Equity/bonds: will reflation trigger a new tantrum?

Equity/bond correlation p l ays a crucial role in the asset allocation process and depends chiefly on the inflation regime. In the absence of inflationary pressures, asset allocations concentrate on the uncertainties shrouding growth, with bonds acting as safe have n plays. During the COVID-19 crisis, equity/bond correlation remained solidly anchored in negative territory, save during the liquidity shock that rocked govies in March 2020. With the crisis having played out, but only in the United States, equity/bond correlation is tending to move back to a more neutral level (i.e. become less negative ) , with the emergence of uncertainties over inflation (clean sweep by Democrats, massive fiscal stimulus, new mandate for Federal Reserve). Furthermore, the rebound in activity points to there being less dovish signals from the Federal Reserve going forward, which could create spikes in positive equity/bond correlation ( new tantrums). The capacity of bonds to act as a hedge against shocks is not brought into question in our view. We expect inflation ary pressures to remain measured, and for the Federal Reserve’s action to remain cautious and restrained , which ought to maintain equity/bond correlation in negative territory. The introduction of a Yield Curve Control by the Fed could bring this correlation back to more neutral levels but not into positive territory. We therefore believe that the safe haven role of the bond will not be durably impacted in the post-Covid recovery. On the other hand, it will have to pass through different channels: with expectations of short rates very anchored on a ZLB, it is essentially the bond term premium that will ensure the bond rally during shocks.