Stock-Bond Correlation and Duration Risk Allocation

Abstract

Using weekly stock-bond correlations estimated with high-frequency data, the authors find that a lower (more negative) stock-bond correlation forecasts falling 10-year interest rates over the coming weeks, and it also forecasts a falling 1-year interest rates over the next year. The reverse is true when the stock-bond correlation is higher (more positive). Therefore, investors, in particular those with long-term bond-like liabilities, should take greater duration risk when the recent stock-bond correlations are lower. The authors propose two possible explanations of such predictive power: (1) the markets and/or policymakers’ under-reaction to the changing economic conditions implied by the stock-bond correlation; and (2) the markets’ initial under-reaction to the long-term bonds’ safe-haven status.

Keywords: Stock-bond correlation, Safe-haven, Portfolio Management