Economic resilience complicates hedging with bonds

Key takeaways:

• Since the March trough the S&P 500 Index has gained around 14% and ten-year Treasury yields have risen roughly 0.50%.
• As market conditions have improved, inter-asset correlations have also shifted.

Russ Koesterich, CFA, JD, Managing Director and Portfolio Manager of the Global Allocation team discusses the outlook for stock/bond correlations going forward.

As fears of another banking crisis fade, both stock and bond yields have moved higher. Since the March trough the S&P 500 Index has gained around 14% and ten-year Treasury yields have risen roughly 0.50%.

As market conditions have improved, inter-asset correlations have also shifted. Bonds proved an effective hedge in the aftermath of the initial bank failures in early March but less so recently. Going forward, I would expect stock/bond correlations to continue to be less stable than the post-Global Financial Crisis norm.

Shifting investment narratives

Investor concerns are evident in the way stocks and bonds co-move. Recent shifts suggest a renewed faith in a benign economic outcome. Since early May, daily stock/bond correlations have been approximately zero. In contrast, back in March and April correlations were decidedly negative, arguably reflecting greater fears of more bank failures and a recession.

As I’ve discussed in previous blogs, how stocks and bonds co-move is influenced by several factors, including inflation and financial conditions. And while inflation is coming down, it remains too high and too volatile. Core inflation is slowly decelerating but remains comfortably above 5%. Not only has inflation remained elevated but it is still much more volatile than the multi-decade average. The three-year standard deviation of core inflation is roughly four times the pre-pandemic average. Higher inflation volatility, which undermines investor confidence in bonds, has been associated with higher stock/bond correlations.

The second problem for those looking to use bonds as a hedge: The Federal Reserve is once again shrinking its balance sheet. After peaking at $9 trillion last spring, the Fed’s balance sheet began a slow decline, reaching a nadir of around $8.3 trillion in early March. However, following the banking stress the balance sheet expanded by around $400 billion on the back of emergency provisions. As the situation stabilized and emergency provisions became less necessary, the Fed’s balance sheet resumed its decline, along with those of most other central banks (see Chart 1).

Central bank balance sheets in U.S. dollars

Historically, changes in the Fed’s balance sheet, along with broader financial conditions, have co-moved with stock/bond correlations. If the worst of the banking crisis is behind us and the Fed’s balance sheet continues to shrink, bonds may prove a less effective hedge going forward.

Outside of extreme events in the banking system, the outlook for bonds as a hedge will be determined by one of two economic scenarios. If inflation is decelerating and the Fed is on hold, investors should have more confidence in bonds as a hedge. However, if recent economic resilience continues, core inflation remains elevated, and the Fed is forced to continue hiking, bonds may provide some diversification but prove a less reliable hedge. My base case is a slowing but still resilient economy. This suggests staying tactical with your bond allocation and diversifying your hedges.

Russ Koesterich, CFA, is a Portfolio Manager for BlackRock's Global Allocation Fund and the lead portfolio manager on the GA Selects model portfolio strategies.

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