Bitesize: 250 years of the bond-equity correlation

Matt Roberts-Sklar.

For most of the 18th-20th centuries, government bonds usually behaved like a risky asset. When equity prices fell, bond yields rose, i.e.  bond and equity returns were positively correlated (bond prices move inversely to yields). But since the mid-2000s, bond and equity returns have been negatively correlated, i.e. bonds became a hedge for risk. Before this, the last time this correlation was near zero for a prolonged period was the long depression in the late 19th century.

Bond-equity correlation

Source: Thomas and Dimsdale (2016) and author calculations.
Line shows ten year trailing correlation of monthly returns.

The change in the bond-equity correlation since the mid-2000s partly reflects investors being less worried about inflation risks. As well as demand-type shocks being more prevalent than supply-type shocks, the introduction of credible inflation targeting has helped anchor inflation expectations and reduced the likelihood of high inflation risks. Investors may also have become more focussed on bad states of the world.

At the same time, there has been a structural increase in demand for ‘safe assets’, with more investors demanding safe government bonds for reasons unrelated to their expected cashflows. This has been exacerbated during and since the financial crisis, with deterioration in risk sentiment leading to episodic ‘flight to safety’.  And the addition of QE and forward guidance to the monetary policy toolbox may mean long-term bonds react differently to previously.

Matt Roberts-Sklar works in the Bank’s Macro Financial Analysis Division.

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3 Comments

Filed under Bitesize, Economic History, Financial Markets

3 responses to “Bitesize: 250 years of the bond-equity correlation

  1. Doug Chorna

    This doesn’t make sense, to me.
    Stocks and bonds are both up tremendously since 2009.
    Seems like they are highly correlated for the last 7 years, other than during the brief flights to bonds (during stock market corrections).

  2. Con Keating

    Thank you for this work. I think that the three centuries dataset is a remarkably useful resource for analysts
    Con Keating
    Chairman
    EFFAS Bond Commission

  3. David Cule

    Maybe it depends how you define risky? Any 1960/1970 (even 1980) will tell you bonds are the natural investment of Pension Funds and Insurance Companies. It was the “cult of the equity” that changed this thinking ( and ultimately fuelled the dot com boom). So maybe the millennium crash in equities relative to bonds is not a change in nature of bonds – but equities going from a non risky asset ( equities always beat bonds in the long term) to a much more risky asset class now. Bonds still do what they always do – pay out when you want them and this is clearly valued at this time

    Really good graph though !!