What the Fed Pivot Means for Asset Class Correlation
As the Federal Reserve (Fed) has shifted its policy to be more accommodative, both stocks and bonds have generated exaggerated returns. Depending on the reason for the Fed’s pivot, different scenarios could unfold. In light of this uncertainty, Leah Reed, Financial Engineer for Diversified Alternatives, believes investors should be especially mindful of diversification, paying close attention to correlation.
- Central banks have shifted their policies to be more accommodative, causing stocks and bonds to move up.
- A couple of scenarios could result from this shift in stance – the worst-case scenario being that stocks and bonds both fall together.
- We believe a focus on diversification is more important than ever in this environment, but caution that investors should be aware of how different types of strategies are correlated with the market.
Leah Reed: Central banks have shifted policy to be more accommodative, which has really caused stocks and bonds to move up. We’ve seen these exaggerated returns in stocks and bonds, we’ve hit new equity highs.
So I think the real question is, why such a pivot by the Fed? First, it might be that the Fed sees some troubling economic data or trends in the data that would warrant greater accommodation. Or you could have the situation that they’re willing to keep the monetary supply expansive in order to ignite inflation. But even given that, and the uncertainty of both of those, it’s unlikely that both equities and fixed income will continue to rise together because they’re such two different scenarios. So if the Fed is successful in igniting inflation, then likely you’re going to see interest rates rise and then bonds are going to have a difficult time. And if there’s some kind of unstable part of the economy, then you’re going to see some difficulty or headwinds for equities. But I think the worst scenario is that, we’ve seen stocks and bonds both go up, if they happen to both go down together. And that’s why we feel that it’s really important for investors to focus on diversification.
There’s a slight negative correlation between fixed income and equities and commodities and a slight positive correlation between equities and commodities. So the correlations are very low, and we’re almost in this Goldilocks type of regime where you have stocks and bonds going up, volatility is low, correlations are low. But to us, that means that we should be a little bit more cautious about being in the market.
So we like to look at different types of opportunities or strategies in the market that could give return, especially during stress periods when vol [volatility] shoots up and correlations rise. That’s typically what happens in those types of stress periods. So the type of strategies we like to look at are strategies that can be both long and short. So trend following strategies, for example, allow investors to capitalize on persistent trends in the market. So if inflation and rates start to go up, then the portfolio could engage in a short bond position.
And then there are opportunities in other asset classes as well, like commodities. There’s more to commodities than just being long the commodity index. There are ways to be both long and short in that market, and there are things outside economic factors like the weather that can give opportunities to trade and generate a return from those markets.
And then even currencies. You can look at rate differentials and be both long and short for different currencies. So there are a number of different opportunities across asset classes that can be uncorrelated. But I would tell investors to be very careful about the ties those strategies have to the market, their correlations and their betas to the market.
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Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
Equity and fixed income securities are subject to various risks including, but not limited to, market risk, credit risk and interest rate risk.
Alternative investments include, but are not limited to, commodities, real estate, currencies, hedging strategies, futures, structured products, and other securities intended to be less correlated to the market. They are typically subject to increased risk and are not suitable for all investors.
Beta measures the volatility of a security or portfolio relative to an index. Less than one means lower volatility than the index; more than one means greater volatility.
Correlation measures the degree to which two variables move in relation to each other. A value of 1.0 implies movement in parallel, -1.0 implies movement in opposite directions, and 0.0 implies no relationship.
There are special risks associated with selling securities short. Stocks sold short have the potential risk of unlimited losses.
An index is unmanaged and not available for direct investment.
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