The current stock market correction is closely associated with heightened inflation expectations, which also drove a surge in the US 10-year Treasury yield from 2.4 per cent to 2.9 per cent year-to-date.
This resulted in concerns that rising inflation will pressure the Fed towards a faster pace of rate hikes, which will in turn negatively impact accommodative financial conditions that have been supportive of the market for nearly a decade.
Stocks more likely to rise when Fed hikes rates to neutral levels
Contrary to thse concerns, history shows that stocks generally rose over the last three instances when the Fed hiked rates towards neutral levels.
An analysis of bond yields and stock returns over the last 20 years similarly shows a positive relationship; that is, stocks tend to rise when bond yields move up.
The return of inflation to normal levels is typically a healthy consequence of rising growth and robust demand-side activity, as the economy nears full employment and capacity.
To counter-balance the risks of over-heating in this situation, the Fed increase interest rates as a result.
This more mature stage of the economic cycle - which we are now in - is still a healthy one for stocks.
However, because there is less room for policy error here, and because it is less ideal than the earlier 'Goldilocks' phase of accelerating growth and subdued inflation seen in 2017, we can expect markedly higher market volatility than last year.
Shock from rapid reset of inflation expectations
The trigger for the current correction was a minor shock experienced by the stock market as it rapidly reset inflation expectations higher, while recognising that it is, in fact, in a more mature stage of the cycle than thought.
As the stock market declined over the last three weeks, bond yields increased alongside higher inflation expectations.
This marks a negative correlation between stock prices and bond yields.
A sustained period of such negative correlation, however, will be unusual at this stage of the economic cycle - especially when short term rates have not yet reached neutral levels of 2.5 to 3 per cent.
When conditions normalise over time, we believe a positive correlation between stock prices and bond yields is likely to resume, particularly as the overall outlook for econmic growth and corporate earnings remains firm.
Technical factors exacerbate correction
While inflation expectations triggered this correction, the depth and speed of the sell-off was exacerbated by technical factors.
Before this correction began, the stock market was on its longest run since the 1970s without a 5 per cent drawdown, and multiple technical factors - such as investor positioning, margin levels and market sentiment - were at recent records.
Due to the large technical component of this correction, the extent of risk-off contagion to other asset classes was relatively contained.
For instance, we saw the US high-yield corporate spread widen by only 50 basis points over this 10 per cent stock market decline from peak to trough, versus the 110 to 230 basis-point moves during the last two 10 per cent declines.
The record surge in volatility also played a key role in this correction, triggering significant selling from various systematic investment strategies.
Over the short term, we remain cautious of continued selling pressure from these systematic strategies as they adjust to a higher volatility regime, and we are also cognisant that various technical factors could take some time to balance out.
A measured pace of yield increase
One tail risk is that a continued surge in bond yields - at the pace we saw over 2018 to date - could ultimately have a disruptive impact on underlying economic and market fundamentals.
Of course, higher yields directly impact borrowing costs for consumers, corporates and sovereigns, and also affect the prices of assets that reflect discounted future cash flows.
In our view, an increase at the same pace is not likely.
First, while inflation is likely to trend steadily higher, a 'take-off' scenario is improbable.
Second, bond yields are already reflecting more realistic expectations, and we note that the reaction of the US 10-year Treasury yield was quite controlled after the last Consumer Price Index (CPI) figures on Feb 14 came in above expectations, while the stock market also rose on that day.
Our base case is for the US 10-year Treasury yield to increase gradually by about 35 basis points over the next 12 months to 3.25 per cent.
As this scenario plays out, notwithstanding rising yields, the long-term outlook for stocks remain positive.
Investors, however, should be prepared for significantly higher volatility ahead.
Disclaimer applicable to recommendation
*This article first appeared in The Business Times on Feb 21, 2018.
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