Falling prices flip stock-bond confirmation

A two-regime confirmation problem

For much of the twentieth century, equity prices tended to follow bond prices, sometimes with a noticeable lag. That pattern is price-to-price confirmation.

Editorial view: inflation-tolerant decades trained observers to treat that mapping as a single historical rule. A falling-price backdrop can invert the map so equities travel with yields. Regime-dependence means the useful stock-bond confirmation rule changes when the inflation-versus-falling-price backdrop changes. Intermarket confirmation checks one asset class against another before a single-market signal is treated as complete.

The inflation-tolerant map

In the 1969-70 equity decline, 10-year Treasury yields rose. The 1970-73 equity advance came with falling note yields. The 1973-74 cyclical equity drop saw those yields climb from below 6 percent to near 8.5 percent.

After U.S. inflation was contained, 1980s charts of the S&P 500 and 10-year note prices showed equities tracking bond prices, with bonds leading. The 1990s U.S. price-to-price alignment held until after the 1998-99 bond break and the 2000 equity downturn.

The falling-price map

When the price level falls inside an expanding money-supply system, weaker corporate margins can put downward pressure on equities even as bond prices rise and yields fall. Corporate pricing power is the ability of firms to protect margins when the general price level is rising or falling. A rebound in the price level can lift bond yields and press bond prices while equities recover as firms regain pricing power.

That inverted pairing is Gibson's paradox: equity prices tend to move with bond yields rather than with bond prices. In 1990s Japan, equity prices moved opposite government-bond prices and therefore more closely with those bond yields.

The equity-follows-yields mapping was more common when a gold standard made falling-price episodes frequent, and it faded from use after that standard was left in the early 1970s.

Currency and the long bond

Long-maturity bonds embed the market's inflation and currency view. Expected currency weakness tends to lift yields and depress bond prices so that eroded principal and coupons are offset. That long-bond currency signal is one reading of the backdrop.

Unit-of-account valuation judges inflation or falling prices by whether the currency is cheap or dear versus goods, often using gold as a reference. A falling-price regime pairs a strong, overvalued currency with declining goods prices, squeezing corporate pricing power and making existing debts harder to service, while high-quality creditors can benefit from a stronger unit of account.

Noticing the switch

From 2000, stock and bond prices moved opposite. The early-March 2002 note break alongside an equity rally was readable as equities following yields during an inflationary pause inside an otherwise falling-price backdrop.

Editorial view: the teaching point is how to notice that switch before a lone-market move is treated as confirmed under the wrong map.