The ability of one asset to hedge losses in another asset is of fundamental importance to the investment community. For such diversification to occur, the returns of these two assets must be negatively correlated. Recent evidence suggests that in the case of stocks and bonds, not only does the correlation of their returns change with time, but that this correlation has become increasingly positive in recent years. We expand on this topic by considering the extent to which movements in the stock-bond returns correlation can be explained by macroeconomic fundamentals. This analysis is conducted for the U.S. and the U.K., and considers the correlation of major equity indices with both 3 Month Treasury Bill and 10 Year Government Bond returns. The explanatory variables considered in this analysis include inflation, output growth, monetary policy and the term spread. Additionally, we consider output growth and inflation uncertainty. The inclusion of these variables is a key novelty of this examination.
We employ the asymmetric BEKK multivariate GARCH model of Kroner and Ng (1998). This model allows for asymmetries and spill-over effects in the conditional variance and covariance of financial returns. Our results indicate that in all four asset pairings, the conditional correlation has varied significantly across the sample period. However, these movements appear to be largely independent of the prevailing macroeconomic circumstances. Changes in the monetary policy cash rate, output and inflation uncertainty and inflation are found to be significant in some cases. Although, models which include such variables perform little better than the reference autoregressive model. Finally, we examine the estimated returns correlation during four major market crashes. In all events, the correlations are positive, a result which is consistent with 'Murphy's Law of Diversification': the benefits of diversification are least available when most required. These results have important implications for the investment community as well as Central Bankers whom must closely monitor developments in financial markets.