The era of "Great Moderation", where bond yields and stock prices are positively correlated, could be over. But it could be entering what one strategist refers to as "the temperamental era", moving toward uncertainty and volatility in markets.
Charles Schwab Chief Investment Strategist Liz Ann Sonders joins Yahoo Finance Reporter Josh Schafer for the latest edition of Yahoo Finance's Chartbook, to discuss these periods in the market and the impact they can have on markets in both long and short-term periods:
"There may be a bit more volatility than what we are used to longer term, but let's hope, and probably not to the same degree that we saw it last year. We've been in this unique cycle, it's often said that the Fed takes the escalator up when they're hiking rates, and the escalator down — this one's been at the opposite. They took the elevator up, and I guess they'll take the escalator down. But because they are operating on the data dependency, and they are simultaneously doing QT [quantitative tightening], that has been sort of a force behind higher volatility in the fixed-income side, even more so than on the equities side.
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RACHELLE AKUFFO: Now the era of great moderation, where bond yields and stock prices were positively correlated, is likely in the rearview mirror, at least according to our next guest. For a deeper dive into this chart, we're joined by Liz Ann Sonders, Charles Schwab chief investment strategist, alongside Yahoo Finance's Josh Schafer as well. Great to have you back on the show here. So Liz Ann, for people who aren't familiar with this phrase, low inflation, low volatility, how does that tend to show up in bond yields, as well as in the stock market prices?
LIZZ ANN SONDERS: Well, specific to what we now generally think of as the great moderation era, which was from the late 1990s up until the pandemic, that was a '22, three, four-year era where you were essentially in disinflation the entire period of time. You were in the latter part of the long, secular move down in interest rates, certainly long-term bond yields having come down.
And it was a period when because inflation wasn't much of a concern, the moves in bond yields would tend to be in the same direction as the moves in stock prices. Because when bond yields were, as an example, rising in that era, it was typically because growth was improving without the attendant concern about inflation. That's a great backdrop for equities, visa versa.
But if you look at the 30-year period prior to the Great Moderation, you can see that the correlation was negative nearly the entire period of time. And that was because there was more of an inflationary backdrop. There was more inflation volatility, which meant, again, as an example, when yields were rising, it was often because inflation was sort of rearing its ugly head again, not necessarily because growth was improving. That's not a great backdrop for equities.
Vice versa, if yields were coming down, it was often because the inflation genie had been put back in the bottle. And that was a good backdrop. And I think the secular shift might be underway towards something that looks a little bit more like the-- what we've been calling the temperamental era that preceded the great moderation era.
JOSH SCHAFER: Liz Ann, what does that mean as far as volatility goes with bond yields? Obviously, that was a big story last year, specifically thinking October. We had that big run-up in the 10-year, and it felt like as stock investors, we were watching the 10-year every day, right? And it was going to tell us essentially where the market was going to move. Is that a trend that you think we see this year?
LIZZ ANN SONDERS: I think there may be a bit more volatility than what we're used to longer term, but let's hope and probably not to the same degree that we saw it last year. You know, we've been in this unique cycle. It's often said that the Fed takes the escalator up when they're hiking rates and the elevator down. This one's been a bit the opposite. They took the elevator up, and maybe they'll take the escalator down.
But because they are operating under data dependency, and they're simultaneously doing QT, that has been a force behind higher volatility in the fixed income side, even more so than on the equity side. We think that will ease at the point where the Fed has shifted to easier policy, and we have a better sense, but there's been so much uncertainty with regard to inflation and Fed policy and its reaction function that that drove an outsized amount of volatility, which we think will calm, to some degree.
AKIKO FUJITA: So with that expectation, Liz, how are you advising clients to position themselves, specifically in the fixed income space right now?
LIZZ ANN SONDERS: Well, it depends on who the client is. And I always say, shame on anybody that answers that question with precision, because we have more than $7 trillion of client assets and one client could be entirely different than another. You could have a retired client that is living on their nest egg, and they need to live on the income associated with it and can't afford to lose any principal, versus somebody with a much higher risk tolerance.
So in terms of the allocation specific to asset classes, that's specific to each investor. Both on the fixed income side and the equity side, we've been saying stay up in quality. So on the equity side, that means quality oriented factors, like strong free cash flow and interest coverage, strength of balance sheet, good earnings profile. On the fixed income side, it means you want to avoid the really high-risk areas. Lots of opportunities, obviously, in treasuries, more of a focus on investment grade corporates, as opposed to high yield or junk. And then for some investors, there's opportunities in munis as well. But that's going to vary from investor to investor.
JOSH SCHAFER: And Liz, I wanted to ask you about Kathy's chart as well. Kathy Jones, your colleague, had highlighted the other chart that we just showed, which was a sanctuary that we peaked later, the 10-year peaked later than it normally would, in a Fed cycle. And I was curious just sort of what you make of that chart and perhaps maybe it speaks to some of the volatility you were talking about or just how it's shown that maybe this rate cycle is a little bit different and maybe what the takeaway is there to bring forward for us.
LIZZ ANN SONDERS: Well, I think it is a little bit different. And again, that's because in past cycles, at times, the Fed wasn't on necessarily a predetermined path, but they've been able to telegraph the path that they were on in terms of speed of rate hikes or rate cuts. And this sort of environment of data dependency amid a 40-year high in inflation sort of changed the landscape there.
And I think the recent peak at just north of 5%, that was a really, really massive move, obviously, from late July to late October. And the bulk of it occurred within the term premium, which is that catch-all category, some of which may have had to do with just positioning by more speculative money. And of course, you saw the reversal happen just as quickly when you peaked out at 10, and you came back down.
So again, I think the volatility is tied to the unique nature of this cycle and the Fed combating a 40-year high in inflation, but continuing to be data dependent before deciding when to shift. As I mentioned, I think some of that volatility in those really dramatic swings in such a condensed period of time are probably not going to be repetitive this year.
AKIKO FUJITA: Liz Ann Sonders, Charles Schwab chief investment strategist, alongside our very own Josh Schafer. Thanks so much.
