What Drives the Correlation of Stock and Bond Returns in the US and UK Markets?

The stock-bond correlation is critical to investment activities, such as forming optimal portfolios, designing hedging strategies, and assessing risk. This paper examines this relationship using a rolling correlation between long-term government bonds and stock returns. We focus on the US and the UK markets and show that the stock-bond correlation follows a similar reverting pattern in both markets during the past twenty years. Overall, volatility in equity market returns, jointly with macroeconomic factors such as interest rates, growth in GDP per capita and inflation, can efficiently explain the rolling correlation between stock and bond returns. However, the stock-bond correlation is not determined by the same macroeconomic factors in both markets, implying that the explanatory power of each factor varies from country to country. The results can provide invaluable insights into asset allocation decisions by forecasting the expected correlation between stock and bond returns using macroeconomic factors. Keywords: stock-bond correlation, rolling correlation, macroeconomic drivers, stock market volatility, asset allocation