A second reason the term premium may be lower than in the past is the changing correlation between stock and bond returns, likely caused by changes in expected inflation outcomes. While in the 1970s and 1980s stock and bond returns tended to be positively correlated, more recently the correlation has tended to be negative. With an inverse correlation, bonds recently have been a good hedge for stocks, and that correlation may have contributed to lower bond term premiums by increasing the demand for bonds as an instrument for hedging portfolio risks. This changed correlation between stock and bond returns in turn may be related to better anchored inflation expectations following a long period of low and stable inflation.
Looking ahead, it seems likely the term premium will increase somewhat, although perhaps not to the levels seen historically. On the one hand, a continued gradual runoff of the balance sheet of the Federal Reserve and reduced bond buying by other central banks will tend to put upward pressure on the term premium. On the other hand, the FOMC’s demonstrated commitment to maintaining low and stable inflation makes it unlikely that expectations of high inflation will reemerge. Thus, on balance, while term premiums may recover somewhat from their recent depressed values, it is unlikely they will return to the high levels of earlier decades.
– Governor Lael Brainard, 31 May 2018
Equity markets had another wobbly week. Investors were initially skittish about rising inflation following the strong reports on employment and wages, as well as producer and consumer prices reports, further escalation in the rhetoric around the trade disputes, and no sign of the Fed shifting to a more dovish stance that would be more in line with the market’s view/desires. Meanwhile, these inflationary fears were somewhat allayed by the sudden collapse in oil prices, which led to a debate amongst economists as to whether or not this was a net positive or negative for growth—would the benefits of lower gasoline prices for consumers outweigh the costs from reduced production and capital spending in the now much larger energy sector, or vice versa. As a result, in the last week the total return on stocks has been -2.7%, while the return on 10-year bonds was +1.1%. Hence, bonds acted as a buffer against the equity market weakness. Yet, questions are starting to arise as to whether this relationship might be breaking down due to the possibility that we are moving into a new economic regime. If so, an important question for investors would be what might this mean for the relationship between stocks and bonds? It is also the topic of this week’s Economics Weekly.
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Richard de Chazal, CFA is a London-based macroeconomist covering the U.S. economy and financial markets.