Bonds vs equities: the double-rally dilemma

Conditions look good for both bonds and equities right now, but one asset class should come out ahead. AMY XIE PATRICK explains

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US two-year bond yields have slipped from 3.95% to 3.54% since the start of August.

Over the same period, the S&P 500 clocked three new highs.

On the surface, that feels like a contradiction. Aren’t bonds supposed to rally when growth looks shaky, and equities move ahead when conditions are strong?

The story I’m hearing goes like this: softer labour market data plus Jay Powell’s Jackson Hole nod toward prioritising jobs over inflation equals imminent Fed cuts.

Bonds markets like this, because lower rates usually lifts bond prices. Equities like it because lower rates boost valuations.

Goldilocks achieved.

But if history teaches us anything, it’s that labour markets rarely weaken just enough to ease inflation pressures while staying benign (see figure 1 below).

Once unemployment inflects up, it usually keeps going.

If that’s the case, then one side of this rally is wrong. Either labour weakness proves more serious than equities are willing to admit, or not serious enough to justify the bond market’s enthusiasm for a rapid return to neutral.

Figure 1: Is this time different? US unemployment rate (%)

Here’s where I think the narrative misses a beat: it’s not just about jobs – it’s about tariffs.

This week’s US Producer Price Index (PPI) data surprised to the downside.

Companies hit by tariffs are swallowing the cost instead of passing it through to customers (see figure 2). That’s why inflation has stayed tame enough for bonds to rally.

Figure 2: US producers report higher costs through the ISM survey but aren’t passing it on US ISM prices index and US producer price index

Normally, margin compression would spell bad news for equities.

But tariff-sensitive stocks make up just 1% of S&P 500 market cap, 2% of earnings and 4-to-5% of revenues.

In other words, even if some corporates are hurting, it barely dents the index.

That’s the real reason bond and equities can both be in a happy place.

They’re being driven by different forces.

Bonds aren’t “slaves” to equities, and their correlation isn’t programmed to always be negative.

What it means for investors

For investors, the lesson is two-fold.

First, don’t let the surface-level story of “Fed cuts = everything rallies” fool you into thinking bonds and equities are in perfect harmony. They’re not.

Second, don’t over-index on tariffs either.

Both markets are effectively telling us to move on.

What will matter next is how growth and unemployment actually unfold.

It’s hard to see both asset classes continuing to benefit equally from that story.

For now, I’m positioned lightly in both bonds (via duration) and equities/riskier assets.

Dry powder matters more than chasing today’s consensus. When the next shoe drops – whichever side it lands on – that’s when the real opportunity will open up.

If you’d like to hear more, Pendal’s Income & Fixed Interest team would welcome an opportunity to chat.

You can contact us through the client account team here.