In Decades, Stocks and Bonds Haven't Been This Aligned: Why Both Should Be Part of Your Portfolio

The conventional wisdom dictating that stocks should rise when bond prices fall, and vice versa, has long been upheld in investing circles. However, the historical relationship between these two asset classes is far more intricate than commonly believed.

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Market strategists emphasize the importance of recognizing this complexity, particularly in light of data from Morningstar revealing that Treasurys and large-cap U.S. stocks are currently exhibiting an unusual degree of correlation.

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Over a rolling three-year period, the correlation between intermediate-term government debt and large-cap stocks peaked at 0.57 in December, marking its highest level since September 1997, and has since remained near this level through April.

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Given that bond yields move inversely to prices, periods of strong correlation between stocks and Treasurys indicate that equity prices tend to rise as Treasury yields fall, and vice versa. A correlation coefficient of 1.0 indicates perfect synchronization in the movements of two asset classes, while a coefficient of -1.0 suggests that one reliably rises as the other falls. A correlation of zero implies little to no relationship between the two.

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Many investors are concerned that bonds seem to have lost their traditional role of protecting stock portfolios from sudden downturns. The memory of the simultaneous decline in stocks and bonds during 2022, a scenario rarely witnessed before, still lingers for many.

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As U.S. stocks have continued to climb following their October 2022 lows, the disparity in returns between stocks and bonds has sparked debates about the continued relevance of bonds in portfolios, especially for investors with relatively moderate risk tolerances.

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The ongoing three-year downturn in U.S. bonds represents the longest period of decline in the history of the Bloomberg U.S. Aggregate Bond Index, which encompasses various types of bonds including Treasurys, corporate bonds, asset-backed securities, and municipal bonds, since its inception in the 1970s.

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However, Amy Arnott, a portfolio strategist at Morningstar, cautions against placing undue emphasis on the expectation that bonds should always offset losses in stocks, attributing such expectations to recency bias. Arnott suggests that the negative correlation between stocks and bonds witnessed over the past two decades before turning positive in 2022 was actually the anomaly. Prior to this, the relationship between stocks and bonds often hovered closer to zero.

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According to Sébastien Page, head of global multi-asset and chief investment officer at T. Rowe Price, two primary factors determine the relative movements of stocks and bonds: the level of inflation and the Federal Reserve's monetary policy actions. Inflationary shocks, as experienced in recent years, tend to lead to a positive correlation between stocks and bonds, with both asset classes declining together. Conversely, during periods of economic growth shocks, bonds typically serve as a hedge against stock market declines.

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Page's analysis suggests that once the Fed begins to lower interest rates, bonds should regain their effectiveness as diversifiers for stocks, a sentiment echoed by CME Group's FedWatch tool, which indicates market expectations for rate cuts before year-end.

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Despite the current correlation between stocks and bonds, Arnott emphasizes that bonds still offer diversification benefits due to their imperfect correlation with stocks. Even with correlations around 0.6 or 0.7, adding bonds to an equity-only portfolio can improve risk-adjusted returns.

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Commodities are also exhibiting close correlation with stocks at present, although strategists at Wells Fargo Investment Institute maintain that commodities still provide diversification benefits.

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Looking ahead, Treasury yields edged higher on Wednesday, with the 10-year yield up 2 basis points at 4.48%, while U.S. stock futures signaled a lower open on Wall Street. Since the beginning of the year, major stock indices have seen varied gains, with the S&P 500 up 8.8%, the Nasdaq Composite up 8.8%, and the Dow Jones Industrial Average rising by 3.2%.

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