The great equity party may be drawing to a close

It may be more than bond market volatility that investors need to get used to; lower stock prices may also be a feature of the bond market reset.

Bond prices were spectacularly volatile on Thursday. Yields on German 10-year Bunds spiked by 10 basis points to 0.988 per cent, with prices, as always, moving in the other direction, before a highly unusual call by the International Monetary Fund for the Federal Reserve to wait until next year to raise interest rates helped the market to reverse course. The bund rallied all the way down to a yield of 83 basis points, three bps below where it began the day.

In the absence of some momentous event, and no, Greece does not qualify, this is a heck of a day for a developed sovereign bond market. But bond markets, particularly in Europe, have been having a succession of trying days.

Though in absolute terms it may look small, the more than 50 per cent rise in Bund yields in four trading days so far in June is extraordinary. The 10 per cent move in US 10-year Treasury yields, to 2.31 per cent, is less so, but still unusual.

Eurozone bonds, though still supported by the European Central Bank’s €1.1 trillion (Dh4.5 trillion) quantitative easing programme, had a nasty dose of reality on Wednesday when ECB chief Mario Draghi proved less than sympathetic to complaints about volatility. “One lesson is that we should get used to periods of higher volatility. At very low levels of interest rates, asset prices tend to show higher volatility,” Draghi said.

True enough, Mario, but here is another truth: at higher levels of volatility investors tend to demand lower prices. Bond market volatility is not going to be supportive of bond market prices.

The more volatile an asset is, the more expensive it is to hedge and to hold. As bond volatility spikes, especially at such historically low yields, investors are almost certain to want more compensation for a given amount of inflation and liquidity risk.

Weaker bond market prices, in turn, will not be supportive of equity prices. Bond market yields are the price of money in a competitive marketplace.

As an equity is a call on future corporate cashflows, the higher the discount rate presented by the bond market the lower the net present value of those future dividends or share buy-backs.

Systemic risk

So equities will be hit not just with rising bond yields but with rising volatility. All else being equal, neither will be supportive of stock market prices. And indeed stocks have shown a bit of weakness during the bond sell-off.

It is not necessary to work out an argument for there being systemic risk in any of this to make the observations about securities prices any less true. It may simply be the case that volatility is on the rise, asset prices are vulnerable, but all of this can happen without any need for official intervention.

One issue also confronting equities is a rising correlation between how they and bonds trade.

Throughout the financial crisis and in the vast majority of the time since, the correlation between developed market equities and bonds has been negative. That means if one moves one way you can usually expect the other to move in the opposite direction. For investors this is helpful because they get a benefit from diversification and are less vulnerable to being forced sellers.

However since the beginning of 2015, correlations, measured on a three-year basis, have been rising sharply, according to data from Societe Generale. Having been strongly negative at the beginning of the year, stock and bond markets are now roughly 35 per cent positively correlated, the most in more than a decade.

“Cross-asset correlation continues to increase and is near its highest-ever level,” Socgen analysts write. “The correlation between developed market equity and bond prices has turned positive, indicating that rising bond yields may be accompanied by falling equity prices.”

There is also some historical evidence associating high stock and bond market correlations with higher or rising levels of inflation. It is far from clear that inflation is on the rise, and bond markets may be demonstrating they want more risk compensation rather than that prices are headed much higher.

Still, a rise in interest rates in the event of inflation would likely not be very good for equities either.

As Mario Draghi says, we may want to get used to it.