In the main advanced economies the correlation between returns on stocks and government bonds was positive until the end of the 1990s, but became negative afterwards; the stock/bond correlation is relevant because it allows investors to diversify their portfolios and wipe out the corresponding aggregate risks. This work analyzes the determinants of the stock/bond correlation in Germany and the US. We use a theoretical model, borrowed from the macro-finance literature, where returns on bonds are determined by the real interest rate and inflation while returns on stocks are determined by the real interest rate, inflation and the dividend yield.
The correlation between stocks and bonds is determined primarily by the variability of inflation and by the returns on stocks compared with those on bonds. Until the end of the 1990s, a positive value of the stock/bond correlation reflected the prevalence of supply shocks, largely due to increases in oil prices, which led to a countercyclical inflation trend: during recessions, as stock markets decrease, inflation rises inducing a decrease in government bond prices. From the early 2000s onwards, the stock/bond correlation has changed sign, becoming negative owing to the prevalence of procyclical inflation. During the last ten years, unconventional monetary policy measures have weakened the negative value of the correlation both in the US (in 2009-13) and Germany (in 2014-17).
Published in 2020 in: International Finance, v. 23, 3, pp. 392-416.
