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