Is the correlation between stocks and bonds broken?

With yields and credit spreads recently hitting lows, investors might be re-considering the wisdom of their allocation to fixed income. Yet, traditional bonds still offer diversification benefits despite market lows.

In a recent market insights report, Richardson GMP addressed the potential problem: with prices for both stocks and bonds rising this year, recency bias could cause investors to perceive that the inverse correlation between the two asset classes is broken. As a result, investors might be fearful that fixed income won’t offer protection during the market’s next correction.

However, the correlation isn’t broken, the report said, pointing to the correlation between the S&P/TSX 60 and the Canadian bond universe, which is about minus 0.34 this year. While the relationship between stocks and bonds isn’t predictive in the short term, it holds over the long run, the report said.

Further, the inverse relationship is strongest during bouts of market volatility. For example, in May 2018, the S&P 500 fell 6.4%, while the U.S. aggregate bond market edged higher by 1.7%. Similarly, last December the same U.S. index fell 9.3%, and bonds rose 1.5%.

Still, in a lower-for-longer interest rate environment, some investors are moving away from traditional fixed income. Specifically, the report noted the trend toward passive fixed income ETFs, and it addressed the pros and cons of such a move. Ultimately, the report stressed that choosing the fixed income portion of a portfolio comes down to an investor’s individual goals. “It’s important to carefully establish those specific objectives in order to develop an optimal solution,” it said.

Read: The 60-40 portfolio gets a fixed income overhaul

In commentary this week, BlackRock described its latest investing strategy, which includes upgrading European sovereigns to an overweight stance, based on the European Central Bank’s easing bias. (It also said yields look attractive for hedged U.S.-dollar-based investors thanks to the hefty U.S.-euro interest rate differential; the US/EUR exchange rate on Wednesday was 1.1143.)

BlackRock is also overweight emerging market debt, based on income potential. “The Fed’s dovish shift has spurred local rates to rally and helped local currencies recover versus the U.S. dollar,” it said. “We believe local-currency markets have further to run and prefer them over hard-currency markets.”

In particular, the firm expects to find opportunities in Latin American and countries not directly exposed to U.S.-China trade tensions.

Outlook for U.S. and Canada 10-years

In the U.S., the Federal Reserve is expected to move toward a lower target fed funds range to keep its monetary policy neutral. The Fed’s current policy stance looks somewhat tighter than the Fed previously intended, said National Bank in its monthly fixed income monitor for July, because of lower inflation results and other economic data.

“With the balance of risks now appearing somewhat tilted to the downside, this is not the time to let monetary policy drift into a slightly restrictive stance,” the  report said.

As a result, National Bank, along with the other Big Six banks, forecasts two Fed rate cuts this year, with the first one coming next week. As a result of the easing, the National Bank report said it expects the 10-year Treasury will remain in a trading range in coming months, drifting higher in 2020 as the business cycle remains on track with GDP growth close to potential (1.9% in 2020).

At year-end 2020, it forecasts the 10-year Treasury yield to reach 2.52%.

Read: With a July cut almost assured, how far will the Fed go?

For Canada, risks to the economy tilt to the upside: positive economic data include strong employment growth and an increase in hourly wages this year. Yet, as noted by the Bank of Canada in its last monetary policy statement, global trade tensions are a concern. Those tensions, along with Fed and ECB easing, argue for the Bank of Canada to refrain from a hawkish stance despite the positive economic data, the National Bank report said.

Thus, no moves are expected from Canada’s central bank this year, and National Bank forecasts 10-year Canadas to yield about 1.73% by year-end, and 2.42% by year-end 2020.

It added that Canada’s central bank would likely ease its policy only if the Fed were to cut more than 50 basis points off the fed funds rate.

For full details, read the reports from Richardson GMP, BlackRock and National Bank.