The stock-bond correlation measures whether equity and Treasury bond returns move together (positive correlation) or in opposite directions (negative correlation). It is the single most important parameter in multi-asset portfolio construction.
Historical regimes:
- 1960s-1990s: predominantly positive correlation. Rising inflation drove both stocks and bonds down; the "Fed model" of equity valuation tied stock prices to bond yields.
- 2000-2021: predominantly negative correlation. Growth shocks dominated — bad economic news pushed stocks down and bonds up (the "flight to quality" response).
- 2022-present: correlation turned positive again as inflation re-emerged as the dominant risk factor, simultaneously hurting both stocks and bonds.
The blog series "Is Gold a Stock-Bond Diversifier?" (Parts 1-4) and "The End of the Hedge" provide extensive analysis of this relationship:
- When growth risk dominates, correlation is negative (good for diversification)
- When inflation risk dominates, correlation is positive (diversification breaks down)
- The transition between regimes is gradual and detectable through rolling correlation analysis
The sign and magnitude of the correlation has direct implications for:
- 60/40 portfolio effectiveness: negative correlation is necessary for bonds to hedge equities
- Optimal portfolio weights: the equilibrium allocation to bonds increases when correlation is more negative
- Risk budgeting: the portfolio's risk changes dramatically depending on the correlation regime
- Asset pricing: the required term premium on bonds depends partly on their hedging properties