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What’s in store for fixed income and equity returns as investors, markets and the world respond to the global fiscal policy we’ve seen in response to coronavirus?
Using correlation as a lens to see the coronavirus impact
As highlighted in my blog last week, the end of monetary dominance and return of fiscal reliance is well and truly upon us. But as explained, the return of government action doesn’t mean the end of central bank policy – and the bazooka package of stimulus measures we have seen over the last two weeks clearly demonstrates this. Combined, these measures are – and will continue to be – significant across many market channels, but I think perhaps the best way of thinking about it is through the correlation between fixed income and equity returns.
Up until now fixed income vs equity correlation has been negative
Then: Low bond yields, flat bond curves and low market risk premia
In the last decade of monetary dominance, the correlation between fixed income assets and equity returns has been very negative: when one goes up, the other goes down. This is mostly because over that period, it became very commonplace for central banks to respond strongly in times of risk asset stress (Chart 1).
Typical central bank policy included slashing interest rates and issuing large bond buying programmes. Why? To ease financial conditions in markets and encourage investors to be less risk averse so that they purchase riskier assets again, such as equities. As such, the impact for markets was a mix of low bond yields, flat bond curves and low market risk premia.
Chart 1: The correlation between equity and fixed income returns is changing
Now: Higher bond yield, steeper curves and higher market risk premia
The rise in fiscal reliance will significantly alter the policy impact on financial markets. Unlike monetary policy, fiscal policy is achieved mainly through large bond borrowing, and the policy is aimed at more directly impacting the economy. All else equal, this should mean higher bond yields, steeper curves and higher market risk premia than what we have experienced in recent years.
Coronavirus impact: What will the rise in fiscal policy reliance look like for assets?
While the past few weeks have been pretty dysfunctional in markets, we have had some taste of what the rise in fiscal reliance could look like. Despite the significant declines in risk assets such as equities, this month – core bond yields are mostly higher (such as bonds from developed market governments). To be fair, part of the rise in yields was likely related to the market dysfunction. Meanwhile, the huge sizing up of central bank quantitative easing will put a lid on how far bond yields can rise.
But make no mistake, the policy shifts now in place helped accelerate things, and will be game changers for the interaction between core bond markets and risks assets.