How Correlations Are Influenced

It’s been said diversification is the only free lunch in investing, with the largest benefits of diversification coming from adding assets with low, or—even better—negative correlations.

However, when designing portfolios, investors also need to be aware that correlations are not constant—they are averages of the relationships of returns. Thus, it’s important to understand not only that correlations can drift, but also under what circumstances the correlation of returns are likely to increase and decrease.

For example, while the correlation of high-yield bonds to stocks tends to be low, during bear markets caused by recessions, their correlation tends to rise toward 1 (at exactly the wrong time).

Thus, high-yield bonds are not as effective as safer Treasury bonds (and other high-quality bonds; the lower the credit quality, the more equity-like the risk) at diversifying equity risks.

Demonstrating their nonstable relationship, while U.S. stock and bond return correlations have been predominantly positive over the last 40 years, there have been persistent episodes of large, negative stock/bond correlations. U.S. stock/bond correlations were about 0.2 during the 1970s; increased to, on average, 0.4 during the 1980s and first half of the 1990s; and fell to, on average, -0.2 since 1998.

Correlations also varied substantially over subperiods: They were as high as 0.7 in the fall of 1994, and as low as -0.7 in the second quarter of 2003 and third quarter of 2012. The evidence on stock/bond correlations in other developed markets followed a similar pattern, suggesting that one or more common factor(s) are driving international stock/bond correlations.

The shifting correlations can often be explained by demand and supply shocks. For example, a negative supply shock (such as the 1970s oil embargo) can lead to positive correlations between stocks and bonds, as can a positive supply shock (such as from fracking). On the other hand, negative demand shocks can explain much of the negative correlations observed since 2000. Demand shocks push inflation and output in the same direction, resulting in lower stock/bond correlations.

Correlations, Monetary Policy & Inflation

Lieven Baele and Frederiek Van Holle contribute to the literature with their October 2017 study, “Stock-Bond Correlations, Macroeconomic Regimes and Monetary Policy,” which examined the relationships between high, intermediate and low inflation, output regimes and monetary policy.

The authors note that, in terms of monetary policy, in an accommodating regime, output stabilization dominates policy, while in a restrictive regime, the central bank is mainly focused on controlling inflation. Their data set consisted of daily total equity index and 10-year benchmark bond returns for 10 developed markets (the United States, Canada, Japan, the U.K., Germany, France, the Netherlands, Belgium, Italy and Spain).

The dataset’s starting dates varied because of the lack of daily data, with the longest series being for the United States and starting in June 1961. For several other countries, however, the sample starts at the end of the 1980s or early 1990s. The end date is December 2013.

Following is a summary of their findings:

  • There is a strong association between stock/bond correlations and monetary policy regimes.
  • Stock/bond correlations tend to be slightly negative in recessions and positive in expansions.
  • Negative stock/bond correlations are associated with periods of accommodating monetary policy, but only in times of low inflation.
  • Irrespective of the inflation and/or growth regime, stock/bond correlations are always positive when monetary policy is restrictive.
  • Pure inflation and growth regimes have little explanatory power for stock/bond correlations.
  • In the low-inflation regime, inflation averaged 1.9%. Inflation volatility was also low, at 0.5%. In the intermediate-inflation regime, inflation averaged 4.2%, and its volatility was 0.9%. In the high-inflation regime, inflation averaged 10.5%, and its volatility was 2.7%. The low-inflation and high-inflation regimes both had an expected duration of about 11 years, compared to about five years for the medium-inflation regime.

Baele and Van Holle also found that, irrespective of the inflation or output regime, stock/bond correlations turn positive as soon as monetary policy turns restrictive.

They provided the following intuition: “In the low inflation state, investors are mainly concerned about the economy entering into a deflationary spiral. Accommodating monetary policy reduces the likelihood of this bad state, and instead makes positive inflation shocks more likely, leading to a drop in bond prices. At the same time, by reducing the likelihood of a deflationary state, a credible monetary policy stimulus also raises growth expectations and hence stock prices. In addition to a pure cash flow effect, accommodating policy may lead to increasing equity prices through its dampening effects on both economic uncertainty and risk aversion, and hence risk premia, amplifying the initial cash flow induced increase in equity prices. When instead monetary policy is restrictive, central banks are expected to react strongly to inflation shocks by (more than proportionally) raising short-term interest rates. This does not only lead to a drop in bond prices, but also to lower real output and equity prices, and hence a positive stock-bond correlation.”

