The coronavirus poses a unique and difficult to quantify threat to health, the economy and financial markets. One manifestation of this has been how fast stocks and other risky assets have collapsed. But while the catalyst is without precedent, other aspects of investor behavior have conformed to well established patterns. As stocks cratered, traditional “safe-haven” assets rose (see Chart 1). Even today, despite record low yields, I would continue to advocate for Treasuries as a hedge, albeit with one caveat: Focus on the long end of the yield curve.
Back in February I last made the case for Treasuries as an equity hedge. At the time, I recommended Treasuries at what seemed at the time to be a ridiculously low yield, around 1.60%. Today, the yield on the U.S. 10-Year note stands at 0.75%.
At today’s levels bonds are no longer a source of meaningful income. That said, bonds continue to prove a risk mitigant, i.e. displaying a tendency to rise when equity markets fall. Although correlations briefly broke down during the worst of the panic selling, 90-day stock bond correlations remain at around -0.50, right in-line with the post-crisis average.
Surprising as it may seem, there is still demand for bonds. For investors outside the U.S., yields still appear attractive relative to the negative yields on offer in their domestic markets. Beyond foreign investors, Treasury owners now have the privilege of investing alongside the 800-pound gorilla of bond buyers: the U.S. Federal Reserve. With the Fed now embarked on the open-ended purchases of Treasuries, there is a limit to how much yields are likely to rise.
Although bonds are still likely to work as a hedge, investors should focus on the longest maturities. Bond correlations remain negative, but higher equity volatility suggests you’ll need more duration to maintain an effective hedge. While investors could simply buy more 5 or 10- year bonds, the better solution might be to maintain a constant allocation while emphasizing the long end of the curve.
Focusing on long-dated issues has the potential advantage of being more capital efficient, i.e. it frees up cash to allocate to cheaper stocks. However, there may be another advantage to being at the longer end of the curve. As my colleague Mike Walsh notes, a key variable to watch is the shape of the yield curve, i.e. the yield differential between 2-year and 30-year bonds. With most central banks setting their policy rate at zero, 2-year yields have little room to fall. That is why a relatively steep yield curve has become the key differentiator between places where bonds are working, U.S. and Germany, and places where they are not, like Japan.
With the U.S. 30-year bond still yielding around 1.35%, 110 basis points above 2-year notes, there is room for the curve to flatten and long yields to fall. For investors looking to hold onto their stocks while hedging an uncertain outlook, the evidence suggests long-duration bonds are likely to continue to work, even at these levels.