Stock and bond markets: the new normal of correlation

The New Normal of Stock and Bond Market Correlations

The next shock to stock markets could also hit bond markets, and this combination - once rare - is becoming the new normal. A structural change in the relationship between stock and bond volatility has undermined one of the fundamental assumptions of financial risk management, with consequences that regulators and policymakers have yet to fully address.

Quick Answer

A Structural Change

Before 2013, the VIX index (which measures expected volatility in stock markets) and the MOVE index (its equivalent for Treasuries) moved in tandem only during acute crises. The correlation between the two reached about 0.4 during the dot-com crash and the global financial crisis, only to return to zero once the crises had passed. Today, however, even in the absence of acute crises, the annual correlation between VIX and MOVE exceeds 0.5 - a level previously observed only at the peak of systemic crises.

The Mechanism of Systemic Risk

Systemic risk increases when financial institutions fail to absorb the losses generated by market shocks. Historically, a balanced portfolio of stocks and bonds offered protection: when stocks fell, Treasuries often maintained or increased their value, providing a hedge that institutions could liquidate to meet margin calls. However, when stocks and bonds fall together - as has happened with unusual frequency since the pandemic - there is no obvious solution. If many institutions face collateral shortages simultaneously, forced sales further depress prices, fueling a potentially self-reinforcing spiral.

The Regulatory Architecture Is Not Keeping Up

The risk weighting models of the international Basel III framework - as well as the stress tests calibrated for the independence of asset classes and the collateral hierarchies embedded in central clearing - still treat high-quality sovereign debt as a nearly risk-free buffer. This assumption, however, seems no longer supported by investors. Regulators should require institutions to re-evaluate these models in light of the new reality of post-pandemic correlations, rather than relying on the pre-2013 scenario.

The Need to Reform Liquidity Structures

The design of central bank liquidity structures is equally problematic. Permanent repo windows, built for stress on individual assets, could prove insufficient when stocks and bonds fall simultaneously. These structures must be resized and restructured to address this new scenario. Moreover, policymakers must address the underlying cause: if persistent fiscal deficits are eroding confidence in sovereign debt, pulling bond market volatility in sync with stock market volatility, the policy response cannot be a vague commitment to sustainability. A concrete and credible path for medium-term consolidation, capable of restoring the safety premium that Treasuries have traditionally guaranteed, is needed.

Implications for Risk Management

This structural change requires a reform of risk management practices. Financial institutions must review their hedging strategies, developing new tools and approaches to address a reality in which diversification between stocks and bonds no longer offers the same protection as before. Furthermore, portfolio managers should consider the use of more sophisticated derivative instruments and alternative hedging strategies to mitigate the increased systemic risk.

Prospects for Investors

For investors, this new scenario requires a more careful approach to risk management. The traditional portfolio allocation between stocks and bonds may no longer be sufficient to balance risk and return. Investors may need to consider the use of alternative assets, such as commodities or real estate, to further diversify their portfolios. Moreover, more dynamic investment strategies, capable of quickly adapting to market changes, may be necessary.