Shifting Correlations: How Trade Policy Uncertainty Alters stock-T bill Relationships

Abstract

This paper examines how trade policy uncertainty influences the correlation between U.S. stock indices and short-term government bonds. The objective is to assess whether policy-related shocks, especially those linked to trade tensions, alter the traditional stock-T bill relationship and its implications for investors. We extend the Dynamic Conditional Correlation (DCC) framework by incorporating exogenous variables to account for external shocks. Three specifications are analyzed: one using the Trade Policy Uncertainty (TPU) index, one including a dummy variable reflecting presidential-cycle effects, and one combining both through an interaction term. The analysis is based on daily data for major U.S. stock indices and the 3-month Treasury bill. Results indicate that trade policy uncertainty exerts a significant effect on stock-T bill correlations. Moreover, its influence becomes stronger under specific political conditions, suggesting that political agendas can amplify the impact of trade-related shocks on financial markets. Crucially, augmenting the DCC framework with trade-policy-related variables improves also the economic relevance of correlation forecasts. Therefore, this study contributes to the literature by explicitly integrating policy-related uncertainty into correlation modeling through an augmented DCC framework. The findings provide new insights for portfolio allocation and risk management in environments characterized by heightened trade tensions.

Figures (7)

• Figure 1: Heatmap representing the sample correlations of the de-GARCHed returns as defined in Eq. \ref{['eq:stand_res']}. Darker colors indicate stronger positive correlations, while lighter colors indicate weaker or negative correlations.
• Figure 2: 60-day rolling correlation between stock and T bill returns (black line), with periods exceeding one standard deviation highlighted in red. The dashed red line represents the threshold of one standard deviation.
• Figure 3: Conditional correlations from the DCC model (black line, left axis), Trade Policy Uncertainty (TPU) index (red line, right axis), and key trade-related events (vertical blue-dashed lines)
• Figure 4: Impulse Response Function (IRF) of the stock-T bill correlation to a one-standard-deviation shock in trade policy uncertainty (black line, left axis) and VIX (red line, right axis), expressed in percentage points
• Figure 5: $\hat{\theta}_3$ rolling window estimated coefficient (black line) from the $DCC-X_{TPU}$ model and break dates (dashed blue line, details in the text).