Last year David Glasner produced one of the strongest pieces of evidence in favor of the view that the current recession was caused by an AD shortfall. He found that beginning around 2008 stocks became highly correlated with TIPS spreads, suggesting the market was rooting for higher inflation, higher aggregate demand. Even Paul Krugman gave him a high five.
Now Alexander David of the University of Calgary and Pietro Veronesi of the University of Chicago have a study that reached broadly similar conclusions:
At the onset of the financial crisis in 2008, the volatility of stock returns increased dramatically as the equity markets plunged. At the same time, U.S. Treasury bond prices shot up. The correlation of bonds and stock prices has been mainly negative ever since.
This makes sense: In times of trouble, we dump stocks and buy safe Treasury bonds, and their prices should move inversely. This also would mean that in better times, we buy stocks and sell bonds, implying that the correlation between Treasuries and stocks should always be negative.
It isn’t. The correlation between the aggregate stock market and long-term Treasury bonds has been mainly positive and rising from the 1960s to the end of last millennium. With the new millennium, the correlation between stocks and Treasuries turned negative, and strongly so, especially around the last two recessions.
Here they explain why the correlations have changed in recent years:
Before describing the implications of our model for the last decade, we should look at the late 1970s. Our estimates suggest that at that time investors faced large uncertainty about whether the U.S. would enter a persistent stagflation regime. Any consumer-price data that were above expectations were taken as an indication that the U.S. was transiting into such a regime, which brings about low growth and high inflation. The former makes stock prices decline, the latter makes long- term yields increase. Thus, data-driven fluctuations in investors’ beliefs about a stagflation regime pushed the prices of stocks and Treasuries to move together, and increased volatility for both.
In the recent Great Recession, the opposite occurred. The market now fears deflation, which is accompanied by low growth, as we know from the Great Depression. In this case, CPI data above expectations are great news for the economy, as investors interpret them as a signal that the bad deflation regime could be averted.
Stock markets cheer higher-than-expected CPI, and Treasury yields increase in expectation of accelerating inflation. Thus, data-driven beliefs about entering a deflationary state push the prices of stocks and Treasuries in opposite directions. Large uncertainty about deflation also increases the volatility of stocks and bonds, as we observed in the data. In other words, the signaling role of inflation dramatically alters the joint behavior of stocks and bonds, with important implications for risk and returns of stock and Treasury investments.
In late 2008 the markets were telling us that the Fed was making a tragic mistake by allowing NGDP expectations to plunge. But the economics profession didn’t listen, as they view stock investors as being irrational. Economists were obsessed with the notion that the real problem was banking distress, and that fixing banking would fix the problem. No, the real problem wasn’t banking, the real problem was nominal.