Why Does the Correlation between Stock and Bond Returns Vary Over Time?

Abstract

This paper examines the impact of inflation and economic growth expectations and perceived stock market uncertainty on the time-varying correlation between stock and bond returns. The results indicate that stock and bond prices move in the same direction during periods of high inflation expectations, while epochs of negative stock-bond return correlation seem to coincide with subdued inflation expectations. Furthermore, consistent with the “flight-to-quality” phenomenon, the results suggest that periods of elevated stock market uncertainty lead to a decoupling between stock and bond prices. Finally, it is found that the stock-bond return correlation is virtually unaffected by economic growth expectations.

Keywords: stock-bond return correlation, dynamic conditional correlation, macroeconomic expectations, implied volatility

JEL Classification: G10, E44