A new paper by Malcolm Baker and Jeffrey Wurgler looks at the “Co-movement and Predictability Relationships between Bonds and the Cross-Section of Stocks”:
The empirical relationships between the stock and bond markets are of considerable interest to economists, policymakers, and investors. Economists are interested in understanding the mechanisms that link these markets. Through such understanding, financial market regulators aim to improve the markets’ information aggregation and capital allocation functions and their robustness to shocks to the financial system. Investors want to know the return and diversification propeties of major asset classes.
The relationships between stock and bond returns have proved difficult to pin down, however, let alone understand. Over the last four decades, the correlation between stock index and government bond returns has been highly unstable. Baele, Bekaert, and Inghelbrecht (2009), for example, find that the daily correlation between stock and bond indices is on average modestly positive but has ranged anywhere from +0.60 to -0.60 over the last forty years and exhibits sharp changes of 0.20 or more. In negative correlation periods the markets are said to have “decoupled.” Many attempts have been made to explain this time variation, but no consensus exists, and the literatures on stock and bond pricing remain rather separate.
In this paper we look at these two markets from a different perspective. We document and discuss the links between government bonds and the cross-section of stocks. Prior research has focused almost exclusively on index-level time-series relationships. The cross-sectional perspective complements this research, and it uncovers new and robust facts about the connections between stocks and bonds. Download the full paper here.