Understanding Asset Correlations
64 Pages Posted: 6 Jul 2011 Last revised: 12 Dec 2012
Date Written: September 30, 2012
We document an inverse relation between stock-bond correlations and correlations of growth and inflation. We find that rising inflation uncertainty lowers stock prices but can either lower or raise nominal bond prices depending on whether inflation is counter- or procyclical. We show that the time-varying comovement of growth and inflation has important implications for how inflation impacts asset prices. We explain our findings in a long-run risk model with non-neutral inflation shocks and regime shifts, allowing for countercyclical and procyclical inflation regimes. The model can produce an upward-sloping real yield curve and rationally explains the so-called Fed-model. Finally, inflation and monetary policy shocks were important drivers of stock-bond correlations during the countercyclical period 1965-2000 while output shocks dominated during the procyclical period 2000-2011.
Keywords: cyclicality, fed-model, inflation, long-run risks, money illusion, regime-switching, stock-bond correlation
JEL Classification: E43, E44, G12
Suggested Citation: Suggested Citation