Indrani De, CFA, PRA
Mark Barnes, Ph D,
Robin Marshall, M.A., M. Phil,
Alex Nae, M.Sc
- Evidence from FTSE Russell indices shows higher correlation of multi-asset returns persisted in the post-Covid period, despite disinflation…
- …with confirmation of a structural break higher in 2021 for asset return correlations across bonds, equities and credit
- It is too early to draw structural conclusions about the durability of this increase in the correlations of returns…
- …but its persistence may be due to higher for longer short rates and inertia in core inflation.
- The results indicate inflation is a strong driver of the higher correlation in returns, even if the relationship is non-linear, with non-linearity evident when inflation moves above Fed target levels.
- This makes portfolio diversification benefits (particularly from sovereign bonds), based on the so-called 60/40 model – 60% equity weighting, 40% in bonds - more variable over time.
Introduction
Figure 1: Correlation of 7-10 year Treasuries with Russell 1000 index
Source: FTSE Russell, data from January 1994 to April 2024. Please see the disclaimers for important legal disclosures.
Changes in key macro drivers may explain both the changes in the correlation of asset returns and in the underlying volatility of returns (which, in turn, drive the higher correlations). So, in a longer paper, published this month, we seek to identify the key drivers of correlations in returns, using FTSE Russell multi-asset index data since 2000. To assess the correlations in returns, we looked at the purest risk-off asset in US Treasuries, using the FTSE Russell 7-10 year Treasury index returns, and its correlation coefficient with US equity returns, using the Russell 1000 index.
Pre-Covid, low inflation meant growth & deflationary shocks drove low correlations
Since Covid, a perfect storm of higher inflation and short rates may have driven high return correlations
Evidence of the impact of higher inflation on asset return correlations since Covid, may be found in Figure 2. Of course, this does not establish a causal link to higher inflation and it may also be due to the sharp rise in short interest rates that followed. But it is consistent with longer term evidence showing “ higher stock-bond correlations tend to follow higher short rates and (to a lesser extent) higher inflation rates “[3] Intriguingly, the correlation of returns also remained high in 2023, when US inflation fell sharply, suggesting the relationship may not be one-directional with inflation, and could be non-linear.
Figure 2: US inflation and correlation of US 7-10 year Treasury and Russell 1000 returns.
Source: FTSE Russell and Refinitiv-Datastream. T Please see the disclaimers for important legal disclosures.
Finally, extending the analysis to other asset classes in fixed income delivers similar results, with correlations of returns again showing a structural break higher after Covid, as Figure 3 shows. The results reflect the risk characteristics of different asset classes, with risk-on high yield credit showing higher correlation to equity returns in all periods. In fact, HY is the only asset class that does not show a structural break higher in correlations since Covid.
Figure 3: Asset class correlation of US 7-10 yr Treasury and Russell 1000 returns.
Source: FTSE Russell and Refinitiv-Datastream. T Please see the disclaimers for important legal disclosures.
1. A marriage of inconvenience: the remarkable harmony between stocks and bonds”, LSEG, April 2023.
2. See “Inflation and Asset returns “, Anna Cieslak and Carolin Pflueger, Working paper No. 2023-34, Becker Friedman Institute, University of Chicago, March 2023.
3. The stock–bond correlation and macroeconomic conditions: One and a half centuries of evidence”, Jian Yang, Ying-gang Zhou, and Zijun Wang, Journal of Banking and Finance, April 2009
Disclaimer
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