Falling correlations suggest bonds can once again perform hedging role
The equity-bond correlation has turned negative. But it’s the context that matters.
Originally published on September 16, 2024, by Fidelity International.
Written by Pranav Aggarwal, Analyst, and Ben Traynor, Senior Investment Writer.
Falling correlations suggest bonds can once again perform a hedging role.
Three-month rolling correlation between MSCI USA Index and ten-year U.S. Treasury Index (both total returns)
An encouraging sign for bondholders: the three-month equity-bond correlation has turned negative again. Granted, we were here not that long ago – there was an inverse relationship between the two asset classes as recently as July 2023 – but how investors think about this correlation should be guided by context, and that is very different now.
The U.S. Federal Reserve (the Fed) has a dual mandate: stable prices (through targeting inflation) and maximum employment. While the last two years have been all about bringing inflation back to target, the focus is now shifting to growth. Growth has been slowing in the U.S., with the fiscal support of 2023 turning into a drag, consumers growing more cautious, and the labour market in a clear downtrend (despite what the August jobs report said).
Central banks and markets are taking note. The Fed stands ready to offer monetary policy accommodation, and we heard Fed Chair Jerome Powell set the tone in his speech at Jackson Hole last month when he said: “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data.”
As the focus on growth intensifies, this pushes the bond-equity correlation to more normal (negative) levels, because lower growth drives equity prices lower and drives bond yields lower. For investors, the implication of this negative correlation is that bonds are once again acting as a hedge in portfolios.
A lower correlation between bonds and equities is generally beneficial for a multi-asset portfolio, other things being equal, because it reduces the expected volatility of the portfolio as a whole. If the correlation is negative, then bonds should offset to some degree negative moves in equities.
However, in the real world other things never are equal, and we should sound a note of caution. The market is currently pricing in a more aggressive path of Fed interest rate cuts than we believe is warranted. While bonds may therefore be a better hedge against downside equity risks than they have been in the recent past, they carry their own downside risk too. Longer-dated bonds look especially vulnerable to a pull-back. The term premium remains very compressed, which in the context of heavy issuance is likely to be a challenge for these bonds. While we remain constructive on the asset class over a longer-term horizon, we have recently moved tactically underweight government bonds for the above reasons.
Issued by Fidelity Investments Canada ULC (“FIC”). Unless otherwise stated, all views expressed are those of Fidelity International, which acts as a subadvisor in respect of certain FIC institutional investment products or mandates.
For institutional use only.
This document is for investment professionals only and should not be relied on by private investors.
This document is provided for information purposes only and is intended only for the person or entity to which it is sent. It must not be reproduced or circulated to any other party without the prior permission of Fidelity.
This document does not constitute a distribution, an offer or solicitation to engage the investment management services of Fidelity, or an offer to buy or sell or the solicitation of any offer to buy or sell any securities in any jurisdiction or country where such distribution or offer is not authorized or would be contrary to local laws or regulations. Fidelity makes no representations that the contents are appropriate for use in all locations or that the transactions or services discussed are available or appropriate for sale or use in all jurisdictions or countries or by all investors or counterparties.
This communication is not directed at and must not be acted on by persons inside the U.S. and is otherwise only directed at persons residing in jurisdictions where the relevant funds are authorized for distribution or where no such authorization is required. Fidelity is not authorized to manage or distribute investment funds or products in, or to provide investment management or advisory services to persons resident in, mainland China. All persons and entities accessing the information do so on their own initiative and are responsible for compliance with applicable local laws and regulations and should consult their professional advisors.
Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The research and analysis used in this documentation is gathered by Fidelity for its use as an investment manager and may have already been acted upon for its own purposes. This material was created by Fidelity International.
Past performance is not a reliable indicator of future results.
This document may contain materials from third parties which are supplied by companies that are not affiliated with any Fidelity entity (third-party content). Fidelity has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content.
Fidelity International refers to the group of companies which form the global investment management organization that provides products and services in designated jurisdictions outside of North America. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. Fidelity only offers information on products and services and does not provide investment advice based on individual circumstances.
©2024 Fidelity Investments Canada ULC. All rights reserved.
