Investors looking to hedge equity risk in the event of another U.S. recession may want to starting dipping their toes back into the fixed income market. Stocks and bonds have struggled year to date, with both asset classes posting their worst first six-month performances in decades. That surprised investors who often hold portfolios with both stocks and bonds to balance risk – historically, bond prices rise when stocks fall. That changed in this market cycle because of the coronavirus pandemic and the Federal Reserve’s moves to stimulate the economy during the covid recession — including fed funds near zero and Treasury yields not much higher. But now there may be a turning point in the correlation between stocks and bonds as the U.S. undergoes an economic slowdown, one that might potentially lead the Fed to pivot from a hawkish stance to a dovish one, easing off rate hikes and eventually cutting them. “Six months ago, it was all about inflation, it was all about an aggressive Fed,” said Russ Koesterich, portfolio manager of the BlackRock Global Allocation Fund. While there’s still persistent inflation, worries of a recession are also mounting. “It’s likely that as recession fears grow that the hedging value of Treasurys will start to re-emerge.” Signs of a weakening economy have already started this switch back to bonds as an offset to balance equity risk. On Wednesday, the Federal Reserve raised its benchmark interest rate by three quarters of a percentage point, pressuring the price of longer-duration bonds and pushing up their yields (bond yields move inversely to their price). On Thursday, yields ticked up on longer-dated bonds, including the 20-year and 30-year, while yields on shorter-term notes fell when the first reading of second-quarter gross domestic product came in negative . Two consecutive quarters of negative GDP are often a strong recession signal. “The markets have left behind inflation and interest rate risk and are focusing on recession risk, and that’s why you’re getting bonds behaving in a traditional way as risk mitigation which didn’t happen earlier this year,” Mohamed El-Erian, chief economic advisor for Allianz, said on CNBC’s “Squawk Box” Thursday. What a dovish Fed would mean for bonds An environment where the Fed is cutting interest rates generally lifts bond prices and boosts longer-duration Treasurys. To prepare for this scenario, BlackRock has been adding back holdings in 5- and 10-year Treasury bonds, though they remain underweight both stocks and bonds, according to Koesterich. “The longer out you go on the curve, the more leverage you’re going to have” for any move by the Fed to eventually take its foot off the brakes, said Eric Diton, president and managing director of The Wealth Alliance. Right now, though, longer-duration bonds have been hit by the Fed’s campaign to tighten policy this year. Currently, investors can get higher yields on shorter-term notes than on bonds with longer durations and more risk. “You can get paid more yield to have a shorter duration bond than a longer duration one,” said Nancy Davis, founder of Quadratic Capital and fund manager of its IVOL ETF. “That’s not a normal environment.” That means that investors looking to snap up longer-term treasurys to hedge against a recession may want to balance that position. One way to do that is to use a barbell strategy, or buying on both the short and long end of the yield curve, Diton said. “We might get hurt on the long end, but we’re also going to be able to reinvest those quickly-maturing short bonds into higher rates,” he said. Though investors may be spooked by this year’s losses from having more traditional portfolio mixes that include both stocks and bonds, there’s even more reason now to buy into that setup. Morgan Stanley this week noted that a traditional portfolio split of 60% stocks and 40% bonds could have an annual return of more than 6% over the coming decade. For investors who aren’t sold on Treasurys, there are other ways to get fixed income exposure into their portfolio , including aggregate bond funds and investment grade corporate debt, which offer higher yields now. Inflation-linked bonds, or Treasury-Inflation Protected Securities, may also be a good add right now. “It’s a cheap time to add inflation protection to portfolios,” Davis of Quadratic Capital said.
A recession could flip the script for U.S. Treasurys as a hedge