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Bailey McCann, Opalesque New York:

The emergence of a negative correlation between stocks and bonds as a result of central bank involvement in the market is not just a significant shift in monetary policy. A new paper from D.E. Shaw argues that it also has profound implications for portfolio construction.

"Understanding the underlying drivers of correlations can help managers and investors think about the risks to their portfolios going forward," said Brian Sack, Director of Global Economics at the D. E. Shaw group and author of the paper in an interview with Opalesque. According to the paper, the change in the way the market works has contributed to a significant repricing of fixed income instruments as investors recognized that government bonds had become an effective hedge for the equity assets held in their portfolios. With this recognition, the term premium on bonds gradually declined creating trillions of dollars of wealth for fixed income investors.

Now as central banks begin tightening, market observers wonder whether the negative correlation between stocks and bonds will persist. D.E. Shaw argues that it all depends on how if central banks can control inflation. So far, they say, central banks have been successful at keeping inflation expectations anchored, which in turn creates conditions where market moves happen based on economic sentiment - reinforcing the negative correlation. If central banks fail, the correlation could snap back the other ......................

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