Understanding correlations between stock returns and bond returns based on income and substitution effects

Abstract

We attempt to better understand the correlation between stock and bond returns, an important factor in asset allocation, based on income and substitution effects. The hypothesis is that there are two forces working to determine the relation between stock and bond returns. Information about the level of economic activity affects the values of stocks and bonds in similar directions. This induces the income effect that results in a positive relation between stock returns and bond returns. On the other hand, uncertainty about (or information about the variance of) the economic activity has opposite effects on the values of stocks and bonds. This induces the substitution effect that results in a negative relation between stock returns and bond returns. In combination, the two effects help determine the actual correlation between stock and bond returns. By empirically identifying the two forces, we find that our hypothesis of the income and substitution effects can explain not only diverse correlations across countries but also different correlations over time for each country. We also find some evidence that the income and substitution effects are related to the size of the financial market, the growth of the economy, and the business cycle over time.