EU Bond vs Equity correlation

assessing the role of bonds in diversified portfolios

Are bonds hedging against stocks?

In summary

• bonds' ability to hedge stocks has been ineffective for the observed the period in Europe
• the short-term 10-week rolling correlation (with daily data)is highly negative at -0.88, and turning more negative since previous market close
• the relationship is robust and damaging, with both falling stocks and rising yields contributing negatively to portfolio performance

Inflation is defined a key driver of yields when their correlation is positive and high

IntroThe correlation between bonds and equities indicates how they move in relation to each other. Understanding this relationship is crucial for portfolio diversification.

OptionsIn this chart we look at bond yields and stock prices together:
(1) a positive correlation would mean that bond yields and stock prices are moving in the same direction, providing diversification benefits (in other words, it would mean that bond and stock prices move in opposite directions), while
(2) a negative correlation would mean that yields and stock prices move in different directions, implying that bond and stock prices move together in the same direction, thus removing their diversification benefits.

ContextHistorically, during periods of strong economic growth and low inflation, bonds and equities have often shown a positive correlation between bond yields and stock prices. This means that when the stock market performed well with bond prices slightly decreasing, or vice versa. However, when inflation is high, both asset classes tend to show a negative correlation between yields and stock prices (with their prices moving in the same direction then, often south).

Drivers of EU bond yields

checking inflation and growth impact on bond yields

What is influencing EU yields the most?

Inflation - last 3 months:

• inflation expectations have not been a key driver of 2yr yields in the period
• their correlation (0.40) has been moderately positive, with inflation expectations and 2yr yields moving in the same direction only sometimes and not consistently
• in such period: German 2yr yields are up by 8 bps (from 2% to 207bps), and European inflation is down by -0.1% (from 2.1% to 2.0%)

PMIs - last 3 months:

• PMIs have not been a key driver of 2yr yields in the period
• their correlation is negative and irrelevant: inflation is the main driver for 10yr yields
• in such period: German 10yr yields are down by -21 bps (from 3% to 265bps), and EU Composite PMIs are up by 0.6 points (from 51.3bps to 51.9bps)

Inflation is defined a key driver of yields when their correlation is positive and high

IntroA number of key factors influence German/EU yields, primarily revolving around inflation and economic growth, both elements used as key input into the ECB monetary policy decisions. Changes in those two key macro variables, along with investor sentiment and global economic conditions, cause yields to fluctuate.

Chart guideIn this chart we measure the correlation between German yields and those two key macro variables - European inflation or growth expectations (via PMI indices) - to confirm if either growth or inflation are behind the recent yield change.