Bonds as a hedge? It depends

Russ Koesterich, CFA, Managing Director and Portfolio Manager for BlackRock’s Global Allocation Fund explains why and when bond hedging may work.

Stock markets around the world continue to come under pressure from multiple fronts: stubbornly high and accelerating inflation, tightening financial conditions and an increasingly brutal war in Ukraine. Even as stocks grind lower, bond yields continue to climb, with U.S. 10-year Treasury yields back above 2%. But while the trend in yields is up, the march higher has obscured some abrupt pullbacks in interest rates.

Since the start of the war many of the worst days for stocks have been accompanied by bond rallies. Does this suggest that U.S. duration is once again working as a hedge? Probably not. Bond hedging may work on those days when equity weakness is being driven by events in Ukraine, but Treasuries still have an inflation problem and real yields remain too low.

Dual risks

2022 got off to a bad start and conditions have only deteriorated from there. Market weakness was initially driven by accelerating inflation and rapidly shifting Federal Reserve reactions. However, during the past month risks have quickly compounded. In addition to inflation, investors now face a major land war in Europe and an energy/commodity shock.

As stocks have corrected, correlations have fluctuated. From the start of the year through March 11th there have been 48 trading days. The S&P 500 has finished lower on 30 of those days. Comparing stock and bond performance for each day, bond returns have been mixed on days when stocks ended lower. However, results change once you bring oil into the equation. On days when stocks were down and oil was up at least 3%, long-dated Treasuries gained approximately 0.80%.

On the surface this seems bizarre. Why would bonds be a better hedge when oil is spiking? There are two explanations. At some point higher oil, while inflationary, also becomes a threat to growth. Many if not most recessions began with an oil shock.

There is another explanation as well: Large spikes in oil have been associated with the Russian invasion of Ukraine. Oil prices initially spiked on the invasion. While crude has subsequently pulled back, crude remains roughly 25% higher year-to-date (see Chart 1). On days when oil is spiking investors are trying to hedge the broader uncertainty associated with war in Europe.

Energy commodities market overview

Energy commodities market overview chart

Source: Refinitiv Datastream and LME, chart by BlackRock Investment Institute, Mar 15, 2022.
Notes: WTI stand for West Texas Intermediate(WTI) crude, the underlying commodity of New York Mercantile Exchange's oil futures contracts. The lines shows the changes in price of different commodities since 2008. Europe natural gas price based on European Energy Derivatives Exchange futures, U.S based on MYM-Henry Hub Gas futures price. Coal price based on ICE-Rotterdam futures price. European electricity prices based on Powernext baseload, U.S on PJM base rate.

Looked at through this lens, duration’s efficacy as a hedge is predicated on the extreme circumstances associated with the war. In this context, Treasuries are fulfilling their role as a less risky asset. In the near term this may continue. That said, to the extent inflation and the Fed move back to center stage, Treasuries are unlikely to prove a reliable hedge. For that to happen we need to see some combination of higher real and nominal yields, as well as an inflection in inflationary pressures.

Russ Koesterich
Russ Koesterich
Portfolio Manager
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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