Risk and Portfolio Construction

The correlation between equities and bonds - past and future

The most important number you rarely think about

The correlation between equity and bond markets is of vital importance to asset allocators; for risk control and portfolio construction, for assessing the market outlook, and for building models of how markets work.

Classic equity valuation models, such as the "Fed model" assume a positive correlation between the prices of equities and the prices of long-duration bonds. For most of the period up to 2000, this has generally been true, but in the period from 2000-2016, we have encountered a highly unusual state of affairs - the correlation has generally been negative.

Correlation graph

Listed below are five papers, recently curated by the Savvy Investor research team, which explore this phenomenon in more detail:

A Century of Stock-Bond Correlations (RBA, 2014)
Throughout much of the 20th century, the correlation between equity prices and bond yields in the United States and other countries fluctuated but tended to be negative. However, stock-bond yield correlations have been largely positive since the late 1990s, rose strongly during the global financial crisis and have since remained at a high level for a prolonged period. This study by the RBA examines the drivers of stock-bond correlations and draws conclusions.

The equity-bond correlation - the most important number you rarely think about (AON Hewitt, 2014)
The stock-bond correlation is a vital assumption. For liability-sensitive investors it matters even more, as it describes how assets and liabilities will move relative to each other. This paper from AON Hewitt models correlations dynamically, to capture both the range of outcomes they can take and variation over time.

Trends in Stock-Bond Correlations (RIETI, 2015)
This paper discusses long-run trends in comovements in stock and bond market returns, examining the impact of stock market volatility, interest rates, yield spreads, VIX and flight to quality behaviours upon equity/bond correlations.

Anomaly in Stock-Bond Correlations - The Role of Monetary Policy (2015)
This paper estimates constant conditional correlation (CCC) GARCH models to test whether the dramatic changes in stock-bond market correlations can be explained by monetary policy variables such as OIS interest rate shocks or volatility regimes.