Equity-Bond Correlations

The equity-bond correlation measures the comovement between returns on stocks (the change in equity index prices) and the returns on bonds (the change in yield).

A positive correlation arises when stock returns increase in step with long term bond interest rates. It is associated with a prevalence of demand shocks as the primary source of risks.

A negative correlation arises when stock returns decrease while long term bond interest rates increase (or vice versa). It is associated with a prevalence of supply shocks as the primary source of risks.

This is because bond yields reflect the cost of borrowing to increase productive capacity of the economy while stock returns represent the expectations of the profitability of that investment. If an increase in interest rates is associated with increased profitability it implies that the expected demand response domminates the supply response.

Recent trends

The equity-bond correlation in the Australian and United States markets are generally very similar, this reflects the globalised nature of markets, syncronisation of interest rates and returns in bond and equity markets.

The US has been more consistently positively correlated over the 2000 to 2020 window. Australia has had slighly lower correlations over most of this period with the exception of the post GFC mining investmnent boom. Since 2023 and the post COVID inflation spike both countries have shifted back to a consistently negative correlations.

Sources:

• US Correlation: US 10 Year Treasury Bond Yield & US S&P 500 Index Returns
• Australian Correlation: Australian Commonwealth Government Bond 10 Year Yield & ASX All Ordinaries Index Returns

Log difference returns are used for all series. In contrast to other papers which use fixed rolling windows, the estimates above use an exponetially weighted movinig average correlation. This method allows short term correlation shocks such as the COVID shut down spikes, to dissipate progressively form the estimate.