Positive correlation between equity and bond returns means stock prices and bond prices move in the same direction, occurring in specific macroeconomic environments. When inflation fears (mainly due to supply shock) dominate in the market, the correlation between the bond return and the stock return becomes positive. Central banks in this environment become restrictive, hiking interest rates.
Negative correlation means stock prices and bond prices move in the opposite direction – when the bond price rises, the stock price falls, and when the bond price falls, the stock price rises. It happens when the market is dominated by growth shock (weaker growth) and demand shock rather than inflation fears. Central banks in this environment are accommodative cutting interest rates.
Positive Correlation Scenarios
High and volatile inflation (Stagflation): when inflation was running hot in 2022, central banks were forced to raise interest rates aggressively to cool down the economy. Higher rates caused bond prices to fall sharply while yields spiked up. Higher discount rates compressed equity valuations (P/E multiple got shrink) and as a result, future earnings were worth less. Both asset classes were sold off showing positive correlation.
Commodity / energy price shocks: This happened during 1973 oil crisis and Russia-Ukraine war in 2022. A supply shock raised input costs for companies shrinking their margins and raised headline inflation, which forced central banks to tighten monetary policy. Both stocks and bonds fell. Stocks fall due to reduction in margin and bonds fell due to inflation fear.
Extreme central bank tightening: In 1981 (Volcker Shock) as well as in periods where market perceives the central bank will prioritize fighting inflation over promoting maximum sustainable employment or supporting asset prices, the negative correlation between the stock return and the bond return breaks down. Both stocks and bonds will be sensitive to the path of short-term interest rates.
Deflationary crises with sovereign risk: The eurozone debt crisis in 2011-2012 marked by bailouts of Greece, Ireland and Portugal had the largest sovereign default in history (from Greece in 2012). Eurozone had a common currency but didn’t have fiscal union meaning that countries couldn’t devalue the currencies or independently adjust the monetary policy. Greece, Portugal and Ireland had large deficits and rising debt-to-GDP ratios and foreign investors stopped lending to weaker economies, driving up borrowing costs in those countries. Yields on Greek, Portuguese and Spanish bonds soared above 6 to 7% signalling default risk. Both government bonds and equities (especially from the banking sector) were sold off. Investors wanted neither stocks nor bonds from those countries showing positive correlation between the two.
Late-cycle overheating: When the economy is too strong, labour market is too tight and wage growth accelerates, yields will rise, which are bad for both stocks and bonds.
Negative Correlation Scenarios
Recession Fears / Demand Shock: During 2008 financial crisis and 2020 Covid pandemic, the economy was slowing,
corporate earnings were collapsing and investors were massively selling-off stocks. Capital fled from risky assets and hid in safe-haven government bonds. This buying demand pushed bond prices up while stock prices went down sharply. Bad economic news was good for bonds and bad for stocks showing negative correlation between the two.
Central bank easing cycles: Central banks notice economic weakness and cut interest rates or signals potential quantitative easing (QE). Expected lower future short-term interest rates will boost the present value of long-term bonds. Stocks may also rally on the promise of easier money but the initial cut is trigged due to a growth scare. If the economic growth falters further, market will expect that the Fed will cut more. This creates a benign environment for 60(consisting of stocks)/40(consisting of bonds) portfolio where stocks have downside risk but bonds have upside risk.
Low and stable inflation regime: From 1998 to 2021, inflation was anchored around 2% and inflation expectations did
not move. In this case, bond yields are purely a function of real growth expectations. When growth data is strong, stocks with good earnings will go up while bonds will go down based on rate hike fears, which shows negative correlation between stock and bond returns. When the growth data is weak, stocks will go down while bonds will go up based on rate cut hopes. However, when inflation is not anchored, this negative correlation between bonds and stocks will easily break down.
Geopolitical risk / Flight to quality / Deflationary shock: When a shock creates uncertain economic environment but does not create an oil supply shock or global trade inflation, stocks and bonds return will show negative relationship. Based on risk-off sentiment, stocks dip while safe-haven assets (US Treasuries) and currencies such as JPY, CHF will rally.
Fed mistake hedge: This happens when the market believes that monetary policy is too tight and can cause a recession. Investors buy long-duration bonds as they think the central banks will be forced to reverse its course and cut interest rates aggressively not to cause a recession. In this case, bonds act as a hedge against equity downside caused by policy error.
60/40 allocation
A 60/40 portfolio is a classic investment strategy allocating 60% of total assets to stocks and 40% to bonds to balance growth with reduced volatility. In this portfolio, stocks provide long-term appreciation while bonds cushion downturns with regular interest payments complementing dividends from stocks. Periodic rebalancing is needed to keep the ratio intact as markets shift. For example, if stocks grow to 70%, sell some equities and buy bonds through rebalancing to restore 60/40 allocation. This strategy is less volatile than all-stock portfolio but has limited upside in a strong equity bull market. The 60/40 portfolio is a moderate-risk strategy for growth and stability but its effectiveness will depend on investors’ goals and market conditions. The 60/40 allocation can deliver positive risk-adjusted returns when the following conditions are met:
Negative correlation regime (demand shock or a recession): When there is growth scare arising from a recession or a credit crunch, stocks will crash while bond yields fall (bond prices go up). The gains from 40% allocation to bonds will offset the losses from 60% allocation to equities. However, inflation cannot be the cause of a downturn in this case. When the inflation is high and stocks fall, bonds will fall as well as seen in 2022 showing positive correlation between the two.
Anchored inflation: For bonds to be the balance for the stock portfolio offsetting any potential losses, inflation must be low, stable and predictable (e.g., below 3%, 1.5%- 2.5% range). When inflation is well-anchored, central banks can easily cut interest rates during crises without worrying over inflation, which will push up long-term bond prices up. However, when inflation is unanchored (above 4% and rising), central banks can’t cut interest rates and bonds will not be able to function as a 40% hedge to the 60% stock portfolio.
A reasonable starting yield on bonds: 40% bond portfolio is supposed to generate income and provide cushion for any stock losses. In an ideal environment, bond yields will start at 4% to 6% (higher than 3% starting yield). For example, if a 10-year Treasury yields 4% and a recession hits, yield can fall to 2%. The bond price appreciation and coupons can provide a decent offset to any stock losses. However, when bond yields starting at 0% to 1% as in 2020, yields can’t fall much further to cushion a stock crash. When the interest rate is at 0%, you cannot collect income either. The entire portfolio will have to rely on stock appreciation for returns making the portfolio much riskier.
Fiscal prudence (no sovereign debt crisis): 40% allocation to bonds assumes that bonds are risk-free assets. This holds true as long as the market believes that the government can and will pay its debts without inflating them away. For example, when US dollar remains as the world’s reserve currency and its debt-to-GDP ratio is not alarming and within a sustainable range, US Treasuries can remain as a risk-free asset. However, during sovereign debt crises (Eurozone crisis in 2011 and UK Gilt crisis in 2022), both bonds and stocks were sold off as the creditworthiness of the issuers was in question.
Disinflationary Pressure: 60/40 portfolio performs best during the period of globalization (1982 – 2020 period). An expanding global workforce and technology kept a lid on wages and goods prices causing a disinflation. It created a structural tailwind for both stocks and bonds. Stocks rallied on higher corporate margins arising from productivity gains, bonds rallied on falling interest rates.