They added: “In a low inflation environment, positive inflation shocks decrease investor beliefs of being in a bad deflationary state. This subsequently leads to higher expectations about future output and inflation, and hence to negative stock-bond correlations. In a very high inflation regime instead, positive inflation shocks confirm investors’ fears of being in a bad stagflationary regime. This moves both stock and bond prices down, leading to positive stock-bond correlations.”

Global Factors Dominate

Baele and Van Holle observed that the strong commonality of correlations around the globe suggests that global—rather than local—factors are generally driving international stock/bond correlations. They found no systematic relationship between the state of the economy and stock/bond correlations. The only major exception was Japan, where correlations dropped to negative values in mid-1993. Since the early 1990s, the Japanese economy has been characterized by low growth and persistent periods of deflation.

They also observed stronger negative correlations in flight-to-quality countries, such as the United States and Germany. In contrast, correlations in peripheral euro countries—such as Italy and Spain—rose substantially during the sovereign debt crisis, as concerns about potential sovereign defaults negatively affected bond and equity markets. Thus, there are times when local conditions dominate, which is why investors should never have all their eggs in one risk basket.

Baele and Van Holle concluded: “Our findings are consistent with recent theoretical research that attributes an important role not only to the cyclicality of inflation but also to monetary policy stance for understanding the dynamics of stock-bond correlations.”

Importantly, they noted that “the historical evidence demonstrates that when inflation is countercyclical, both equities and bonds are risky and move positively with inflation risk, inducing a positive correlation. When, instead, inflation is procyclical, equity and bond risk premia are negatively correlated as nominal bonds act as a hedge, inducing a negative stock-bond correlation. This does not only imply that higher values for inflation imply a higher probability of the economy being in a bad state, but also that positive inflation shocks may be interpreted as being either good or bad news about the future economy.”


The evidence presented by Baele and Van Holle demonstrates the importance of understanding the shifting nature of the correlation of returns between stocks and bonds, and that it depends on a variety of factors, including the presence of demand/supply shocks, monetary policy regime, economic regime and inflation regime.

In other words, even safe bonds (at least longer-term ones) cannot always be counted on to provide havens from bear markets in stocks. Their findings also highlight the important role central banks play in determining the stock/bond correlation.

Given the authors’ finding that, irrespective of the inflation and/or growth regime, stock/bond correlations are always positive when monetary policy is restrictive, and that, at least for the United States, the Federal Reserve appears to be at the end of its accommodative policy stance, with three rate increases forecasted for 2018 following the three in 2017, investors should now expect the correlations of stocks and bonds to turn positive, reducing the diversification benefits of safe bonds.

Of course, the fact that the correlations have been positive doesn’t tell you in which direction the stock and bond markets are going move, only that their returns are likely to be positively correlated.

Given the potential for a reduced diversification benefit from safe bonds, we recommend investors consider such alternative investments as AQR’s Style Premia Alternative Fund (QSPRX), its new Alternative Risk Premia Fund (QRPRX) and its Managed Futures funds (AQMRX and QMHRX), as well as three funds from Stone Ridge: its reinsurance fund (SRRIX), its alternative lending fund (LENDX) and its variance risk premium fund (AVRPX).* (Full disclosure: My firm recommends AQR and Stone Ridge funds in constructing client portfolios.)

All of these alternatives have no-to-low correlation with both stocks and bonds. While alternative lending does take on some equitylike risks due to risks associated with unemployment, it minimizes inflation risk, as the duration of these funds is only about 1.5 years. We believe these funds offer equitylike forward-looking returns with less-than-equity-like volatility.** That means a much higher forward-looking return expectation than for safe bonds, but not much higher volatility (at least for a portfolio of alternatives, due to their return correlations being low, once again demonstrating the benefits of diversification).

*The funds referenced herein are provided for informational purposes only and is not intended to serve as specific investment or financial advice. This list of funds does not constitute a recommendation to purchase a single specific security, and it should not be assumed the securities referenced herein were or will prove to be profitable. Prior to making any investment, an investor should carefully consider the fund’s risks and investment objectives, and evaluate all offering materials and other documents associated with the investment.

**It is important to understand expected returns are the mean of a very wide potential distribution of possible returns. Thus, they are not a guarantee of future results. Expected returns are forward-looking forecasts and are subject to numerous assumptions, risks and uncertainties, which change over time, and actual results may differ materially from those anticipated in an expected return forecast. Expected return forecasts are hypothetical in nature and should not be interpreted as a demonstration of actual performance results or be interpreted as a target return.

Larry Swedroe is the director of research for The BAM Alliance.   

This commentary originally appeared March 7 on

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