Not Your Hedge

Not Your Hedge

Meanwhile, from the “things you don’t see everyday” file, TLT fell 50bps on three consecutive days last week with the S&P down simultaneously during all three of those sessions.

That’s anomalous. In fact, according to Macro Risk Advisors’ Dean Curnutt, it’s only happened two other times in history, both during the financial crisis.

The concurrent declines (figure below) are a simple way to conceptualize of “diversification desperation” — a straightforward illustration of the idea that greater macro volatility triggered by the collision of pandemic distortions and an unprecedented policy experiment, could ultimately derail the negative correlation that investors of all shapes and sizes have been able to take for granted over the last two decades.

This is no small matter. Over the years, I’ve broached the subject any number of times, often asking whether 60:40 is “dead” and/or what consistent co-movement between stocks and bonds would entail for risk parity.

For market participants, this is a topic that never gets old, precisely because the assumption of a negative relationship between stocks and bonds is built into so many portfolios. I talked at length on Saturday about it in “Shaking The Edifice.”

I’ve said it time and again: At some point, when yields run out of room to fall (and one mistake over the years has been proclaiming that “This is the low!” only to see yields keep falling, in some cases deeply into negative territory) bonds will morph into a source of volatility due both to a grossly asymmetric risk-reward profile and heightened sensitivity to “tantrums,” as yields become hyper-sensitive to even the most harmless utterances from developed market central bankers.

For years, those of a fretful persuasion were in the habit of suggesting that the point beyond which bonds morphed from reliable hedge into source of risk was near at hand. Those predictions never panned out. Or not really anyway, in part because they lacked a catalyst strong enough to bring about an epochal shift in the macro regime. That catalyst may have been the pandemic or, more accurately, the policy response to the pandemic, which finds developed market policymakers delving as deeply (and overtly) into monetary financing as they’ve ever dared tread.

MRA’s Curnutt made many of the same points in a Friday note documenting the risk posed to markets by the interplay between inflation expectations, realized inflation and the Fed’s reaction function. “From a market stability standpoint, if investors face a widely shared risk, you would prefer a healthy supply of the insurance for that risk [but] with respect to inflation, this appears to be the opposite,” he said. “Stocks are vulnerable to inflation because bonds, the very instrument often used to hedge stocks, are highly vulnerable to inflation.”

Therein lies the problem. And the talking point du jour.

“What happens when the bond market, instead of being a part of the solution, is the source of the problem?,” Curnutt asked, rhetorically.

In a “tantrum,” bonds are the proximate cause of the turmoil and “the equity market, having long benefitted from extremely low rates, suffers from the uncertainty about the ultimate magnitude of the increase,” Curnutt went on to say. “The result: lower share prices, increased volatility and a positive correlation in stock and bond prices.”

The bond exposure that’s long served as a stabilizer and risk dampener is suddenly the locus of the pain and a risk amplifier.


8 thoughts on “Not Your Hedge

  1. I really struggle to understand why people who have a significant long term unrealized capital gain in bonds would stay in bonds if they really think rates are going up. Instead of watching your unrealized long term capital gain get smaller, wouldn’t you just cash out, pay the tax and reinvest in dividend paying stocks?

    1. Your last point is well made. I had a very large UST strip bought to yield 7%. It was set to mature in 2026 and made a perfect college fund for my grandson. Problem was that by last year it was already essentially at par, leaving me with big unrealized gain or the prospect of a pile of ordinary taxes on OIDs every year. Fortunately, I had a fairly good size cap loss carry forward so I sold the strip to make the gain disappear and saved all the future OID taxes. Bought a nice safe income producer as you suggested. That stuff can be slowly liquidated for college. I do have a 7.25% UST with a huge unrealized gain I won’t worry about because I can’t safely beat the income on the bond so I am stuck on that one; but don’t care because the gain will just disappear in a few years.

    2. What’s bad for bonds isn’t necessarily rates going up, but rather rates going up by more than what the forward curves are implying. Right now, there’s a fair amount of rate hikes already embedded into forward rates (swap, OIS and forward USTs). For example, 3y3m fwd OIS is 1.15% currently, while 3y3m swap is 1.27%. That’s at least 3-4 rate hikes already embedded over the next 3 years, despite Fed forward guidance to the contrary.

  2. For the small-time individual boomer investor, 60:40 is dead…for now. The beauty of being a small-time individual boomer investor is you can do a 180 whenever you feel like it. (And listen to the Grateful Dead whenever you want and not have to make excuses for yourself.)

  3. BTW, can I just state the obvious: any “asset” that falls $10,000 in a session or two b/c of something one rich dude tweeted (for godssake) is not an asset; it’s a fad.

  4. Interesting, so most likely a part of the money invested in bonds will look for alternative portfolio stabilizers. I guess because of the enormous amount of money invested in bonds, all alternative portfolio stabilizers will get some of the money…..That is only one of the reasons why gold will continue to rise.

    1. I guess I take a slightly different view. If the biggest source of risk to a 60/40 portfolio is rates, then unless the fixed income exposure is 30y zeroes or an ETF like EDV, you should be more worried other kinds of duration expressions than simply Treasuries, given something like the Nasdaq or gold probably has far more “effective duration” than the 10y note or an ETF like AGG, GOVT or IEF.

      If you’re worried about rate risk, maybe the problem isn’t bonds but rather duration proxies disguised as something else.

  5. 60/40 portfolios don’t use TLT, the fixed income portion has been shifted into other things that the managers can call bonds: short duration, munis, HY, TIPS, floating rate notes, etc. As such, the bond component is probably down 1-3 percent YTD. Since the SP500 is +10% YTD, the 60/40 manager isn’t sweating it yet. He or she is also rehearsing lines about how bonds provide stability and ballast, and why you should stay the course.

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