When deflation flips the stock-bond map

The four-asset map and the intermarket cycle

A four-asset map is a working snapshot of equities, government bonds, a broad commodity basket, and the dollar. It is used to place one market in a larger regime.

A standard intermarket cycle ties firmer rates and a stronger dollar to later peaks in gold, a broad commodity index, bond prices, and then equities. After that sequence, easier rates reverse the same chain.

Core pairings in that framework include an inverse link between commodities and bonds, an inverse link between the dollar and commodities, and a normally positive link between stocks and bonds. The dollar and commodity pairing is the commodity-dollar inverse.

A deflationary inversion of the stock-bond sign

In a deflationary climate with an overvalued currency, that normally positive stock-bond price link can invert. Bond prices then move opposite equities, and bond yields start to lead stocks.

That pattern is a deflationary inversion. The stock-bond sign has changed, and yields rather than bond prices become the more useful equity lead.

Japan and the United States as sign-flip cases

A 1990s comparison of Japanese government bonds and the Nikkei 225 showed bond prices climbing in a nearly unbroken rise while equity prices swung widely on a largely downward path.

For three consecutive years into the early 2000s, the S&P 500 and the 10-year Treasury moved in opposite directions, with equities lower and the government long bond higher. After the July 2002 lows, the S&P 500 spent about nine months in sideways trade while the government long-bond advance remained in force.

Commodities, the dollar, and the 2003 fork

Gold and crude advanced through 2002 and peaked early in 2003 after sharing relative bottoms around 1999. Gold's later low came in early 2001, while crude's 2001 high sat on a rise that began in 1999.

A broad commodity basket appeared to top in 2003, even after allowing for a grain bear market of more than five years. Dollar futures looked to be bottoming after a long decline and had moved opposite commodities for more than a year.

If a deflationary inverse stock-bond link still dominated, further equity weakness would be expected to coincide with even lower long-bond yields. An equity advance extending into the second quarter of 2003 would be expected to coincide with lower bond prices and higher yields.

Joint declines in stocks and bonds were read differently by the commodity-dollar pair. Rising commodities and a weaker dollar would imply inflation stress. Falling commodities and a stronger dollar would imply a deflationary bind.

Editorial note: that check is the reflation test. Weaker financial assets are sorted by whether they coincide with stronger commodities and a softer dollar, or with weaker commodities and a firmer dollar.