Inflation and interest rates have been the significant driver of equities since the beginning of 2022, so, notably, the positive correlation of interest rates/inflation to the performance of equities has only started to break down in recent weeks, with the significant fall in short and long-term bond yields (interest rates) corresponding with a sell-off in equities.
Historically, bonds and equities have been negatively correlated. Still, the low-interest rate environment had tested that relationship over the last decade or so as rates headed to zero, inflating the valuations of equities (particularly the tech sector, which now makes up such a significant portion of the S&P 500). Bonds appreciate in value as interest rates head lower (and vice versa).
However, with the turmoil in a few problem names in the global banking sector – with Silicon Valley Bank (SVB) and Credit Suisse the headline names – we have started to see a flight to safety (bonds) and the expectation that the fastest rate rise cycle in generations is beginning to have an impact on the underlying portfolios of the banking sector, and that deeper recessions are now more likely.
Notably, while there may not be the widespread contagion needed to cause a real crisis, the likely impact of what has transpired in the last few weeks is that we will see tighter credit conditions which means that some of the work will be done for central bankers. Locally, with very different exposures in our banking sector and the industry’s highly regulated nature, it is improbable we see the bank runs that ultimately were the leading cause of SVB and Credit Suisse’s problems. It is worth considering that, despite the mistakes within SVB and Credit Suisse, both banks would likely have avoided catastrophe but for the massive influx of deposit withdrawal requests. That is the nature of bank runs – it is the panic itself that causes the bank’s failure and becomes a self-fulfilling prophecy.
Interestingly, the tale told by bond markets is in stark contrast to the continuing hawkish rhetoric of the US Fed Chair, Jerome Powell, who continues to insist that the Fed board can’t see rate cuts this year, which bond markets are currently implying. While only time will tell where rates head, it’s worth noting that bond markets predicted an aggressive tightening cycle well ahead of the actions of central bankers. It seems, for now, the market is more focused on the likely economic impact of the stress we are witnessing in the banking sector. And that could ultimately mean that the traditional relationship between bonds and equities is re-established.
