For the past 20 years, when U.S. stocks have gone up, U.S. bonds have generally gone down — and vice-versa.

If this negative correlation between stocks and bonds were to turn positive, that could force institutional investors to rethink their portfolios.

The current negative correlation regime has been beneficial to institutional investors, allowing stocks and bonds to hedge each other and providing chief investment officers with opportunities to increase equity allocations while maintaining a portfolio risk budget. A positive stock-bond correlation would eliminate those hedge benefits, pushing CIOs to restructure their allocations across asset classes and reevaluate their portfolio risk management.

“A positive correlation has the opposite effect [of a negative correlation],” PGIM managing director Noah Weisberger told Institutional Investor. “If one is doing well, then the other is doing well. And when one is doing badly, the other is doing badly. So, you get an amplification of the fluctuation. Whatever is driving the returns of the one asset is also driving the returns of the other asset.” 

In a study expected to be released on Thursday, Weisberger and PGIM vice president Junying Shen identified the macroeconomic conditions that drive both negative and positive stock-bond correlations and showed how these conditions were linked to specific monetary and fiscal policy over the past 70 years. Using historical stock information from the S&P 500 index and bond data from 10-year Treasury notes, Shen and Weisberger found that the negativity or positivity of a stock-bond correlation is dependent on the macroeconomic context. 

The correlation between stocks and bonds has been negative since 2000. Before that, the last time the correlation was negative was from 1950 to 1965. Weisberger and Shen found that during both time periods, certain macroeconomic conditions — like low and stable risk-free interest rates, low and stable inflation, a positive correlation between economic growth and rates, and diverging equity risk premiums and bond risk premiums — may have created an optimal fiscal environment for a negative correlation regime. Specific economic and policy drivers — rules-based monetary policy, sustainable fiscal policy, independent fiscal and monetary policy, and demand shocks — may have also contributed to the present and past negative correlations.

“Stock-bond correlation is in our view, reliably associated with interest rate volatility, the co-movement of economic growth and interest rates, and the co-movement of equity and bond risk premia, both in theory and in the data,” Shen and Weisberger wrote in the paper. “These economic conditions themselves are best thought of as ‘symptoms’ of the underlying macroeconomic environment, which ultimately relates to monetary and fiscal policy and broad economic shifts.”

What Happens When Stocks and Bonds Move in Tandem

The stock-bond correlation hasn’t always been negative, meaning it’s not “immutable,” the co-authors said. From 1965 to 2000, stocks and bonds generally moved in the same direction. Weisberger and Shen documented macroeconomic conditions like high and variable risk-free rates, high and variable inflation, a negative correlation between growth and rates correlation, and equity risk premium and bond risk premium moving together as symptoms of this positive regime. Economic and policy drivers included monetary surprises, unsustainable fiscal policy, interdependent fiscal and monetary policy, and supply shocks. 

Weisberger said the effects of a positive correlation are not ideal for investors, who want security. Asset allocators, he said, want to know that if one asset goes down, the other will be able to do well and compensate for any losses — hence, the preferred negative correlation. 

“Investors may be less willing to pay top-dollar for correlated portfolio inputs, reducing valuations as investors demand higher expected forward returns to compensate for bearing greater cross-asset risk,” Weisberger and Shen wrote in the report. “Such a paradigm shift would affect asset allocation decisions and long-term capital market assumptions.”

They added that understanding the relationship between stock-bond correlation regimes and economic conditions and policy is not a remedy to the issue but a “roadmap.” The co-authors encouraged CIOs to “vigilantly monitor” crucial economic and policy changes that may impact the stock-bond correlation, including changes like interest rate volatility, the co-movement of bond and equity risk premia, and the co-movement of economic growth and interest rates.

“Anticipating changes in correlation is an exercise in foreseeing how policy makers will likely behave and how economic data respond,” they said in the paper. “Although the current negative stock-bond correlation regime has coincided with persistently falling and low interest rates, continued low interest rates alone are not enough to support a negative correlation. Focus ought to be on the broader policy backdrop and its implications.”

As for the future of stock-bond correlation, the PGIM researchers explained that while neither theory nor data point to a single macroeconomic policy that determines whether the correlation between stocks ands bonds will change, “prudence dictates being attuned to a potential change in the correlation regime.” 

If the current correlation regime were to change from negative to positive, Weisberger said investors have options. A shift would mean that stocks and bonds would no longer hedge each other, increasing the volatility and value-at-risk of a balanced portfolio and decreasing the portfolio’s risk-reward profile, according to the report. If everything else stayed the same, investors could either keep the same level of returns with higher risk, or they can lose some of their returns and maintain their risk budgets, Weisberger said.

For asset allocators, watching for correlation regime changes may be less important than being aware of the implications of larger, macroeconomic factors, Weisberger said. Often, conversations about macroeconomic factors and regime changes are divorced from one another, but Weisberger said he hopes his research will help asset allocators understand the two as related in a broader context.