Stocks, Bonds, and Causality

Abstract

In this article, the authors estimate a model establishing the casual relationships between equity and government bond returns. They show that the relationship between stocks and bonds—whether they are positively or negatively related—depends largely on whether a shock emanates from the stock market or the bond market. Equity market shocks are associated with flight-to-quality effets and a negative relationship, whereas bond market shocks typically induce a positive stock-bond relationship. The authors show that the relationship between those two asset classes depends critically on the level of market valuation. When markets are cheap or expensive, the effect of valuation can dominate the transitory impact of equity or bond market shocks. Therefore, investors who wish to form a forward-looking view on the stock-bond relation need to take current market valuation into account.

TOPICS: Fixed income and structured finance, portfolio management/multi-asset allocation, risk management