The intermarket relationships depend on the forces of inflation or deflation. In a “normal” inflationary environment, stocks and bonds are positively correlated. This means they both move in the same direction. The world was in an inflationary environment from the 1970s to the late 1990s. These are the key intermarket relationships in an inflationary environment:
Positive relationship between bonds and stocks
Bonds changing direction ahead of stocks (typically)
Inverse relationship between bonds and commodities
Inverse relationship between the US Dollar and commodities
POSITIVE: When one goes up, the other goes up also.
INVERSE: When one goes up, the other goes down.
In an inflationary environment, stocks react positively to falling interest rates (rising bond prices). Low interest rates stimulate economic activity and boost corporate profits. Keep in mind that an “inflationary environment” does not mean runaway inflation. It simply means that the inflationary forces are stronger than the deflationary forces.
Murphy notes that the world shifted from an inflationary environment to a deflationary environment around 1998. It started with the collapse of the Thai Baht in the summer of 1997 and quickly spread to neighboring countries, becoming known as the “Asian Currency Crisis.” Asian central bankers raised interest rates to support their currencies, but high interest rates choked their economies and compounded the problems. The subsequent threat of global deflation pushed money out of stocks and into bonds. Stocks fell sharply, Treasury bonds rose sharply and US interest rates declined. This marked a decoupling between stocks and bonds that would last for many years. Big deflationary events continued as the Nasdaq bubble burst in 2000, the housing bubble burst in 2006 and the financial crisis hit in 2007.