Bonds have returned as a hedge after failing investors for years

(Bloomberg) — Gregg Abella, a money manager in New Jersey, didn’t expect the flurry of phone calls he received from clients last week. “All of a sudden people are saying to us, ‘Wow, do you think it’s a good time for us to add bonds?'”

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It’s something of a vindication for Abella. He has been, in his words, “banging the gong” for bonds — and asset diversification, more broadly — for years. This has long been a decidedly unfavorable recommendation. Until, that is, stocks started to fall this month. Demand for the safety of the debt quickly increased, driving 10-year Treasury yields at one point early last week to their lowest levels since mid-2023.

The rally surprised many on Wall Street. The old relationship between stocks and bonds — where fixed income instruments offset losses when stocks fall — has been called into question in recent years. Especially in 2022, when that correlation completely collapsed as bonds failed to provide any protection amid the slide in equities. (U.S. government debt, in fact, saw its biggest losses on record that year).

But while the sell-off since then was sparked by an outbreak of inflation and the Federal Reserve’s struggle to stop it by raising interest rates, this latest slide in stocks was largely triggered by fears that the economy would slide into a recession . As a result, expectations for rate cuts have risen rapidly, and bonds are doing very well in that environment.

“Finally, the reason for bonds is visible,” said Abella, whose firm — Investment Partners Asset Management — oversees about $250 million, including for wealthy Americans and nonprofits.

As the S&P 500 lost about 6% in the first three trading days of August, the Treasury market posted gains of nearly 2%. This allowed investors with 60 percent of their assets in stocks and 40 percent in bonds — a time-honored strategy for building a diversified portfolio with less volatility — to outperform one that held only stocks.

Bonds will eventually erase much of their gains as stocks have steadied in recent days, but the broader point — that fixed income has worked as a hedge at a time of market chaos — remains.

“We bought government debt,” said George Curtis, portfolio manager at TwentyFour Asset Management. In fact, Curtis started adding Treasuries months ago — both because of the higher yields they now offer and because he too expected the old stock-to-bond relationship to return as inflation eased . “It’s there like a hedge,” he said.

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Again the opposite

There is another way to see that the traditional, inverse relationship between the two asset classes – which occurred mainly in the first two decades of this century – has returned, at least for the time being.

The one-month correlation between stocks and bonds last week hit its most negative since last year’s regional banking crisis. A reading of 1 indicates that assets are moving in step, while minus 1 suggests that they are moving in the opposite direction. A year ago, it eclipsed 0.8, the highest since 1996, indicating bonds are virtually useless as portfolio ballast.

The relationship was turned upside down as the Fed’s aggressive rate hikes starting in March 2022 sent both markets tumbling. The so-called 60/40 portfolio lost 17% that year, the worst performance since the 2008 global financial crisis.

Now the backdrop has shifted in favor of bonds, with inflation more under control and focus turning to a potential US recession at a time when yields are still well above their five-year average.

Next week brings plenty of risks for bond bulls. July reports are due on US producer and consumer prices and any sign of a resurgence of inflation could push yields back. They had already started to rise on Thursday after weekly jobless claims – a data point that is suddenly drawing attention as recession worries swirl – surprisingly fell, tempering signals that the labor market is weakening.

For all the excitement about bonds today, there are still plenty of people like Bill Eigen who are afraid to jump back into the market.

Eigen, which manages the $10 billion JPMorgan Strategic Income Opportunities Fund, held more than half of it in cash — mostly in money market funds that invest in cash-equivalent assets such as Treasury bills — in recent years. At just over 5%, short-term Treasuries are yielding at least a full percentage point more than long-term bonds, and Eigen isn’t convinced that inflation is really low enough, nor that the economy is strong enough. weak to merit the kind of Fed easing that would change that dynamic.

“The rate reductions will be small and progressive,” he said. “The biggest problem for bonds as a hedge is that we still have an inflationary environment.”

What Bloomberg Intelligence says

“The yield curve tends to steepen into recession. The exceptionally short non-inversion of the 2-year/10-year Treasury curve on August 5 could foretell a downward trend in velocity that we expect to persist as the economy slows. In the meantime, we think the equity/bond correlation may normalize.”

—— Ira F. Jersey and Will Hoffman, BI Strategists

Maybe. But a growing number of investors like Curtis have relegated inflation to a secondary concern. During the height of market volatility last week, bond investors sent a fleeting message that their worries about growth were turning dire. Yields on the two-year note briefly traded below those on the 10-year bond for the first time in two years, a sign that the market was bracing for recession and rapid rate cuts.

“With inflation trending lower and risks much more balanced or even leaning towards concerns about a more significant economic slowdown, we think bonds will show more defensive characteristics,” said Daniel Ivascyn, chief investment officer at Pacific Investment Management Co.

What to watch

• Economic data:

  • August 12: New York Fed 1-year inflation expectations; monthly budget statement

  • August 13: NFIB Small Business Optimism; producer price index

  • Aug. 14: MBA mortgage applications; consumer price index; average real earnings

  • August 15: Empire manufacturing; retail sales; Philadelphia Fed Business Outlook; unemployment claims; import and export price index; industrial production; capacity utilization; manufacturing production (SIC); business inventory; NAHB real estate market index; ICT data

  • Aug. 16: Housing begins; building permits; NY Fed Services Business Activity; The sentiment of the University of Michigan

• Fed calendar:

  • August 13: Atlanta Fed President Raphael Bostic

  • August 15: Fed President in St. Louis, Alberto Musalem; Philadelphia Fed President Patrick Harker

  • August 16: Chicago Fed President Austan Goolsbee

• Auction calendar:

  • August 12: 13, 26 week bills

  • August 13: 42-day cash management bills

  • August 14: 17 weeks bills

  • August 15: 4, 8 weeks bills

“With the help of Michael Mackenzie.”

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