The Real and Nominal Determinants of Stock and Bond Returns Comovement

The comovement between returns to stocks and nominal Treasury bonds varies over time in both magnitude and direction. Earlier research attempts to interpret this phenomenon as a consequence of variations in the link between inflation and future economic activity. I present some opposing empirical evidence, and instead argue that in the data, the comovement between stock and nominal bond returns is driven by real factors. I build a New Keynesian model that generates this behavior through the joint dynamics of output, inflation, and interest rates. The model features two types of persistent shocks to productivity growth: mean-reverting “cyclical” shocks and permanent “trend” shocks. The relative importance of these two shocks varies stochastically over time. The model quantitatively explains the observed patterns in stock-bond return comovement