- Key insight: The relationship between stocks and bonds demonstrates that the driving force behind the U.S. economy has shifted from the demand side to supply, according to recent analysis by the Federal Reserve Bank of San Francisco.
- Expert quote: "Recent uncertainty in oil markets has also been associated with higher oil prices, which is a stark change from the previous decade. Consequently, policymakers may face more frequent supply shocks as well as an uncomfortable combination of elevated inflation with softer economic activity in the near term." — Thomas Mertens and Wesley Wasserburger, Federal Reserve Bank of San Francisco researchers
- Forward Look: A supply-driven economy is more vulnerable to supply-side shocks, which have become more common in recent years. This economic dynamic could complicate the Fed's approach to monetary policy.
The driving force behind the U.S. economy has shifted in recent years, according to recent analysis by the Federal Reserve Bank of San Francisco, and the results could have significant implications for the business cycle, monetary policy and portfolio construction.
In an
As evidence of this shift, Mertens and Wasserburger highlight the changing correlation between stock prices and bond yields. For most of the 2000s and 2010s, the two types of securities had a positive correlation, meaning equities markets and interest rates rose and fell at the same time. This peaked in 2014 with a correlation around 0.6 — with 1 being perfect correlation.
In 2020, that relationship began to weaken and by 2023 had turned negative, meaning higher equities prices led to low interest rates in debt markets and vice versa. Today, the correlation is around -0.3 — with -1 being perfectly uncorrelated — the strongest negative correlation since 1999.
"The reemergence of supply-side risks due to the pandemic, swings in immigration, changing tariff policies, and disruptions to energy markets led to significant repricing in asset markets," Mertens and Wasserburger wrote. "These events led the stock-bond correlation to change to negative again in the early 2020s. The correlation has remained negative since then, implying that investors may not expect a quick return to a demand shock-driven economy."
In portfolio theory, assets that are strongly negatively correlated are seen as powerful tools for mitigating risk, as they create hedging opportunities. But in their note, Mertens and Wasserburger said the phenomenon could also portend deeper concerns in the U.S. economy.
Specifically, the researchers highlight the impact of this shift on oil prices. In a demand-driven economy, stock prices and oil futures rise together, as economic activity expands and requires more inputs, such as oil. From the late-aughts until last year, the correlation between stocks and oil futures had been positive. That correlation, too, turned negative.
"Recent uncertainty in oil markets has also been associated with higher oil prices, which is a stark change from the previous decade," Mertens and Wasserburger wrote. "Consequently, policymakers may face more frequent supply shocks as well as an uncomfortable combination of elevated inflation with softer economic activity in the near term."
In a demand-driven economy, higher demand leads to more economic activity and higher inflation, which brings about higher yields and rates, the analysis notes, just as a dip in demand curbs activity, inflation, yields and rates. In a supply-driven economy, on the other hand, a lack of supply pushes up prices, triggering inflation and bringing about higher rates but little economic growth — hence the decline in stocks and rise in yields.
The analysis does not touch on the implications of a supply-driven economy on monetary policy, but conventional wisdom dictates that it could create issues for the central bank, as its primary policy tool — short-term interest rates — are most effective for addressing aggregate demand in the economy.
If the Fed deems inflation to be too high, a rate hike could cool demand in a supply-driven market. However, if the central bank is concerned about economic growth and the job market, stimulating activity through a rate hike could supercharge inflation in a supply-constrained environment.
Fed officials appear to be split about what part of their policy mandate is most jeopardized. The Federal Open Market Committee opted to keep the federal funds rate unchanged during its meeting last month despite inflation remaining above the group's 2% target and the labor market at roughly full employment. Some members noted that, despite strong employment data, the current labor market is not a source of confidence for workers.
"Employers tell me that layoffs are infrequent," Philadelphia Fed President Anna Paulson said in a speech last week. "Despite this, surveys suggest that workers are worried about job security and that jobseekers are pessimistic about finding work."
This argument was bolstered by last week's July employment report, which tallied a net loss of
Meanwhile, several members of the FOMC see inflation as their primary concern, one they argue should be addressed with a rate hike. Cleveland Fed President Beth Hammack, one of three dissenting voters at last month's monetary policy meeting, said
"When I look at policy broadly, I don't see any tension in our mandate. We've been missing on the inflation side for more than five years, but the labor market is right around my estimate of full employment," Hammack said. "I don't think policy is restrictive, meaningfully restrictive at this point."
