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Bonds May No Longer Provide a Hedge Against Stocks, Warns Jim Bianco

Thu, Oct 11, 2018 - 12:30pm

News headlines proclaimed a strange anomaly in the financial markets this week as both stocks and bonds fell together. Typically, when stocks crash, money moves into the bond market and other safe-haven assets to protect capital, but that's not what we've seen since earlier this year.

Jim Bianco, founder of Bianco Research, says investors are switching from a deflationary to an inflationary mindset, similar to what we saw during the 1970s, and bonds may no longer provide a hedge against the stock market.

Here's what he recently told Financial Sense Newshour (see Jim Bianco on Fed Killing the Recovery, Kavanaugh Political Aftermath for audio).

The Breakout We've All Been Waiting For 

Early last week the 10-year yield broke above 3.11 and prior to our interview with Bianco, it had reached as high as 3.23. This is a seven-year high in the 10-year yield, Bianco noted.

What's pushing the yield higher is a fear of inflation, and Bianco said that’s happening in one of two ways. Either as part of a combination of what economists call the Phillips Curve, in which strong growth is going to push inflation or, simply, inflation is finally returning after years of easy monetary policy.

bond yield breakout
Source: Bianco Research

Bianco asserted there’s one thing everyone’s missing with the fear of inflation returning—what this means for asset allocation models. There is a perception today that we still exist in a risk-on, risk-off environment, he added. In a risk-on scenario, investors assume that when stocks go up, bonds will go down, and vice versa.

The key, Bianco noted, is that the two asset classes move in opposite directions at the same time. This has led many mangers to recommend getting out of bonds, because as interest rates rise, bond prices will fall, meaning stocks should benefit in a risk-on, risk-off environment.

“We've been arguing that story ended this year, and that we're now back to a more traditional 1970s to 1990s period where bonds and stocks go up and down at the same time,” Bianco said. “When rates broke out to new seven year highs, I’m not at all surprised that over the last two days the Dow has fallen 500 points. That's because higher rates now bring up the idea that it might mean a return of inflation, and that is bad for stocks.”

Major Shift Underway

One of Bianco’s biggest pet peeves is the belief that the relationship between interest rates and equities is fixed. It isn’t fixed, no matter how much we want to accept it as orthodoxy, he said. It flips over time. The biggest factor that inaugurates this change is our perception of inflation and deflation.

From 2000 to 2017, the biggest concern we had was deflation. This led to the creation and widespread acceptance of tools such as the 60-40 stock/bond portfolio, because one of the two asset classes in that portfolio was always going up.

stock bond correlation
Source: Bianco Research

We’ve now vanquished our deflation fears, Bianco stated, meaning the change is underway. The new fear will be the threat of inflation. But this change doesn’t happen overnight, he noted.

“Eventually, a couple of years from now, it will settle into a new pattern,” Bianco said. “During these periods, when it flips — the mid-1960s, the late 1990s — there is tremendous stress in the financial markets because these relationships become very unknown. … It will take a few years to get there, but I think we've started.”

One Rate Hike Too Far

The danger in this situation is that the Fed will do what it has always done and cause a recession by raising interest rates too far.

The signal will be an inversion of the yield curve, which hasn’t happened yet, but according to Bianco, it will. Each time it happens, markets try to argue that it isn’t a valid signal anymore. But as long as the inflation rate holds steady, Bianco thinks we’re closer to danger than many think.

“I'll give it to you straight up,” Bianco said. “I think they have one more rate hike to go, and then after that they've gone too far. … If they think they can go three or four more times — again in December and then maybe three more times next year — and the inflation rate doesn't move, they're going to go too far. … I really want to leave with the message that everybody is doing what they do every single cycle, trying to tell us the curve doesn't matter. … In every single instance, when the curve inverted, we had a recession right after it. We're just doing that again.”

Listen to this full podcast with Jim Bianco by clicking here. For more information about Financial Sense® Wealth Management and our current investment strategies, click here. For a free trial to our FS Insider podcast, click here. 

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