What are the reasons that make stock return - bond yield correlation a meaningful one?

Question

I have come across interesting charts that show the changing correlation between stock returns and government bond yields.

My gut instinct tells me that such relationship would be expected to be negative (bond yields go up, less demand for stocks, stock returns decrease as people are no longer adequately compensated for risk and move to bonds).

However, I believe that simply stating this is not enough reasoning. I was wondering: what established theories can show that stock returns and bond yields are meaningfully connected rather than it being just a correlation in numbers and are a bit more complex than just stating that these are competing asset classes.

I assume that there must be some theory behind it as we can see the correlation move from positive to negative and vice versa but am only aware of simplistic theories that state that it should stay strictly negative. Looking for a starting point in my research.

Thank you!

Answer 1

The relationship of stocks to bonds is a very complicated question. The way I think of it is like this.

Bonds are discounted PV of known future cash flows. Equities are discounted PV of unknown future cash flows, which far from being constant are highly sensitive to the future state of the economy (corporate profits drop in a recession, etc.).

So what happens when "news" hits? If the news is purely about (higher/lower) future riskless discount rates, both equity prices and bond prices fall/rise, i.e. they move together. (Equities BTW are said to have "duration" just like bonds do).

If the "news" is about future corporate profits (e.g. "a recession is coming") then stocks drop a lot, the bonds may rise a little because riskless rates will be lower during the recession. And vice versa if the news is "no recession on the horizon, strong corporate profits expected"). In these cases bond prices and equity prices move inversely.

A third case is where the equity risk premium rises/falls for whatever reason (perhaps greater expected risk from investing in equities). In this case also stock and bond prices don't move together (the stocks move and the bonds stay about the same).

With so many moving parts it is hard to understand how it all works.

Historically, as you noted, there has been different behavior over different time periods (with the correlation sometimes changing signs). In my opinion it is not understood why this is. But generally at a monthly frequency for the past few decades bond and equity prices have tended to move largely differently (negative or near zero correlation), so that holders of 60/40 portfolios have benefited from the diversification that holding both bonds and equities provides.