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Lorenzo Pangallo

16 November 2022
Financial Stability Review Issue 2, 2022
In many previous editions of the FSR, we have warned about the risk of a “disorderly correction in asset markets”. In the most recent publication, we argued that higher than expected inflation can increase this risk and provide some arguments to substantiate this claim. However, with the inflation remaining a key topic, our “warning” needs to be better substantiated and more specific. The analytics in the box do exactly this. In both 2021 2022, the 12-month correlation between daily US bond and stock returns has crossed into positive territory. The assumption of having a low correlation between stock and bond returns has historically been one of the bedrocks of strategic asset allocation (e.g. the “standard” 60-40 split). The resulting diversification benefits, however, are contingent on the low correlation between asset classes. Higher or unstable cross-asset correlations complicate portfolio optimisation and risk management, and could also destabilise bond markets, where volatility is already elevated. We discuss the challenges that this poses for portfolio management and the implications for financial stability. Then we go on to investigate the direct and indirect drivers of the stock-bond correlation. We find empirical evidence that the current higher correlation, with its associated financial stability risks, may be driven by the present high inflation environment and related monetary policy expectations.
JEL Code
C21 : Mathematical and Quantitative Methods→Single Equation Models, Single Variables→Cross-Sectional Models, Spatial Models, Treatment Effect Models, Quantile Regressions
C58 : Mathematical and Quantitative Methods→Econometric Modeling→Financial Econometrics
E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy
F65 : International Economics→Economic Impacts of Globalization→Finance
G11 : Financial Economics→General Financial Markets→Portfolio Choice, Investment Decisions
G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates