Rate Cuts: Bonds Back in Play?
The Impact of Fed Policy Changes on Stock-Bond Correlation
With the Federal Reserve recently slashing rates by 50 basis points—the first cut after holding steady for over a year—a significant shift in the stock-bond relationship appears to be unfolding.
Our analysis of the last 25 years reveals that stock-bond correlations tend to shift notably around Federal Open Market Committee (FOMC) decisions. Rate cuts, marked in red in the chart below, have coincided with economic slowdowns or recessions, during which bond yields decline and Treasurys act as a counterweight to weak equity markets. On the other hand, periods of rate hikes, shown in green, see higher correlations as inflation shocks drive stocks and bonds in the same direction.
Figure 1: Stock-Bond Correlation During Fed Policy Changes
Source: Verdad analysis. Correlations are calculated between a global cap-weighted basket of equities and the US 10-year Treasury. Correlations are exponentially weighted with a three-month half-life.
For multi-asset portfolios, the stock-bond correlation can help investors gauge how much equity risk can be hedged through credit exposure. The stock-bond correlation has been generally negative for the last 40 years until the post-COVID inflation spike sent correlations spiking sharply positive.
But if recent trends persist, further de-correlation between stocks and bonds could be on the horizon, particularly if the Fed continues cutting rates as widely expected. This may present a strategic opportunity for investors to dial up exposure to bonds.
The table below compares the performance of an all-equity portfolio and a 60/40 portfolio following changes in the stock-bond correlation from 1998 to 2024. We measured stock-bond correlation trends daily with a rolling six-month lookback and then tracked portfolio performance over the subsequent month. The table shows average annualized excess returns for each portfolio after periods of falling, stable, or rising correlations.
We found that after periods of declining stock-bond correlations, a 60/40 portfolio tends to outperform an all-equity portfolio on both an absolute and risk-adjusted basis. The strength of the 60/40 portfolio in these periods lies in its ability to reduce equity volatility and benefit from bond price appreciation during equity downturns.
Figure 2: All-Equity vs 60/40 During Changing Stock-Bond Correlation Regimes
Source: Verdad analysis. 60/40 refers to a 60% allocation to global equities and a 40% allocation to US 10-year Treasurys. All returns are annualized and presented as excess returns above a risk-free rate.
In an environment where the hot streak of equities may begin to feel the effects of a cooling economy, the case for a more balanced portfolio that leverages the renewed diversification benefits of bonds appears increasingly appealing.