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Stock-bond correlation has recently turned from positive to negative. Exhibit 1 plots the annual return series for equities and bonds. Three periods of decoupling stand out-near 1930, near 1960, and near 2000. Exhibit 2 shows the history of 12-month trailing stock-bond correlations since 1926. Clearly, the relation between the two main asset classes has not been particularly stable. The correlation has tended to be positive but has occasionally dipped below zero for extended periods. The three episodes of negative correlations-1929-1932, 1956-1965, and 1998-2001-coincide with the decoupling of stock and bond performance in Exhibit 1.1
Should we expect stock-bond correlation to be mildly positive, as in the last 40 years, or mildly negative as it has been for the last four years? The answer is important for long-term asset allocation decisions since correlations across asset classes are one key input in portfolio optimization and asset-liability management exercises as well as for hybrid derivatives valuation. Moreover, negative correlation makes government bonds excellent hedges against major systematic risks-recession, deflation, equity weakness, and other financial market crises-and this attractive feature may justify an exceptionally low bond risk premium, that is, higher government bond valuations.
To assess the sustainability of the correlation reversal, we explore factors that cause positive or negative comovements across stocks and bonds. Specifically, we examine stock and bond market sensitivity to the business cycle, inflation, volatility, and monetary policy conditions. Economic growth and volatility shocks tend to push stock and bond prices in opposite directions, and thus cause decoupling. The inflation level is also important, because common variation in discount rates makes stocks and bonds positively correlated at high inflation levels. When inflation is low, discount rates are more stable, and growth uncertainty dominates, making stock-bond correlation lower.
I. FACTORS THAT CAUSE POSITIVE OR NEGATIVE CORRELATION
We conjecture that an immediate reason for the changing correlation sign is the changing direction of causality between stock and bond markets. Correlation does not necessarily imply causality. Yet many investors feel strongly that the causality from bond prices to stock prices is positive (say, falling bond yields tend to also reduce equity discount rates), while the causality from stock to bond prices is negative (say, equity weakness can prompt monetary...