Stock-bond correlation hits 30-year high, threatening 60/40 portfolios

The 120-day correlation between US stocks and Treasury returns has climbed above 50%, the highest since 1997, as inflation erodes the 60/40 portfolio's diversification benefit.

"High nominal yields alone do not suppress S&P 500 performance — the real risk is rapid yield increases," Citi Research said in a note, pointing to the transmission channel from rates to equity valuations.

Stocks and bonds have lost money together in 22% of months over the past three years, up from 14% over the past 25 years, according to Morningstar data. During the market's worst months over the past three years, stocks fell nearly 5% on average while core bonds declined about 1.7%, roughly one-third as much. Both asset classes rose together in 50% of months over the past three years, up from 40% over the past quarter-century.

The elevated correlation means that if inflation persists and markets reprice Federal Reserve rate hikes, both bonds and equities could fall simultaneously, increasing downside risk for balanced portfolios. However, softening employment and inflation data, along with a dovish tone from Fed Chair Kevin Warsh, have tempered the risk of sharp yield spikes, while strong corporate earnings provide a buffer for equities.

Correlation Tells Only Part of the Story

The rising correlation does not necessarily mean the 60/40 portfolio has stopped working, according to Morningstar's analysis. Correlation describes whether two assets tend to move in the same direction, but it says nothing about the size of those moves or whether they help or hurt investors. Stocks and bonds can be positively correlated because they are both rising — which is good news — or because they are both falling.

The 60/40 portfolio was never designed around the idea that bonds would offset every stock market decline. Its purpose is to combine two assets with different risk characteristics to create a smoother investment experience. The objective of diversification is not to avoid periodic losses but to reduce the severity of short-term losses so investors can remain committed to their long-term plans.

Bonds Still Provide a Volatility Buffer

Even with higher correlation, bonds have continued to lose far less than stocks during the market's most difficult periods. Over the past three years, when stocks fell nearly 5% on average during their worst months, core bonds declined about 1.7% — roughly one-third as much. That cushion, while smaller than in prior decades, remains a meaningful reduction in portfolio risk.

The difference also creates rebalancing opportunities. Consider a $100,000 60/40 portfolio. During one of the market's worst months over the past three years, the stock allocation would have fallen to about $57,000 from $60,000, while the bond allocation would decline to roughly $39,300 from $40,000. Because bonds held up better, they would represent about 41% of the portfolio, slightly larger than the 40% target. Rebalancing would involve selling about $900 of bonds and buying stocks to restore the 60% equity allocation — setting up the portfolio to benefit when markets eventually recover.

The three-month correlation between US Treasury and stock returns has also reached its highest level since 1997, reflecting the same inflation-driven dynamic. If inflation remains sticky and forces the Fed to resume rate hikes, both asset classes could face simultaneous pressure. But with employment and inflation data weakening, and Warsh taking a patient approach, the risk of a sharp yield spike has diminished.

This article is for informational purposes only and does not constitute investment advice.