The Determinants of Bond-Stock Correlation: the Role of Trend Inflation and Monetary Policy

Jinyoung Seo ()
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Jinyoung Seo: Wake Forest University, Economics Department, Postal: 1834 Wake Forest Rd., Winston-Salem, NC, 27109, http://jyseo.weebly.com

No 115, Working Papers from Wake Forest University, Economics Department

Abstract: I show that Treasuries’ role as hedge assets is determined by the level of trend inflation and the conduct of monetary policy, using a Generalized New Keynesian habit model. A novel prediction from the model is that when trend inflation is high, nominal bonds exhibit a positive correlation with stock returns, making them risky assets. As trend inflation rises, inflation becomes more countercyclical because any transitory inflation generates temporary output loss due to endogenous cost-push effects, which emerge under positive trend inflation. When countercyclical inflation prevails, bond returns drop when stocks underperform, leading to a positive bond-stock correlation. The model explains the shift in US bond-stock correlation from positive to negative in 1997 as a consequence of stabilized trend inflation.

Keywords: Bond-stock correlation; trend inflation; monetary policy; output gap-inflation correlation; bond risk premium (search for similar items in EconPapers)
JEL-codes: E31 E43 E44 E52 G12 (search for similar items in EconPapers)
Pages: 58 pages
Date: 2024-08-30
New Economics Papers: this item is included in nep-cba, nep-dge, nep-fdg, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:ris:wfuewp:0115

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