Events that have recently been triggering the market have stimulated investor curiosity around the relationship between government bonds and the returns of equities. Looking back, the S&P 500 took a major downturn in January and February of 2018 due to poor market conditions. Not only that, but the 10-year government bonds also showed a positive trend from 2.6% - 2.8% in the beginning of the year. The reputation of bonds as a “safe-haven” asset during a time of crisis is being questioned by investors all around the world today.
With the recent rise in bond yields due to positive results in hourly earnings numbers and payroll, investors reassessed their outlook on inflation. This was backed by a slight increase in bond yields. Simply put, investors believe the shock started spreading from the equity market from the gecko. This is truly inaccurate and a major misconception as the shock emanated primarily from the bond market instead of the equity market. In theory, the relationship between bonds and stocks largely depend on whether a shock starts in the bond market or stock market. It is important to note that bond market shocks induce a positive stock-bond relationship, whereas equity market shocks prove a negative relationship due to the association with the flight-to-quality (FTQ). Government bonds have shown strong performance in nearly all types of economic recessions regardless of investors deciding to be proponents of this theory or not. These bonds have not only shown growth in the last six decades but have also served to act as a way to hedge against pro-cyclical equity exposure.
We use equity prices to better understand the value of a set of discounted future cash flows. There is a major impact on the discount rates due to a shock in the real bond market. This lowers the stock price and increases equity yield thus capturing higher real rates. However, whenever FTQ occurs aka a negative shock in the equity market, bond yields fall as the bond market seems much more favorable to investors.
Looking at equity risk premium, FTQ occurrences seem to be related to a slightly noticeable negative stock-bond relation, while real yield shocks result in a positive market correlation. When markets are expensive, equities become vulnerable to negative bond market shocks and rises in bond yields. Moving forward, this rise in bond yields will serve to be a risk that investors should be aware of and must consider when flocking to either side of the market in search for safe-haven assets.