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Does It Make Sense that Both Stock and Core Bond Prices are Higher This Year?

Jul 06, 2017 / United States, Fixed-Income, Asset Class Research Research Alliance

In light of the very strong returns from U.S. and global stocks this year, it may seem somewhat surprising or contradictory that defensive core bonds have also performed well. For example, the long-duration Treasury bond ETF (TLT) is up more than 6% year to date after plunging 13% in the fourth quarter of 2016. What messages are the stock and bond markets sending, and can they both be right?

Inflation and Inflation Expectations Have Rolled Over

Treasury bond prices typically rise when people are worried about the economy or other macro risks and put their money into safe-haven assets. While there are plenty of things to worry about in the world, that doesn’t seem to be what is driving core bond prices this year, given the accompanying low volatility and strength of riskier asset classes. Rather than fears of an impending macro shock, it seems the bond market is responding largely to the recent declines in inflation and inflation expectations. For example, the core Consumer Price Index (CPI) dropped to a year-over-year rate of 1.7% in May, down from 2.3% in January. Inflation is the enemy of bondholders. So in that regard, the drop in bond yields and rising bond prices makes sense.

The equity market, on the other hand, likes neither too little inflation nor too much inflation—just as with Goldilocks and her porridge. So stock investors have had plenty of reasons to propel prices higher: Inflation is lower but still in the ballpark of the Fed’s 2% target. The global economic recovery is ongoing and S&P 500 company earnings are rebounding. And global central banks, including the Fed, are not seen as becoming too aggressive in tightening monetary policy any time soon.

On a shorter-term basis, both markets may be “right.” But the current state is not sustainable for very long—something has to give. The Fed holds a big key as to how things might play out: will it tighten too much (hurting stocks but good for core bonds), too little (hurting bonds), or manage it just right (producing a continued Goldilocks scenario for the stock market, but implying higher bond yields/lower bond prices as inflation rises to the Fed’s 2% target)? Nobody knows, but based on history, we wouldn’t put all our chips on the last scenario, or on any single scenario. Potential changes to fiscal, tax, and regulatory policies are also big unknowns.

—Litman Gregory Research Team (7/6/17)

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