Deflation Fears Return: A Red Flag For Stocks

Prior to 1997, the dominant fear in the capital markets was inflation, and this resulted in a structurally negative correlation between stocks and bonds.  After the Asian crisis, the dominant fear shifted to deflation, and the structural correlation between stocks and bonds flipped positive.

In the years after the Global Financial Crisis (2009-2012), correlations were extremely elevated, reflecting extreme deflation tail risk.  In 2013, with the backdrop of another round of quantitative easing, shorter-term correlations plunged, suggesting the market was pricing out extreme deflationary risks.  This was a good environment for stocks.

Now, shorter-term correlations between stocks and bonds have flipped strongly back into negative territory.  This suggests the market is quickly re-pricing the likelihood of a deflationary shock.



A surge in the correlation between stocks and bonds preceded the 2010 and 2011 equity market corrections.  The recent increase is a red flag for stocks.