Socks & Bonds correlation in US markets - an overview

In this article, I will be exploring the correlation between the US stock and bond markets. It is important to note that this is not a scientific study, but rather an informative piece designed to provide an overview of the topic and offer hints for further research. I will be examining the historical trends and patterns in the stock-bond correlation, as well as delving into some of the factors that contribute to this relationship. My goal is to provide the reader with a basic understanding of the stock-bond correlation and to offer suggestions for further inquiry.

The relative performance of major public asset classes, such as stocks and bonds, has been stable over the last 20 years, with both prices trending higher. However, the correlation between stock and bond returns has been negative, meaning that when stocks perform poorly, bonds tend to do well, and vice versa. This negative correlation plays a significant role in institutional portfolio construction as it provides a natural hedge against risk and can be used to boost stock allocations with leveraged allocations to bonds. If the correlation becomes positive, it will require investment professionals to rethink their asset allocation decisions and long-term capital market assumptions as investors may demand higher expected forward returns to compensate for bearing greater cross-asset risk, which could lead to lower valuations.

The correlation between equities and bonds is affected by both growth and inflation. When growth and inflation are both positive, the correlation tends to be negative as equities are driven by growth and bonds by inflation. However, when growth is negatively impacted by supply-driven inflation, the correlation tends to be positive.

The correlation regime may change in the future, and it's important to be aware of the risks and gather evidence to assess the potential change. The level and stability of interest rates alone do not fully determine stock-bond correlation, other factors such as macroeconomic policy backdrop and its implications for interest rate volatility, co-movement of bond and equity risk premia, and co-movement of economic growth and rates also play a role. There are three potential paths for future stock-bond correlation: continued negative correlation, positive correlation due to shifting Fed priorities and expansionary fiscal policy, or a shift to positive correlation with synchronous monetary and fiscal policy goals. In the latter case, stock and bond risk premia could trend higher together, reflecting their diminished mutual hedging properties and muted expectations for forward returns.

Macroeconomics factors involved in the SBC

The Federal Reserve's mission shifted in 1951 from controlling federal debt to maintaining price stability and full employment. Prior to the mid-1960s, the Fed followed a set of rules that resulted in low and stable interest rates and inflation, leading to a negative correlation between stocks and bonds. However, starting in the late 1960s, the Fed began to use more discretionary policies, causing interest rates to fall below the rules-based rate for the next 15 years, leading to a positive correlation between stocks and bonds. In 1979, the Fed implemented new monetary policies under Chairman Volcker, but it continued to operate in a discretionary manner for the next decade, causing interest rates to remain volatile and leading to a positive correlation between stocks and bonds. From the late 1980s to the 1990s, the Fed returned to a rules-based policy, leading to a negative correlation between stocks and bonds. In the current regime starting in 2000, the Fed's policy was initially rules-based and led to a negative correlation, but in the wake of the 2008 Financial Crisis, the Fed's policy became more discretionary, and to bypass the lower bound on policy rates, the Fed used other tools to ease financial conditions. The Fed also committed to being more transparent in its policy-making, which contributed to a negative correlation between stocks and bonds.

The factors that influence stock and bond returns, and thus the Stock-Bond Correlation (SBC), are not limited to growth and inflation news, as a quick analysis would suggest. Other potential drivers include monetary policy shocks that impact both stocks and bonds through the discount rate, which are difficult to quantify as they often overlap with growth and inflation shocks. These shocks may contribute to the high-frequency fluctuations in the SBC, such as the spike during the "taper tantrum" of 2013. Additionally, credit risk and the "flight to safety" during times of financial uncertainty, like the Financial Crisis of 2008, can also affect the SBC and intensify its negative correlation.

In all this analysis we tend to look at long term horizons (>10 yrs), as it is likely that short-term fluctuations in the Stock-Bond Correlation (SBC) will be more difficult to predict or explain based on macroeconomic fundamentals.

Potential Solutions

A good move for investors and PMs in general would potentially be that of including an alternative Diversifier, investment in asset classes and/or strategies diverse from plain stocks and bonds allocation. There are, of course, some better alternatives to this purpose than others such as: Commodities, Dynamic strategies (such as Trend and Macro) and Long-Short Equity strategies.

• Commodities tend to have a low correlation with both stocks and bonds, on average. This low correlation makes them a good source of diversification, particularly during times of uncertainty related to inflation. A study by Brixton, Maloney, and Ooi (2022) found that a diverse portfolio of commodities can provide inflation protection that is as strong as that provided by any individual commodity sector.
• Dynamic investment strategies, such as Trend and Macro, are designed to make directional bets at any given time. However, over the long term, these strategies tend to have a low correlation with financial markets. A range of studies found that these strategies have historically performed well during times of macroeconomic volatility, including both upward and downward inflation shocks.
• Long/Short Equity strategies use financial instruments such as short selling and leverage to generate returns that are less correlated with stocks and bonds. Some of these strategies are designed to be market neutral, and they align most closely with the assumptions of the hypothetical diversifier we are looking to include in our portfolios.

Today uncertainty in markets and policies remains very high, long-term inflation expectations remain relatively stable and central banks maintain a credible reputation. The Stock-Bond Correlation (SBC) has been volatile, but it mostly remains negative. For a sustained shift towards a positive SBC, there would need to be an increase in long-term inflation uncertainty combined with supply-driven inflation shocks.