Forecasting Short-Term Stock-Bond Correlation

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Stock-bond correlation is a critical factor in portfolio diversification, influencing how different asset classes interact during market movements. The correlation between stocks and bonds helps investors understand the degree to which these two assets move in relation to each other.

In the years of 2010s, stocks and bonds have had a negative correlation, meaning they tend to move in opposite directions. When stocks perform well, bonds may experience a decline, and vice versa. This negative correlation is valuable for portfolio diversification because it implies that during times of stock market volatility or downturns, the value of bonds may rise, providing a potential buffer for overall portfolio losses.

Recently, the stock-bond correlation has turned positive, resulting in losses for 60/40 and risk-parity portfolios. To manage these portfolios, an important question arises: can we forecast stock-bond correlation?

Reference [1] examines this question. It employs a country’s Correlation Outlook, Prospective Inflation Volatility, the Yield Curve Momentum Regime, and the Trailing 3-month stock-bond correlation to build a predictive model. The authors pointed out,

This paper builds on a framework that uses macroeconomic drivers to explain long-term variation in the correlation between stocks and bonds. The existing work focuses on the relative volatility of growth and inflation and the correlation between them and explains about 70 percent of the variation in rolling 10-year stock-bond correlation. We focus on forecasting short-term variation in stock-bond correlation with measures that capture the extent to which individual forecasters’ predictions about those markets have the same sign or opposing signs. Our framework enhances stock-bond correlation forecasting at tactical horizons, which we define here as the next three months.

In short, it is possible to forecast short-term correlation.

This article offers guidelines for modeling correlations, a critical aspect of managing portfolio risks.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Flannery, Garth and Bergstresser, Daniel, A Changing Stock-Bond Correlation: Explaining Short-term Fluctuations (2023). SSRN: https://ssrn.com/abstract=4672744

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