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When Do Stocks and Bonds Move Together, and Why Does it Matter?

The Issue:
Recent research has looked into what the co-movement of stocks and bonds indicates about the risk characteristics of US Treasury bonds — as…

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This article was originally published by Econofact

The Issue:

Recent research has looked into what the co-movement of stocks and bonds indicates about the risk characteristics of US Treasury bonds — as well as market expectations of the U.S. macroeconomic outlook.

The Facts:

  • While US Treasury bonds have very little risk of default, they are not risk-free assets. 
  • One measure of the risk to holding bonds in a portfolio comes from comparing how they move relative to other assets. We can calculate Beta — the standard Capital Asset Pricing Model measure of systematic risk — for long-term Treasury bonds by comparing their return with the stock market as a whole. This measure gauges the extent to which Treasury bonds move like stocks over time – or not (see chart). 
  • During the 1980s and 1990s, US Treasury bonds had a positive Beta with stocks —  when stocks went down, bonds went down; when stocks went up, bonds went up. At the time, the Fed’s monetary policy prioritized fighting inflation even though this led to disruptions in economic activity and higher unemployment. In situations like this, or if inflation rises because there’s an energy crisis or a war, the Fed will choke off inflation by raising interest rates even if it causes a recession. That’s bad for bonds and bad for stocks, and the prices of both will decline, resulting in a positive bond Beta.
  • But, around the turn of the millennium, this co-movement switched sign and became negative: bonds moved opposite stocks and served to balance portfolios. The Fed had good credibility regarding its commitment to fighting inflation and there were no major supply shocks moving inflation expectations. Under those conditions, if there’s a recession, the Fed will cut interest rates to stimulate the economy. The recession is bad for stocks. Low interest rates are good for bonds. Bond and stock prices move opposite one another and bonds, resulting in a negative bond Beta.
  • Do current conditions — high inflation, war in Ukraine, high and volatile energy prices — indicate that the U.S. economy is likely to move back to the regime of the 1980s and 1990s when stocks and bonds moved together? While the current moment has some similarities with the 1980s and 1990s, there are also important differences. The recent empirical patterns can arise when the economy is subject to strong inflationary supply shocks, like those experienced in the 1980s, but in contrast to the 1980s, markets expect the Fed to achieve a “soft landing”.


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