For the better part of two years, multi-asset investors were bedeviled by that most nefarious of market dynamics: A positive stock-bond return correlation.

If you’re young (or relatively young) you’ve spent most of your investing lifetime enjoying a “have your cake and eat it too” conjuncture, wherein both stocks and bonds generally rallied over time, but nevertheless exhibited a negative correlation such that gains in one asset cushioned losses in the other (typically bonds performing when stocks sold off), even as both experienced bull markets.

You know what they say about things that seem too good to be true. Inflation was always the risk, and it came calling in the 2020s. I’ve been over this again and again. The correlation assumption we all came to take for granted (even those of us who might not be considered “young” in a relative or absolute sense) was exposed as yet another manifestation of recency bias. Bonds sold off into the inflation spike, equities de-rated as the Fed hiked and the 60/40 crowd was left staring vacantly at a rather vexing drawdown.

Fast forward to 2024 and inflation is receding, setting the stage for the stock-bond correlation to flip sustainably back into negative territory — a return to the post-2000 “normal,” with the scare quotes to remind readers that a 60- or 70-year lookback suggests a negative stock-bond correlation wasn’t normal at all.

“[The] inflation trend is ‘mission critical’ to the asset correlation regime, where for two years, above-trend inflation dictated a brutal positive stock-bond correlation [in] a world where the prior decade’s performance was built upon the ‘everything duration’ edifice,” Nomura’s Charlie McElligott wrote Thursday.

As the figure shows, it’s all about inflation when it comes to the correlation, and we’re moving into the negative zone.

“A push back to a world of 2.5% inflation and below — especially as we’re now rather violently disinflating back to and even lower than target on medium-term rates, annualized — sees the negative bond-stock correlation regime develop,” Charlie went on.

That’s a good thing, right? Well, yes. Particularly if, for you, the “multi-” in multi-asset just means bonds and stocks. Because then you really, really need bonds to serve their purpose as an effective hedge.

But there’s a caveat: Equity vol can actually be higher as inflation moves “too” low.

McElligott told the story via the annotation: The sweet spot is the 2% to 3% bucket.

That makes sense. Notwithstanding the extent to which the threat of deflation gave central banks plausible deniability to engage in the deliberate, heavy-handed suppression of volatility, deflationary environments aren’t stable environments.

“Moving to below target (< 2.0%) inflation” risks “transitioning into a higher vol space” based on a “VIX regime backtest,” McElligott remarked.

Another way to think about that in the 2024 context is simply to note that if there’s a hard landing (deflationary) equity vol would surely wake up.