European Equity and Bond Correlation Indicates Growth Fears Highest In 40 Years

Submitted by Tyler Durden on 09/27/2011 11:16 -0400

In a brief note this morning from Goldman, the correlation between European equities and bond yields is noted at a 40-year high - above the levels reached in the initial credit crunch period of '07/'08. They find that the rolling correlation is highly dependent on the absolute level of bond yields and at current levels is very indicative of significant growth concerns(much more so than any inflation fears) and furthermore that the relationship is starting to look a lot like the lost twin-decades in Japan.

From Goldman's Strategy Espresso: Bond-equity correlation at a 40-year extreme

The way European equities have performed recently suggests investors are more fearful about growth – and less worried about inflation – than at any time in the last 40 years. The chart below shows the rolling correlation between European equities and bond yields; the current correlation at +67% is at a 40-year high.

It’s not dissimilar to the levels reached in the initial credit crunch period of ‘07/’08. A high positive correlation means that rising bond yields are seen as a good thing for equities whereas falling yields are seen as bad as they imply deteriorating nominal growth and growing chances of deflation.

We’ve shown before that the relationship between bonds and equities is a dynamic one and depends not just on the direction of bond yields but on the level. The scatter plot shows that when yields are above 4-5%, correlations between equities and bond yields tend to be negative; equities underperform when yields rise as this is a signal of inflationary problems and it raises the discount rate for equities. But this relationship flips the other way when bond yields fall below the 4-5% threshold; at these levels, rising bond yields are a good thing as this signals growth and moves you further away from the nasty outcomes deflation can involve. Indeed the correlation between bond yields and equities has been high and positive in Japan since the mid 1990s, and reached the same levels we see in Europe today on a temporary basis on several occasions. In Europe, the current point on the scatter plot below is at the extreme top left; we see little chance that it will move away from this point in the short term while concerns about growth risks dominate.