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

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.