The signal from stock/bond correlation

Good morning. Donald Trump went to Michigan today to unveil new carve-outs for the US’s beleaguered car industry — just one more instance of the president backing down on tariffs. Call it the Taco trade (for Trump Always Chickens Out). While the Taco trade may not be sufficient to stabilise US asset prices, it sure beats sticking with harmful policies. Email us: robert.armstrong@ft.com and aiden.reiter@ft.com.

Why are stocks and bonds moving in the same direction?

For the past six trading days, stocks prices and bond prices have risen together. The S&P 500 is up 9 per cent or so; the 10-year yield has fallen by 25 basis points (remember: yields down = prices up). Nominally, this is great news from your average diversified portfolio: both bits are making money. But it is also slightly ominous. The good thing about owning stocks and bonds at the same time is that, at least some of the time, the one offsets the other. At risk-on moments, stocks up; at risk-off moments, bonds up. When the two are correlated on the way up, thoughts turn to the queasy possibility that they will go down together, too — as they did in the wretched year 2022.

Six days does not a market regime make, but we’re a little paranoid here. Why are stocks and bonds positively correlated? For context, here is a one-year chart of stock prices and bond yields, with the yield axis flipped so when that lines goes up, bond prices are rising:

As you can see at the right, the “liberation day” tariffs killed stocks and supported bonds at first, but they have fallen into step since, first falling together, then rising together.

One possibility is that either stocks or bonds are wrong — their prices are failing to properly discount what the future holds. It could be that the dip-buying risk monkeys who manage active stock portfolios are leaping at any sign of tariff dovishness from the administration, and ignoring the economic damage a trade war will do. Alternatively, you might argue that plodding bond investors are, once again, unwisely ignoring inflation risks. Treasury yields have two primary components: real interest rates and break-even inflation expectations. In the recent bond rally, inflation expectations have been stable as real rates have fallen. But aren’t tariffs inflationary?

There is a more conciliatory reading available, however. It could be that both stocks and bonds are hurt, not by tariffs in particular, but by unpredictable and inept US policymaking in general — something the “liberation day” announcements personified. When the US government shoots itself in the foot, you sell stocks because growth is at risk, and you sell Treasuries because you have second thoughts about who you are lending to. You do the opposite when the administration walks bad policy back, as it has been doing lately (that’s the Taco trade at work).

We leave it to readers to pick which theory they like, or to suggest others.

Agricultural commodities and diversification

It’s a hard time to own the standard stuff. Stocks are volatile and the outlook is murky; bond yields are all over the place, too; gold is on a tear, but looks overbought. Are (non-gold) commodities a source of stability? A hedge? A diversifier?

It is common thinking in some corners that commodities are a good equity hedge. That turns out to be misleading — while there are periods where the broader commodity index and individual commodity prices move against stocks, the relationship is quite unreliable:

There are just too many commodities, with different relationships to growth, risk and rates, for this to be a stable one-way relationship. And the enactment of tariffs — taxes on physical imports, including commodities — has muddled the relationship further. Since Trump’s “reciprocal tariffs” were enacted and retracted, the S&P 500 has outperformed the broader commodity index a bit, but they have mostly followed the same pattern:

The broader index hides individual price moves, and is heavily weighted towards energy. Breaking the index down further gives a clearer picture:

Gold’s run is well documented. Fears of a global slowdown, the potential for disrupted trade flows, and Opec+’s potential policy changes are behind energy’s wretched performance. And US steel and aluminium tariffs and China’s rare earths bans, all of which are bad for growth, seem to be holding down industrial metal prices. That is where the easier answers end, however.

The steadiness of agriculture prices is more surprising — and echoed both in futures markets and across the three agriculture sub-indices (softs like coffee and lumber, grains like soyabeans and wheat, and livestock). This could be because supply is expected to wane as farmers pull back in the face of uncertainty. But it is easy to imagine the opposite scenario, as well: geopolitical rifts and slower growth suppress demand for farmed goods.

Agricultural commodity markets are diverse, and behaved weirdly the last time they faced tariff pressure, in 2018. Take soyabeans, the US’s largest agricultural export. Before Trump’s first round of tariffs in 2018, China bought over 60 per cent of US soyabean exports. But China swapped US soyabeans for Brazilian ones when tariffs hit; China was only 18 per cent of US soyabean exports at the end of 2018. US and global soyabean prices plummeted, while Brazilian soyabeans added a premium. Indeed, we saw this price differential take place again after “liberation day”, but it quickly disappeared:

It is possible that market dislocation will recur this time around. But, to repeat a familiar mantra, we don’t know where tariff policy globally is going to end up. The US and/or China may climb down.

That uncertainty may be what is keeping agricultural commodity prices and returns up in the meantime. “I think the market is waiting to see something concrete . . . in the current environment, markets may be relying more on fundamentals in the individual agricultural markets,” says Joe Janzen at the University of Illinois Urbana-Champaign. But we don’t yet know what this year’s harvest will look like. Oliver Sloup at Blue Line Futures, a commodities and futures brokerage firm, explains:

[This is] a unique time of year to be in a trade war for the markets, mostly to the benefit of US farmers. It is currently planting season: corn is 25 per cent planted, while soyabean 16 per cent planted, for example. There is still uncertainty of what we can produce . . . With those questions looming, there is an inherent weather premium in the market. If a trade war had kicked off in the fall, things could have been much uglier.

That is not necessarily true for other agricultural commodities, however. Coffee and chocolate prices are sky-high after bad growing seasons. And fears of a global economic slowdown have more clearly pushed lumber prices down.

It is also possible that markets are more ready to look through the impact of tariffs on commodities than they were back in 2018. As Joana Colussi at the University of Illinois Urbana-Champaign pointed out to us, China has found new producers of agricultural and energy products it once sourced from the US (soyabeans from Argentina, coal from Mongolia), and the US has found new buyers, too. And China got over its grudge quickly last time around — US soyabean exports to China rose steadily after 2018, back up to 52 per cent of total US exports last year. Traders may choose to look through trade rifts, and assume that all commodities will eventually find buyers.

There is a separate question of how best to hold agricultural commodities; commodity ETFs and future-linked products are imperfect vehicles. That said, due to their complex dynamics and interplays with tariffs, exposure to agricultural commodities should provide meaningful diversification. And diversity is particularly valuable right now.

(Reiter)

One good read

A sinking feeling.

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