(Bloomberg) – Risky and safe assets have depended on the every word and deed of Jerome Powell and company for more than a year. Now the Federal Reserve’s stranglehold on the financial markets is slowly but surely easing.
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As the latest inflation and jobs data give currency officials fresh impetus to halt their aggressive monetary tightening campaign, Wall Street’s attention shifts to the prospect of an economic slowdown. That spurs traders to reward the strongest companies in the stock market while punishing the weakest — thereby reducing parallel movements between S&P 500 stocks.
At the same time, bonds have regained their traditionally negative correlation with equities and rallied amid the banking crisis and bets that the era of monetary tightening is about to end. So, after hitting a nearly two-decade high in December, the measure of simultaneous movements between assets tracked by Barclays Plc has fallen sharply in recent months.
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“Cross-asset correlation remains historically high but is clearly declining sharply,” said Barclays strategist Stefano Pascale. “This decline is most likely due to bonds resuming their role as risk spreaders.”
All of this is helping to calm nerves among stock pickers and 60/40 allocators even as the bond market issues recession warnings, bank stress mounts and a US debt debacle looms.
Obviously, the Fed’s inflationary policies are still affecting assets. For example, data on Friday showed a rise in long-term inflation expectations, causing the S&P 500 to fall slightly and yields to rise. Still, the central bank’s vise-like hold on investor psychology is becoming less extreme, while macro market swings remain muted. The S&P 500 ended five days down 0.3%, marking the sixth consecutive week without a 1% move — the longest period of inertia since late 2019.
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Reactions are in stark contrast to last year, when the only trading game in town was betting on the Fed’s next tightening move – which caused stocks and bonds to fall simultaneously. As Chairman Powell threatened fresh rate hikes to stem runaway price increases, assets of all stripes trembled on the same monetary headlines. Volatility increased. And life for money managers got harder as correlations between assets soared — impacting their diversification strategies as well.
However, time-honoured trading patterns are now returning: bonds act as a haven in times of risk aversion and corporate earnings have a strong influence on stock movements. In addition, a semblance of stability has returned. A Morgan Stanley metric that quantifies extreme movements in wealth has fallen by more than half since peaking in 2022 – when currency turmoil gripped everything from UK government bonds to the Japanese yen.
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A study by Citigroup Inc. examining the downside of the markets also suggests that the influence of macroeconomic forces is waning. Using a model that calculates the extent to which differences in stock returns can be explained by factors such as interest rates, Citi strategists, including Chris Montagu, found that the macroeconomic contribution fell from 80% to 73% over the past month — the strongest decline for three years.
At the same time, stock traders are increasingly biased toward companies best positioned to weather an economic slowdown, such as tech giants, while dumping stocks of the most vulnerable companies, such as energy producers.
The result: loose lockstep movements in S&P 500 stocks. According to data compiled by Bloomberg, a measure of their three-month correlation fell below 0.3 in April for the first time in more than a year. (A value of 1 means they are moving in unison, with -1 indicating the opposite.) Although it has since risen, the value is still almost 30% below last year’s average.
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“Since the regional banking crisis in the US materialized, fears of a recession have increased significantly, and this has led to strong stock-level repricing as investors focus on companies’ near-term vulnerability to a modest economic downturn,” he said Peter Chatwell, Head of Global Macro Strategy Trading at Mizuho International Plc.
Declining equity correlations were accompanied by lower fluctuations in the overall market. That’s because stock winners outweigh losers, resulting in muted moves at the index level. The Cboe volatility index, a measure of implied stock fluctuations known as the VIX, is below its one-year average despite economic fears.
Markets and asset classes becoming more independent is good news for active equity managers, who tend to benefit when stocks are influenced by company-specific factors like earnings and balance sheets, rather than macroeconomic factors like monetary policy. Additionally, the reintroduced inverse correlation between stocks and bonds provides relief for 60/40 strategies that suffered double-digit losses in 2022 as the two assets fell simultaneously due to high inflation.
“As we approach peak interest rates, the focus is shifting to the economic and earnings slowdown – giving equities a fresh boost,” said Marija Veitmane, senior multi-asset strategist at State Street Global Markets. “Additionally, the ability to defend margins and protect profits would be a key driver of stock and sector returns.”
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