ORLANDO, Florida, April 10 (Reuters) - Correlations

between U.S. stocks and bonds are weakening and in some cases

turning negative for the first time in almost a year, breathing

new life into the standard "60-40" investment portfolio.

For longer-term investors with a balanced portfolio between

equities and fixed income or 60-40 in stocks' favor, a negative

correlation between the two asset classes should be a good

thing, as it increases diversification and dilutes risk.

And it is a situation that looks likely to persist in the

months ahead if the economy stays on its "soft landing" or "no

landing" glide path, and inflation remains reasonably well

behaved.

There are probably hundreds of ways to measure the

correlation between stocks and bonds, depending on the indexes,

assets, returns and time frames plugged into the calculation.

All will offer their own unique perspective.

But short-term correlations, at least, are breaking down. A

simple rolling 25-day correlation between the S&P 500 index and

the iShares 20+ Year Treasury Bond TLT exchange-traded fund this

week fell to -0.1635, the most negative since June of 2023.

It has been positive for most of the last two years, topping

out at +0.7 last August.

The 60-day correlation is still positive but only just, and

again is close to its weakest since last summer, while the 30-

and 60-day correlations between the S&P 500 and rolling 10-year

Treasury note futures contract paints a similar picture.

This breakdown is a result of investors dumping fixed income

and jumping on the AI-fueled stock market rally. The i-Shares

TLT ETF is down 7% this year, while the S&P 500 is up 9% and hit

a record high last month.

Broadly speaking, it breaks two years of mostly positive

correlation - stocks and bonds both sank in 2022 as the Federal

Reserve started jacking up interest rates to combat 40-year high

inflation, and rebounded in tandem last year.

"Zero correlation is good, because you want uncorrelated

assets in your portfolio. That creates diversification," says

Max Uleer, head of European equity and cross asset strategy at

Deutsche Bank.

"You want to have a negative correlation in times of big

drawdowns because that's when government bonds help you in the

portfolio," he says, adding that buying bonds at this juncture

is the way to play the negative correlation.

Lara Castleton, U.S. head of portfolio construction and

strategy at Janus Henderson Investors, agrees.

"Equities are providing the positive return so far this

year, but the 60-40 portfolio is still in a pretty good spot.

Yields are very compelling," she says.

EVAPORATING EQUITY RISK PREMIUM

By some measures, Treasury bonds are more attractive today

relative to stocks than they have been for 20 years. The equity

risk premium, the gap between the earnings yield on riskier

stocks over the yield on safe government bonds, has almost

disappeared.

How long the negative correlation between stocks and bonds

lasts, and how deep it goes, will depend in large part on

inflation.

As a recent Bank for International Settlements paper noted,

high or volatile inflation depresses bond prices and makes

interest rate hikes more likely, weighing on the outlook for

growth, future earnings and stock prices.

This is what happened in 2022, which turned out to be the

worst year on record for a 60-40 portfolio.

Janus Henderson's Castleton notes that, historically, when

inflation is above 3% the correlation between equities and fixed

income tends to be positive as both asset classes struggle.

Headline annual U.S. consumer inflation is running at 2.5%

or 3.5%, depending on the measure, but is expected to cool

further this year. The rise in bond yields and evaporation of

Fed rate-cut expectations is driven more by positive growth

surprises than fears that inflation is becoming unmoored.

All else equal, a "no landing" scenario for the U.S. economy

weakens the equity-bond correlation - growth defies gravity,

enhancing the earnings outlook and supporting equities, while

investors shun bonds in the face of higher yields and "higher

for longer" Fed policy rates.

Equally, if recession suddenly looms on the horizon, Wall

Street will probably topple and bonds instantly become more

attractive - especially given the room for the policy rate and

yields to fall. Again, the negative correlation holds.

But zoom out further, in terms of both correlation metrics

and historical time frames, and a balanced portfolio is probably

never a bad thing.

Noah Weisberger at PGIM says that over the last half century

60-40 portfolio returns have actually been higher in positive

correlation regimes than negative, but risk-adjusted returns

have been a bit worse because volatility is higher on average.

"The current narrow valuation gap between stocks and bonds

is consistent with future bond risk-adjusted outperformance

relative to stocks, underscoring the importance of bonds in a

balanced portfolio," Weisberger wrote last month.

(The opinions expressed here are those of the author, a

columnist for Reuters.)