Years of QE programs and low bond yields have prompted investors to increase equity allocations and the fear is now that higher yields will translate into lower equity prices. Marko Kolanovic, Global Head of Derivative and Quantitative Strategies at J.P. Morgan Securities, says that this fear is justified by correlation data.
In the left pane of the chart, Kolanovic shows that bond-equity correlation has been steadily increasing this year. Recent levels of bond-equity correlation are strong at around 40% (centre pane) and Kolanovic thinks that if yields rise, equities are most likely to sell off.
The figure also shows the correlation of DAX to German government bonds. While bond-equity correlation in the German market is lower than in the US, Kolanovic says that recent DAX/bond moves can give us a flavour of what could potentially happen in the US. The right pane of the chart shows how over the past 2 months 10Y German bonds sold off by around 7% and DAX by around 10%. While he says it is difficult to precisely quantify equity risks coming from a potential increase in bond yields, he says he can estimate it.
For example, he assumes that an adverse market reaction to the exit from zero interest-rate policy could result in around 100-125 bps increase in 10Y yields based on rate spikes over the last 10 years which were in the range of 120-200bps. He estimates equity-rate correlation during a rate increase at 40% and the ratio of equity to bond volatility to be 2.5 to 3. Liquidity in equity markets has also declined over the past 5 years – stock trading volumes have dropped 40% and index volumes by 30%.
Taking into account all of these factors (correlation, beta, liquidity and yield increase), he estimates that an equity selloff on account of a sharp increase in rates could be in the range of 10-15%. While this type of pullback would not be unusual for equity managers, multi-asset portfolios would be hit much harder due to positive bond-equity correlations and they should look to diversify into low or negatively correlated assets or buy portfolio protection.
Kolanovic also notes that bond yields across the world are highly correlated (as bonds of the same credit rating can often be used as a perfect substitute). The correlation between US and German yield levels was 87% and between yield returns was 74%. Given the positive correlation of rates, the expected increase in short term US rates, and ongoing QE in Europe putting pressure on the long end – he says to expect a further flattening of the curve that has historically had an additional negative impact on US equities.