Stock–Bond Correlation and Duration Risk Allocation

Using weekly stock-bond correlations estimated with highfrequency data, the authors find that a lower (more negative) stock-bond correlation forecasts falling 10-year interest rates over the coming weeks. It also forecasts falling oneyear interest rates over the next year. The reverse is true when the stock-bond correlation is higher (more positive). Therefore investors, in particular those with long-term, bond-like liabilities, should take greater duration risk when the recent stock-bond correlations are lower. The authors propose two possible explanations of such predictive power: (1) the markets and/or policymakers’ underreaction to the changing economic conditions the stock-bond correlation implies; and (2) the markets’ initial underreaction to the long-term bonds’ safe-haven status. TOPICS:In markets, VAR and use of alternative risk measures of trading risk