Why Stock–Bond Yield Correlations Can Change Sign

Summary

The document examines why the relationship between Japanese government-bond yields and equity returns may change sign. The question proposes measuring rolling or dynamic conditional correlation between the Nikkei 225 and ten-year government bonds, then relating that correlation to inflation, inflation expectations, and other factors. It notes a perceived mismatch between a simple discounted-dividend-model intuition and observed data.

The response clarifies that, holding the risk premium and dividend growth constant, a higher bond yield raises the discount rate and lowers the present value of future dividends. It also highlights offsetting forces: the equity risk premium may move inversely with government yields, and during crises yields can fall as the risk premium rises, while dividends and expected growth may weaken. These mechanisms offer context for changing correlations, but the document supplies no empirical test, model specification, or evidence identifying the dominant driver.

Key ideas

• A discounted-dividend framework implies that higher bond yields reduce equity value when other inputs are fixed.
• Changes in the equity risk premium can offset or outweigh the effect of bond yields on discount rates.
• In crises, government yields, risk premiums, dividends, and growth expectations may move in different directions.
• The document motivates dynamic correlation analysis but does not provide an empirical test of its proposed factors.

Tags

# Correlation between bond yields and stock returns?


# Correlation between bond yields and stock returns?












I intend to regress the correlation coefficient (rolling window and/or DCC) between NIKKEI 225 adjusted close and 10yr Japanese government bonds on inflation , inflation expectations and other factor which may or may not be important in order to evaluate their relative impact on the correlation coefficient.

However, I can't seem to find a sophisticated enough explanation for the correlation's existence other than the changing dynamics of the demand for these asset classes (viewing them as substitutes).

A discounted dividends model suggest a strictly positive relationship, but the data suggests otherwise.

What are the fundamental reasons for the correlation between stock returns and government bond yields that would explain the correlation switching signs?

## Answer by Lliane (score 2)

https://quant.stackexchange.com/a/36595

Why do you say a DDM suggests a positive relationship between govt bond yield and stock price ? If yield gets higher the present value of future dividends is lower (maintaining risk premium and dividend growth constant).

Also the discount rate is bond yield + risk premium and the risk premium is inversely correlated with the govt bond yield so these effects tend to at least cancel out (during an economic crisis govt bond yields go down but risk premium goes up usually more, furthermore dividend and estimated dividend growth are also lower).

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