Bonds! They’re your hedge again.
On August 3 — so, a day after the Sahm rule triggered, sending out an air raid siren ahead of last Monday’s fire and brimstone — I wrote that “if there was a silver lining in an otherwise bad week for equities and risk sentiment, it was that bonds cushioned losses in balanced portfolios.”
That week (the week before last), 10-year US yields dropped the most since Lehman and the long-end US Treasury ETF rose more than 5% for its best showing since the onset of the pandemic.
The signal from rates over the last several sessions was a bit difficult to discern given a lot of the price action was the market’s attempt to walk back the August 5 panic extremes while retaining just enough rate-cut premium to account for the elevated odds that the Fed goes “big” out of the gate next month (i.e., starts the easing cycle with a 50bps cut). But one thing was clear enough from recent events: The correlation assumption at the heart of 60:40 portfolios — not to mention an entire universe of leveraged multi-asset strategies — holds again.
The figure below’s from SocGen. You can conjure any number of variants using the correlation function in BBG or Excel. How pronounced (i.e., dramatic) your chart looks depends on how you adjust the lookback and so on. I like SocGen’s version as it captures the intraday correlation, and also because I think the caveat (in parentheses) is important.
The important point — or one important point, anyway — is that investors are now on the same page with the Fed in that concerns about the US labor market and, by extension, growth, now outweigh anxiety about rekindled inflation.
“After a long period of bonds and equities moving together, we are now finally seeing bonds act as diversifiers during equity drawdowns, suggesting market participants are much less stressed about inflation and are rather concerned about a meaningful slowdown in growth,” SocGen’s team remarked, in a recent note.
There’s no need to overcomplicate this: As long as inflation’s the “last war,” so to speak, and by extension fending off a recession is the Fed’s next battle, bonds could have more room to run and should anyway serve their “traditional” (with the scare quotes to acknowledge that our tendency to regard a negative stock-bond return correlation as sacred and inviolable is actually a product of recency bias) purpose as an equity hedge.
If, however, inflation has one last scare in it à la the villain from a campy 1980s American slasher flick, then to jump in now is to jump the gun. As SocGen’s Jitesh Kumar and Vincent Cassot put it, “while we have long argued that buying the joint probability of rates and equities heading lower at the same time is likely to be a robust hedge for a recession, we also think the rates market has recently been very eager to price in a recession and therefore risks a whiplash if the data do not eventually comply.”
Now cue CPI.
