Bonds Still a Less Reliable Hedge

In this article, Russ Koesterich discusses the reason that bonds are not providing the same diversification benefit to equities as in prior decades.

Key takeaways

  • Lower macro stability has resulted in a different stock/bond dynamic. With the economy improving and recession fears all but gone, investors are more concerned about ‘sticky’ inflation and the Fed.
  • In this environment, the dollar is likely to respond positively if fewer rate cuts translate into a stock market correction, serving as a hedge to equities.

Stocks are rallying, bonds are (mostly) stable and fears of a recession are rapidly receding. In most respects we’re a long way from the dark days of 2022. That said, one thing has not changed: bonds are still a less reliable hedge then in years past.

After surging in January and mid-February, long-term yields have slipped in recent weeks. However, while the bond market has been calmer, there are still lingering questions regarding inflation, more specifically how quickly it will revert to the Federal Reserve’s (Fed) long-term target of 2%. Both the level and volatility of inflation are important for how stocks and bonds co-move. Until inflation is both lower and more stable, we may remain in an environment in which bonds are a less consistent hedge of equity risk.

I last discussed the role of bonds as a hedge in the summer of ‘23. At the time, I suggested that despite inflation improving and financial conditions easing, we were still a long way from the pre-pandemic norms. While there has been further progress on the inflation front, as the Fed has been at pains to highlight, returning the U.S. economy to low and stable inflation is still a work in progress.