Will the “Great Rotation” Trade Succumb to the “Great Correlation”?

Investors who are betting on the “great rotation” from fixed income markets into equity markets may well be disappointed. As bond yields fell across the global markets, a consensus grew that not only would equity returns exceed bond returns over the next few years, but bond returns would actually be negative. This view encouraged investors to short the fixed income markets to buy equities, rather than using cash to buy equities. The “great rotation”, it was believed, would drive bond prices even lower.

Some evidence in favour of this view surfaced in May and June when the bond markets suffered a major correction; the problem was that equities markets also fell in tandem. Contrary to the “great rotation” hypothesis, bonds and equities moved in the same direction. Adherents to the trade took the view that the bond markets would continue to decline after June while equities would recover. What has happened?

Six months later, the equity markets have recovered well but so have most sectors in the fixed income markets. High yield bonds , for instance, are now trading higher than their peak in April on a total return basis. Concerns over federal reserve “tapering” of their regular security purchases are now solely confined to the Treasury market. Investors who sold bonds across-the-board in May and June have overreacted and subsequently missed out on the longer run attractiveness of the fixed income spread sectors.

The “great correlation” is a phrase I have coined to refer to the long-run positive correlation between bond and equity returns. This correlation is about 0.4 which is both statistically significant and surprisingly stable. In 2013, the correlation is actually higher at 0.6!

Betting against this correlation requires strong justification and a strong will. The “great rotation” hypothesis argues for a negative correlation, based on the extraordinarily low level of bond yields. Investors who have been counting on the statistical facts represented by the “great correlation”, however, seem to be winning.