iFund – Changes in stock – bond correlation

2019-10-11 03:01
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Since 2000, the correlation between the two has changed from positive to negative. Why? The main reason is that the central bank has been good at managing markets’ inflation expectations, which has maintained at a low level for two decades.

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Correlation is a statistical concept. In finance, it is often used to measure the relationship between changes in the return of two assets. Nowadays, many people believe that bonds can act as a hedge against falling stock prices. In other words, prices of stocks and bonds move in different direction. However, looking at past history, we have found another story.

Figure 1: Correlation between S&P 500 Index and 10-year US Treasury Returns

Source: D.E. Shaw & Co

As shown on figure 1, from 1966 to around 2000, the correlation between the S&P 500 Index and the 10-year US Treasury bond returns was positive. Both assets’ price moved in the same direction. During this period, it was difficult to hedge against falling stock prices with buying bonds. However, since 2000, the correlation between the two has changed from positive to negative. Why? The main reason is that the central bank has been good at managing markets’ inflation expectations, which has maintained at a low level for two decades (see Figure 2).

Figure 2: Long-Term Inflation Expectations and 10-year US Treasury Yields

Source: D.E. Shaw & Co

This argument can be proven by studying the relationship between stock-bond correlation and long-term inflation expectations (see Figure 3). We believe that if the central bank is able to successfully stabilize inflation expectations like it did in the past, and the stock-bond correlation will still maintain a negative one. It means bonds are still a good hedge against stock market decline.

Figure 3: Stock-Bond Correlation and Long-Term Inflation Expectations

Source: D.E. Shaw & Co

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