Correlations between Bonds and Stocks: The Seen and the Unseen
Written by QuantArt Market
Forex Hedging | 02 min Read
Most people use statistics as a drunken man uses lamp-post, for support rather than for illumination” – Andrew Lang, 19th-century Scottish poet
Our brains have been evolved to prefer stories over numbers, especially large numbers with complex statistics. This is especially true in this day and age when most eloquent stories can serve false narratives. The frames of references with which we see everything around us are susceptible to behavioural biases. In fact, we live in the universe of accepting facts, outside which no fact matter.
In a recent study, we plotted the last 20 years data of US 10Y and US 2Y bonds and checked how that works as a predictor of USD-INR, Dollar Index, Sensex, DJIA, S&P 500, EUR-USD, Gold & Copper futures on a lead indicator basis. We calculated lead-lag correlation, used forecast function etc to draw our inferences, and discovered few notorious trends! We will be talking only about bonds and stocks in this article.
To begin with look at the above two images. The first graph shows the correlation between S&P 500 and 10 year U.S. Treasury Returns and the second graph shows the correlation between the CHANGES of these two variables. The graphs depict contrasting trend lines. The point here is how easily even the simplest of data points can be manipulated using statistical jugglery to prove the bounded assumptions.
To understand this better, think of it this way: Mutual funds don’t live forever- some make money and some die. However, in the market, the data is quoted for only those funds which make money. Hence it’s not right to judge the returns on a decade’s worth of mutual funds by looking at the returns of those which exist at the end of ten years. This is a simple example of Survivorship Bias, which many people don’t factor-in while making investment decisions.
Coming back to our research, we have often heard that bonds and stocks have a negative correlation. While correlation tells us the direction and magnitude of the relationship between two variables, it’s not a good measure to understand the relative change in prices between two variables. In fact in the graph given below, given the contrasting correlation, a fund manager will be sceptical of using bonds in the portfolio as a hedge for stocks, although in reality bonds acted as a good hedge.
|Start Date||End Date||In-Sample Correlation||Equity||Bond|
Historically, the negative correlation regime in the U.S market began at some point around the late 1990s, following the period of positive correlation that had prevailed over the previous three decades (can see in the first graph).
The fact that bonds & stocks have a negative correlation, has given bonds a more substantial role in the construction of a diversified portfolio. This change from positive to negative was attributed to an efficient central banking system and its ability to control inflation (Can also see graph below). A paper by The Federal Bank of San Francisco stated “ Researchers have found that stability of inflation expectations since the late ’90s in the US has significantly reduced the inflation itself”. We needed this bit of insight to understand the larger picture.
If we plot the correlation between US 10Y and Dow changes, we see that the correlation hovers between positive and negative territory. However, this simple presentation of data might not be helpful. For the uninitiated, there is an obvious lag between how these variables work. There are many factors but mainly it is because different market participants perceive information at different timings and they interpret it differently. When we plot the graph for the period when this lag is maximized, we see the correlation to be largely in the negative territory.
How does everything add up? During the past few weeks, we have seen the stock markets rally along with the rising yields. We fear if this trend is magnified, the correlations might turn positive. Jerome Powell called the recent run-up in yields “a statement of confidence” in the economic outlook. Generally, bond yields reflect the growth and inflation mix in the economy. If growth is robust, bond yields are usually rising. Theoretically, a higher bond yield must be bad for equities also as their borrowing rate has risen, but we will look at why bond yields are changing and not just the direction of change.
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Our clients include Tata Group, AV Birla Group, Sterlite Group, Reliance group, Top Banks, NBFCs, MSMEs, and MNCs. Our senior advisors are specialists in treasury management and ex-bankers having worked with JPMorgan, HSBC, Goldman, etc before joining QuantArt. And have been in business for the last 8 years.
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