(Bloomberg) -- Something has shifted in markets. Fear of stagflation, the return-busting specter of spiraling prices and recession that just sent stocks and bonds to their worst annual drubbing in a generation, has gone missing.

In 2023, traders seem persuaded that rout was an overreaction, particularly in equities, as evidenced by the 7.7% surge that has lifted the S&P 500 in four of the year’s first five weeks. While bonds took a hit alongside stocks Friday, their gains have also been impressive, combining to post the best start of a year for cross-asset returns since 1987.   

Much was made of last year’s tight correlation between stocks and Treasuries as both plummeted in the face of economic and monetary stress. This year, they’re even more correlated — except now the direction is up.

What changed? Not so much that traders decided a recession will be avoided or that central banks are done raising rates, but that it may be possible to look past both. Chairman Jerome Powell warned Wednesday that the Federal Reserve was a long way from winning its war against inflation. Bullish traders heard something else — hints the war is winnable — and decided not to worry about when.

“I wouldn’t say the market has blind faith, but it’s been forgiving,” Yung-Yu Ma, chief investment strategist at BMO Wealth Management, said by phone. “There was a time when investors were extremely skeptical that a soft landing could be achieved,” he added. “It’s definitely been a pretty dramatic shift in how that’s permeated investor psychology.”

This week was a microcosm of the cross-asset pattern that has gripped markets in the last year. The iShares 20+ Year Treasury Bond ETF (TLT) and the SPDR S&P 500 ETF Trust (SPY) rose for three straight sessions through Thursday, bolstered by a soft reading on wages, while Powell announced the start of a “disinflationary process” and brushed off the market rally. The mood darkened Friday when an unexpectedly strong labor report suggested the Fed can remain aggressive. 

For every day over the week, stocks and Treasuries went in the same direction, up or down, producing a stretch of comovement not seen in four months. It’s an extension from last year, when they spent 54% of sessions moving in tandem — the most in at least two decades.  

The dynamic has been playing out outside US markets too. Tracking stocks and government bonds in developed countries, JPMorgan Chase & Co. found the six-month correlation — the degree to which both assets move in lockstep — has risen this year further into positive territory, reaching the highest level since the late 1990s. 

The strengthening link reflects a group mindset that’s laser-focused on inflation, whose post-pandemic trend has proved almost impossible to predict for everyone including the central bank. 

Powell’s comments may have confirmed among traders a sense given in recent data that inflation is now heading in the right direction. Last year, the US consumer prices index came in mostly hotter than expected for almost every month through October, stoking the most aggressive Fed tightening in decades and triggering a massive bond-stock selloff. 

Since then, inflation readings have been either softer or in line. To JPMorgan strategists including Nikolaos Panigirtzoglou, it’s no coincidence that stocks bottomed in October, the same month when 10-year Treasury yields peaked.

“Since last October, negative inflation surprises have been having the opposite impact on Fed policy expectations, boosting equities and bonds at the same time,” the strategists wrote in a note Thursday. “The persistency of the current shift in the bond-equity correlation to positive territory has likely been a function of the persistence in inflation surprises, both on the way up and on the way down.” 

For now, the concerted stock-bond rally is a welcome development for investors who count on asset returns for retirement. Yet their increasingly lockstep moves also highlight a danger: should inflation turn hot again or fail to slow as much as expected, the markets are at risk of repeating the nightmare of 2022. 

That means investors should consider assets beyond the traditional mix, according to Panigirtzoglou, who flagged the dollar’s outlier move and noted that the correlation between emerging-market and developed-country stocks approached zero at the start of 2023.

Sandi Bragar, chief client officer at Aspiriant, had a similar arugment. When economic and market outcomes are wide-ranging, it’s prudent to have a diversified portfolio. 

“We’re not making bets on any of this because it’s just impossible to make those bets correctly and to make them at the right time. So we’re staying broadly diversified,” she said. “Who knows, we could be in a prolonged bear market rally.”

While Powell dismissed traders’ expectations for rate cuts later this year, consensus is building that the central bank’s benchmark fund rate is likely to peak near 5%. That has helped anchor the bond market, where turmoil erupted last year over policy uncertainty. The ICE BofA MOVE Index, a measure of Treasury volatility, this week fell to an 11-month low. 

In the equity market, improving prospects for a soft landing are arousing animal spirits. Speculative shares like unprofitable technology firms are back in vogue. A Goldman Sachs Group Inc. basket of such companies has surged almost 30% this year. Retail investors are flocking to troubled firms like Carvana Co., with orders from the mom-and-pop crowd as a percentage of total market volume surpassing the meme frenzy in 2021, separate data from JPMorgan show. 

Whether all the optimism can be justified is debatable. There are signs that investors are rushing to play catch-up. On Thursday, when the S&P 500 jumped to the highest since August, options traders piled in on bullish contracts, driving call trading to a record.

“This has the hallmarks of FOMO all over it,” said Chris Weston, head of research at Pepperstone Group Ltd. “But this tape is not made for fighting – the market is trading a central bank pause, and active managers are understandably scared about missing out on performance — strength begets strength.”

--With assistance from Christopher Anstey.

©2023 Bloomberg L.P.