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Macroeconomic Factors and the Correlation of Stock and Bond Returns

Author

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  • Lingfeng Li

    (Yale University, Faculty of Arts & Sciences, Department of Economics (Box 8268))

Abstract

This paper examines the correlation between stock and bond returns. It first documents that the major trends in stock-bond correlation for G7 countries follow a similar reverting pattern in the past forty years. Next, an asset pricing model is employed to show that the correlation of stock and bond returns can be explained by their common exposure to macroeconomic factors. The link between the stock-bond correlation and macroeconomic factors is examined using three successively more realistic formulations of asset return dynamics. Empirical results indicate that the major trends in stock-bond correlation are determined primarily by uncertainty about expected inflation. Unexpected inflation and the real interest rate are significant to a lesser degree. Forecasting this stock-bond correlation using macroeconomic factors also helps improve investors' asset allocation decisions. One implication of this link between trends in stock-bond correlation and inflation risk is the Murphy's Law of Diversification: Diversification opportunities are least available when they are most needed.

Suggested Citation

  • Lingfeng Li, 2003. "Macroeconomic Factors and the Correlation of Stock and Bond Returns," Yale School of Management Working Papers ysm324, Yale School of Management.
    • Handle: RePEc:ysm:somwrk:ysm324
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    Cited by:

    1. Marcello Pericoli, 2020. "On risk factors of the stock–bond correlation," International Finance, Wiley Blackwell, vol. 23(3), pages 392-416, December.
    2. Marcello Pericoli, 2018. "Macroeconomics determinants of the correlation between stocks and bonds," Temi di discussione (Economic working papers) 1198, Bank of Italy, Economic Research and International Relations Area.
    3. Khanna, Tarun & Thomas, Catherine, 2009. "Synchronicity and firm interlocks in an emerging market," Journal of Financial Economics, Elsevier, vol. 92(2), pages 182-204, May.

    More about this item

    Keywords

    Stock-Bond Correlation; Asset Allocation; Macroeconomic Factors;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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