The conventional asset allocation model relies on a balanced portfolio (the classic 60/40 mix) under the assumption that bond prices rise when equities contract. This negative correlation is not a permanent law of finance; it is a byproduct of demand-side macroeconomic regimes (growth contractions, financial crashes, credit scares). In a demand-shock environment, the central bank cuts short-term interest rates to stimulate borrowing, driving bond yields down and nominal bond prices up. This price rally offsets the simultaneous deceleration of corporate earnings that depresses equity valuations.
However, this diversification mechanism breaks during supply-side macroeconomic shocks (commodity supply disruptions, tariff regimes, labor-supply contractions). Inflation surges, forcing the central bank to raise nominal interest rates to preserve the purchasing power of the currency. The rising discount rate compresses equity valuation multiples while concurrently driving nominal bond prices down. In this supply-shock regime, stocks and bonds exhibit a highly positive correlation, declining in tandem. This occurred during the stagflationary 1970s and the macroeconomic tightening of 2022, when the aggregate bond market suffered double-digit drawdowns and long-duration Treasury vehicles like TLT collapsed by more than 40%.
For larger portfolios, you must decompose fixed income into specific functional sleeves rather than treating it as a homogeneous asset class:
Protect against demand shocks and maintain immediate portfolio liquidity.
Protect against supply shocks and unexpected structural inflation.
Mitigate both demand and supply shocks by preserving capital at the cost of long-term compounding.
Operates as a directional speculation on falling real rates rather than a risk diversifier.