations for inflation. Since the early fall U.S. 10-year inflation expectations, derived from the price of Inflation Protected Securities (TIPS), have increased approximately 0.50%. Put differently, investors expect inflation to average about ½ percentage point higher over the next decade than they did back in August. As expectations for inflation rose bond yields followed.

And while rising inflation can disrupt equity markets, in this instance higher inflation is being viewed positively, signs of economic improvement and supportive of corporate earnings. So far, so good.