Will Stocks Fall as Interest Rates Rise?

Source: Thinkstock

Source: Thinkstock

There is a common misconception that a falling bond market is good for the stock market. The reasoning goes as follows: Bonds are a safe-haven asset whereas stocks are “risk-on” asset. If money is coming out of bonds that means that people no longer wish to hold safe-haven assets, and they therefore want riskier assets — stocks. Furthermore, many investors think in a binary asset environment — you can own either stocks or bonds — and if money is coming out of bonds then it will flow into stocks.

The negative correlation between stocks and bonds — U. S. Treasury bonds in particular — is the exception, not the norm. However the exceptional case is a big deal and it must be understood. If we seen a deflationary spike such as the one we had back in the Fall of 2008 or the one we saw during the 1929 stock market crash or the 1931 European banking crisis, then this negative correlation will play out.

Investors will seek out safe-haven assets such as Treasury bonds in a financial crisis, but there is no fundamental reason for this. Government bonds are riskier in a downturn because they are backed by tax revenues, and a slower economy means fewer tax revenues. In 1929 and in the early 1930s the U. S. government’s debt load was very small relative to tax collections and relative to what it is today, and so bonds really were a safe haven. Furthermore, back then the U. S. Dollar was backed by gold, and so U. S. Government debt was, in effect, a future claim on America’s gold.

With respect to the deflationary spike in 2008 the story is a little different. People bought Treasuries because they were seen as zero-risk assets. Ultimately, with the Federal Reserve’s unlimited ability to purchase government bonds, there is virtually no fear of a default. But notice that during that crash we saw corporate bonds fall alongside stocks, and this speaks to my point that bonds and stocks are positively, not negatively correlated.