The Changing Role of Nominal Government Bonds in Asset Allocation

The covariance between nominal bonds and stocks has varied considerably over recent decades and has even switched sign. It has been predominantly positive in periods such as the late 1970’s and early 1980’s when the economy has experienced supply shocks and the central bank has lacked credibility. It has been predominantly negative in periods such as the 2000’s when investors have feared weak aggregate demand and de‡ation. Nominal bonds are attractive to short-term equity investors when these bonds are negatively correlated with stocks, as has been the case during the 2000’s and especially during the downturn of 2007-08. They are attractive to conservative long-term investors when long-term in‡ationary expectations are stable, for then these bonds are close substitutes for in‡ation-indexed bonds which are riskless in the long term.