U.S. investors had nowhere to run for cover this week when stocks and bonds nosedived simultaneously. While stocks took back all their January gains, bond yields soared to their highest levels since 2014, with the 10-year Treasury climbing to 2.88 percent on Thursday. Because bond prices move in opposition to their yields, both stock and bond markets fell in unison.
You may be thinking: Wait, aren’t stocks and bonds supposed to move in opposite directions? We hold bonds so that when stock prices go under, at least a portion of our portfolio will stay above water. If stocks and bonds sink together, our portfolios won’t have a life preserver. This is the fear keeping many investors awake at night, and it’s a valid one.
[See: 7 ETFs to Buy as Interest Rates Rise]
What happened this past week? As investors just witnessed firsthand, “it’s certainly possible for stock and bond prices to move in the same direction in the short term,” says Jim Barnes, director of fixed income at Bryn Mawr Trust in Devon, Pennsylvania. When an event spooks stockholders and bondholders alike, both sides of the market can drop off.
The event that triggered the sell-off was the strong wage growth published in the payrolls report. It found that wages had grown three months in a row. To investors, that sounded ominously like rising inflation. If inflation rises, the Federal Reserve might raise rates faster than anticipated, hurting both stock and bond prices.
The Fed had already indicated there would be three rate hikes in 2018, but if the “strong number we had on Friday is corroborated by additional strong data, [we] could see further hikes this year,” says Karissa McDonough, chief fixed-income strategist at People’s United Wealth Management in Burlington, Vermont. For stock investors, additional rate hikes have the potential to choke off the economic expansion, dampening returns. For bondholders, rising rates will drive down the prices of bonds already trading in the market because newer bond issues will pay higher rates.
The jump we saw in bond yields this week was essentially “the bond market trying to catch up with the notion that the Fed is serious” about raising rates and that strong economic data supports such a move, McDonough says. While skyrocketing yields and falling bond prices may spook investors, those shifts are good news. The degree to which the market can absorb the impending rate hikes before they occur means there’s one less thing to startle the market later on. By now, most of the move “is probably already absorbed for the year,” says Wade Balliet, chief investment strategist at Bank of the West.
We may be safe for the time being, but this doesn’t address the concern that stocks and bonds may now be moving in unison, robbing investors of the benefit of diversification and opening the door to simultaneous stock and bond bear markets.
Are simultaneous stock and bond bear markets coming? What we witnessed was the correlation between stocks and bonds rising, or the degree to which they move together. This happens in times of increased volatility, but ultimately, when the bottom falls out, you’ll “see correlations between equities and bonds diverge again,” McDonough says. High rates may slow economic growth and drive stock returns into bearish territory, but eventually, higher rates will also slow down inflation and benefit bonds. Inflation hurts bonds by eroding the purchasing power of their future cash flows.
Plus, a bear market for stocks would only drive investors to bonds. “At the end of the day, investors still have only one place to turn for risk-free assets, and that’s Treasurys,” McDonough says. As stock investors flock to safety, Treasury prices will go back up and bolster the bond market, pushing correlations between stocks and bonds back down. So “a bear market in stocks would be enough to turn things around for bonds,” Barnes says.
Experts disagree if there’s a bond bear market now. McDonough says if bonds are in a bear market, it’s only because there hasn’t been a negative catalyst to compel stock investors to seek safety. And the Fed raising rates is unlikely to be that catalyst. Rate increases are actually a good sign for investors: If and when we do fall into a recession — and experts agree we aren’t there yet — the Fed’s favorite mechanism to rejuvenate the economy is to lower interest rates.
“The theory is if credit is cheap, it will spur business activity” and bolster the economy, McDonough says. But you can’t lower rates if they’re already at zero. In fact, the Fed’s eagerness to raise rates is founded on a desire “to get back to a place where they have that big bazooka at the ready to cut rates to zero if they need to.” From a monetary policy standpoint, rate hikes help build a life preserver for the entire U.S. economy — a life preserver we show no signs of needing yet.
[Read: How the Fed is Affecting Income Investors]
As long as strong economic fundamentals continue supporting growth, stocks can rebound. “We still believe stocks will outperform in 2018, but we don’t believe there will be as large of a return opp as 2017,” Balliet says. Although this year is likely to have more volatility than last, that level is normal and investors shouldn’t be alarmed.
Other experts also predict a positive year ahead for stocks. “We don’t expect this [recent drop] to have a lasting impact on equities and still expect positive gains for 2018,” says John Bredemus, head of capital markets for Allianz Capital Markets in Minneapolis. His firm forecasts solid U.S. economic growth, which will support equity and credit spreads.
Junk bonds are the canary in the coal mine. Credit spreads are worth keeping an eye on, however. “Fixed income is the bellwether in a portfolio,” McDonough says. Signs of market trouble usually appear in bonds first, and nothing gets hit faster than junk bonds.
When the going gets rough, companies with ratings below investment grade will be the first to default. To keep an eye out for trouble ahead, look at the credit spread between Treasurys and junk bonds. If the spread widens, it’s time to tread carefully.
For the time being, “corporate bonds and junk bonds are still well-valued,” she says, but People’s United Wealth Management has begun moving out of some corporate bonds and into more Treasurys. “We see this as an opportunity to add to government exposure in portfolios for a more reasonable level of yield,” she says. Her firm aims to have allocations of corporate and government bonds that are roughly equal in market value through the late stages of the rate-hiking cycle.
[Read: 4 Things to Consider Before Investing in Bonds]
Diversification always wins. Investors may want to follow People’s lead. “Given the length of the ongoing economic expansion, it’s important that [diversification] doesn’t get overlooked,” Barnes says. A lack of diversification “could very well lead to portfolio concentrations and unattended risk.”
More from U.S. News
9 Ways to Invest in America With Bond Funds
9 Psychological Biases That Hurt Investors
10 ETFs That Pay Sky-High Dividends
Are We Heading for Simultaneous Stock and Bond Bear Markets? originally appeared on usnews.com
