Home AM Insights What Drives Equity-Bond Correlations?

What Drives Equity-Bond Correlations?

Stockholm (Ekonamik) – “Investment, over the last 30 years, based on a 60/40 strategy, would have been effective both in terms of smoothing out volatility (the main aim) but also delivering a superior return,” says David Brett Investment Writer at Schroders.

“In its simplest form, the 60/40 rule means having 60% of your portfolio invested in potentially higher risk, historically higher return, assets such as stocks and the other 40% invested in lower risk, but also traditionally lower return, assets such government bonds,” explains the author. The theory is consistent with the oft-quoted argument that equity and bond markets are negatively correlated. As a result, this investment approach should “provide equity-like returns while smoothing out the extreme highs and lows (volatility) that come with an equity-only portfolio”.

In a recent research note, Winton Capital takes a historical perspective to challenge the often-quoted assumption that equities and bonds are negatively correlated. Using correlations over a 52-week rolling window to study this issue since the 1960s, the asset manager’s researchers show that the negative correlation is a relatively recent phenomenon.

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According to the data, equity and bond markets were positively for the vast majority of the four decades between 1960 and 2000. Most episodes of negative correlation up until the new millennium were consistent with episodes of economic turbulence at the end of the 1970s, 1980s and 1990s. However, from 2000 onwards, the correlation inverts itself completely and becomes negative. “Before January 1998, the average correlation was positive with a value of 24%; afterwards, this figure dropped to -35%,” according to the research note.

Uncertain as to whether a single figure captures the complexity of this relationship, Winton Capital shows that the distribution of equity-bond correlations is unusually flat and without a clear peak in comparison to the distribution of other correlations. “While it seems that the correlation of other sector pairs could be modelled reasonably well by a normal distribution, such a model would not capture the variability seen in the historical equity-bond correlation. Given this complexity, it may be better to use an empirical model based on the observed correlation,” the report notes.

Academic research has postulated a range of explanations for this change in the direction of the correlation. The shift from positive to negative correlation was observed in real-time and discussed at length by Anti Ilmanen in a September 2003 article in The Journal of Fixed Income. He was among the first to note that this new trend should “boost government bond valuations owing to bonds’ attractive hedging characteristics”. The year after, Anderson, Krylova and Vähämaa explored this correlation from a macroeconomic perspective. They showed 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 the lowest levels of inflation expectations.” They also note that “consistently with the ‘flight-to-quality’ phenomenon, the results suggest that high stock market uncertainty leads to a decoupling between stock and bond prices.” Finally, the 2004 study suggested that economic growth expectations play no role in the stock-bond return correlation. From a purely financial perspective, PIMCO argued that the correlation appears to be driven by shocks in either of the markets, turning negative if there is a shock specific to equity markets and positive when there’s a shock in bond markets.

According to 2015 research from Jonas Gusset and Heinz Zimmermann, central banks might be able to affect the bond-equity correlation. “Correlations decrease after positive monetary shocks (decreasing rates) as well as in times with large central bank activity (high rate volatility regimes),” the authors conclude.

Filipe Wallin Albuquerque
Filipe Wallin Albuquerque
Filipe is an economist with 8 years of experience in macroeconomic and financial analysis for the Economist Intelligence Unit, the UN World Institute for Development Economic Research, the Stockholm School of Economics and the School of Oriental and African Studies. Filipe holds a MSc in European Political Economy from the LSE and a MSc in Economics from the University of London, where he currently is a PhD candidate.

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