Stock-Bond Return Correlation: Understanding the Changing Behaviour

Abstract

The stock and bond return correlation remains important given its central role in, and implications for, portfolio behaviour. Previous, primarily US, evidence indicates sign switching behaviour, which implies that bonds change between being a diversifier and a hedge. This paper considers the time-varying nature of the stock-bond correlation for G7 markets, including its economic drivers, and whether they are themselves time-varying. Using monthly data over a period spanning 1980 to 2023 evidence demonstrates that the correlation switches from positive to negative around 2000 for six of the seven markets (the switch for Japan occurs in the first half of the 1990s). A switch back from negative to positive is evident for all markets. For the majority, this occurs towards the end of the sample but is earlier for France and Italy. Considering the correlation drivers, evidence support the view that their nature also varies. Nonetheless, results suggest that inflation and interest rates typically exhibit a positive effect on the correlation, consistent with previous work. However, growth also, largely, imparts a positive effect on the correlation, in contrast to the majority view. Higher inflation and interest rates depress stock and bond prices due to higher discount rates and lower real cash flows, moving them in the same direction. Through a portfolio argument, higher growth leads to an increase in demand for all assets. Key implications for investors are identified. From a return and risk perspective, the switch in correlation implies that a portfolio manager will need to alter asset weights to maintain a target value. For example, increasing the weight in stocks over the sample to maintain a given portfolio return. A portfolio variance decomposition reveals that the bond contribution remains broadly constant over the sample, however, that from stocks increases, while the correlation contribution shifts from positive to negative. The results here are of importance to investors and those engaged in modelling market behaviour.

Keywords: Stock Returns, Bond Returns, Time-Varying Correlation, Breaks

JEL Classification: G12