The correlation between U.S. stocks and bonds has fallen to a 30-year low. UBS warns: the next shock may come from the interest rate market.

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The correlation between US stocks and US bond yields has fallen to its lowest level in nearly 30 years. This structural change is reshaping the logic of multi-asset investing and sowing new risks in the market.

According to TrendChasing Trading Desk, UBS pointed out in a US equity derivatives strategy report released on June 16 that stock and bond yields are currently deeply negatively correlated—that is, rising yields correspond to falling stock prices. This pattern fundamentally weakens the traditional function of bonds as a hedging tool against stock risks, forcing multi-asset investors to reduce both stocks and bonds simultaneously when avoiding risk. This may trigger a self-reinforcing effect of coordinated deleveraging.

Meanwhile, interest rate volatility remains relatively low compared to equity volatility, but historical patterns suggest this situation may be at a turning point, with bond volatility having significant room for upside.

The report suggests investors consider using a TLT/SPY at-the-money December straddle swap to capture the repricing opportunity of interest rate volatility relative to equity volatility, and sees upside potential in cyclical sectors such as regional banks under scenarios of rising yields and improving economic growth.

Stock-bond correlation hits 30-year low, challenging multi-asset hedging logic

The two-month rolling correlation between the S&P 500 and the 10-year US Treasury yield has dropped to the lowest level since 1996, and the beta value of stocks to bond yields is also at a multi-decade low.

In a positive correlation environment, bonds naturally serve as a diversification tool against stock risks; but in the current deeply negative correlation, bonds and stocks often move in the same direction, nullifying this mechanism. This condition has a potential self-reinforcing nature: when macro uncertainty rises, investors are forced to simultaneously cut exposure to both stocks and bonds, which may increase market volatility.

Historically, negative stock-bond yield correlation tends to persist and deepen during rate hike cycles. Examining data from rate hike cycles since the 1970s, this phenomenon was particularly prominent during the 1980s and 1990s. It’s worth noting that the Federal Funds futures market has currently priced an approximately 80% probability for the Fed to hike rates by at least 25 basis points before the December FOMC meeting, though this is not the baseline scenario.

Interest rate volatility is relatively low and may not last, bonds have catch-up potential

Since the end of 2023, the strategy of "selling bond volatility and buying equity volatility" has basically played out—mainly benefiting from a sharp drop in bond volatility during Fed rate cuts or pauses. However, this logic may be reaching a turning point.

Historical data shows that in Fed rate hike cycles, the MOVE Index (measuring interest rate volatility) often rises significantly relative to the VIX Index (measuring equity volatility), especially during periods of negative stock-bond yield correlation.

A prominent feature of the post-COVID era is that high interest rate volatility is usually associated with yield curve flattening, particularly bear flattening where front-end yields rise more than long-end yields. This is closely linked to market expectations for Fed rate hikes.

Based on this, the report suggests investors consider a TLT/SPY at-the-money December straddle swap, buying TLT (i.e., long interest rate volatility) and selling SPY (i.e., short equity volatility) at a roughly 1.5 to 1 nominal ratio. The current pricing of this structure is attractive compared to historical levels.

S&P 500 has fully priced in “good yield increases,” but regional banks and other sectors still offer opportunities

Using its Market Cookbook framework, the report assessed the degree of pricing of various assets under a scenario of moderate yield increase. This framework assumes yields rise due to economic growth improvement rather than inflation expectations, accompanied by a modest steepening of real yields and moderate widening of credit spreads.

The assessment shows that the S&P 500 index has basically fully reflected this scenario, with less than a 23% probability of rising more than 3%, and less than a 4% probability of rising more than 7%. However, some cyclical sectors remain underpriced, particularly regional banks, large banks, and oil & gas exploration and production (E&P).

For regional banks, since the post-Silicon Valley Bank (SVB) era, the correlation between this sector and rising yields has clearly weakened, mainly due to market concerns about their balance sheets. This characteristic means that even under Fed dovish or “not overly hawkish” scenarios, the trade still has profit potential. Meanwhile, the call skew for KRE has flattened considerably, with the 1-month at-the-money to 25-delta call skew falling below the 10th percentile over the past five years, making related option structures more attractive in terms of pricing.

Risk Disclosure & DisclaimerThe market has risks, investment requires caution. This article does not constitute personal investment advice, nor does it take into account the special investment objectives, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article fit their specific situation. Investments made based on this are at your own risk. ```