Are Rising Interest Rates a Canary in the Coal Mine for Equities?

The relationship between equities and bonds has long been a cornerstone of portfolio diversification. Historically, bonds acted as a hedge for stocks, with the two asset classes often moving in opposite directions. However, the post-COVID inflationary environment and the Federal Reserve's aggressive rate hikes since March 2022 have upended this dynamic. By September 2025, the equity-bond correlation has become a critical barometer for investors, signaling shifts in risk sentiment and intermarket dynamics.

The Correlation Reset: From Hedge to Symbiosis

Rising interest rates have fundamentally altered the interplay between equities and bonds. During the zero-interest rate policy (ZIRP) era, the correlation between stocks and bonds was negative (-0.24), as falling rates boosted bond prices while stocks thrived on cheap capitalWhere next for the equity-bond correlation? | Barclays Private Bank^[1]. However, as inflation surged post-2020, the Federal Reserve's rate hikes created a new regime: both asset classes became more sensitive to interest rate changes. By 2022, the correlation coefficient had flipped to 0.64, reflecting synchronized declines in equities and bonds during periods of economic stressWhere next for the equity-bond correlation? | Barclays Private Bank^[1]. This shift rendered traditional 60/40 portfolios less effective at mitigating volatility, as both stocks and bonds lost ground simultaneouslyDon’t fight the Fed | Lombard Odier Asset Management^[5].

The mechanics behind this transformation are twofold. First, higher discount rates reduce the present value of future cash flows for both equities and bonds, eroding valuations across asset classesRecent patterns in global risk behaviour in financial …^[2]. Second, inflationary pressures and geopolitical risks—such as the Russia-Ukraine conflict and global tariff tensions—have amplified risk aversion, pushing investors toward cash and away from long-duration assetsThe Great Correlation Reset: Markets Break the Rules in 2025^[4].

Risk Sentiment: The VIX and EPU Index as Early Warning Systems

Risk sentiment indicators have further underscored the fragility of the equity-bond relationship. In Q3 2025, the CBOE Volatility Index (VIX), often dubbed the “fear gauge,” spiked above 50 following the U.S. administration's announcement of sweeping tariffs in April 2025Recent patterns in global risk behaviour in financial …^[2]. This surge mirrored a spike in the Economic Policy Uncertainty (EPU) Index, which reached historically high levels due to the 2024 U.S. presidential election and escalating trade tensionsDon’t fight the Fed | Lombard Odier Asset Management^[5].

The interplay between these indicators and equity performance is stark. As of September 2025, the VIX stood at 16.36—a moderate level compared to its pandemic-era peak of 82.69 in March 2020United States - CBOE Volatility : VIX - 2025 Data 2026 Forecast^[3]. However, the EPU Index remained elevated, reflecting persistent uncertainty about fiscal policy, inflation, and global trade dynamicsWhere next for the equity-bond correlation? | Barclays Private Bank^[1]. This disconnect highlights a critical nuance: while short-term volatility has eased, structural uncertainties continue to weigh on investor confidence.

A Fragile Normalization: September 2025 Outlook

By late 2024 and early 2025, signs emerged that the equity-bond correlation might revert to its traditional negative pattern. Central banks' pivot from inflation-fighting to growth-supporting policies helped drive bond prices higher while equities faltered in response to weak economic dataThe Great Correlation Reset: Markets Break the Rules in 2025^[4]. However, this normalization remains precarious. Producer prices, labor costs, and geopolitical tensions—such as the Russia-Ukraine conflict—still pose risks to inflation stabilityUnited States - CBOE Volatility : VIX - 2025 Data 2026 Forecast^[3]. If these pressures resurface, the correlation could again turn positive, undermining the diversification benefits of bondsRecent patterns in global risk behaviour in financial …^[2].

Investors must also contend with the Federal Reserve's influence on bond yields. As of September 2025, Treasury yields have remained range-bound, with markets pricing in potential rate cutsDon’t fight the Fed | Lombard Odier Asset Management^[5]. This environment has created a “bounded rates” scenario, where bond yields are less responsive to economic news, further complicating the equity-bond relationshipUnited States - CBOE Volatility : VIX - 2025 Data 2026 Forecast^[3].

Implications for Investors

The evolving intermarket dynamics demand a recalibration of portfolio strategies. Traditional 60/40 allocations are no longer sufficient to manage volatility, as equities and bonds now share common risks. Instead, investors should consider:
1. Alternative Assets: Commodities, real estate, and private equity can provide diversification in a high-correlation environmentThe Great Correlation Reset: Markets Break the Rules in 2025^[4].
2. Duration Management: Short-duration bonds may offer better protection against rate volatility than long-term TreasuriesDon’t fight the Fed | Lombard Odier Asset Management^[5].
3. Hedging Tools: Options and volatility products can mitigate downside risks in both equities and bondsRecent patterns in global risk behaviour in financial …^[2].

Conclusion

Rising interest rates have proven to be more than a canary in the coal mine for equities—they are a mirror reflecting broader shifts in intermarket relationships and risk sentiment. As the equity-bond correlation continues to oscillate between positive and negative, investors must remain agile, leveraging alternative assets and dynamic hedging strategies to navigate an increasingly interconnected market landscape.