Thursday, October 5, 2023
Additional content provided by John Lohse, CFA
As the tides of inflation appear to be shifting, we thought it would be interesting to look at the historical correlations between stock and bond yields during periods of these changes, and what it could mean for stock prices going forward.
Appropriate with any inflation story, we must start in the 1970s. Throughout the entire decade, with a brief lull between 1971 – 1973, we saw runaway inflation. Core CPI reached its pinnacle in February 1978, coming in at 11.7%. As inflation was raging, the relationship between equity prices and bond yields was inverted. Higher yields used to fight off inflation stymied stock returns. Between 1970-1980 the S&P 500 price index had an average annual return of just 1.6%, while yields on 10-year U.S. Treasury notes breached 10%. The stock and bond yield correlation during that period averaged -0.21.
The chart below shows stock and bond yield correlation versus Core CPI year-over-year (Y/Y) by decade.
As inflation began to wane in the first half of the 1980s, we continued to see that same negative correlation, however the roles were reversed this time. Equities experienced tremendous growth, inflation had finally broken, and bond yields began to decline. Core CPI fell below 4.0% in May 1983. From that point until the end of the decade, the S&P 500 price index appreciated at an average annual rate of 12.15%. The stock and bond yield correlation remained inverted at an average of -0.4. The same held true throughout the 1990s as yields marched lower, inflation was normalized, and equity markets experienced continued strength.
As we move into a new regime of lower inflation, we should look to concerted changes in stock prices relative to bond yields. We’ve seen, as evidenced in the 1970s, that when inflation is high, rising yields do significant damage to stocks. Also, when inflation cools, and yields turn lower, then stocks can do well, as we saw in the 1980s and 1990s. inflation continues to decelerate, the high interest rates we’re currently experiencing don’t necessarily spell doom for stocks. The chart below shows recent history during the 2020s and how this new trend could already be materializing.
As we wrote in this week’s Weekly Market Commentary here, we believe interest rates hold the key to whether we get a fourth quarter rally from stocks, and inflation may hold the key to whether interest rates come down—though there are certainly other factors putting upward pressure on interest rates (including government dysfunction in Washington, D.C.).
Given the historical relationship between stocks and bond yields, we believe lower inflation will eventually be met with negative correlations between stocks and yields, and we will see stocks up as yields fall. The timing is uncertain, but with the Federal Reserve likely done hiking interest rates and inflation poised to continue its steady decline in the coming months, we wouldn’t be surprised if stocks started another run higher in short order. Something else to keep in mind: The best two-month period of the calendar for stocks historically is November-December as we wrote about here.
Thank you to Strategas for their contribution to this analysis.
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