By Walter Kurtz, Sober Look
With all the talk of the so-called Great Rotation, evidence points to investors still pumping billions into fixed income. And in spite of a fairly broad conviction that rates will be rising in the near future, investment portfolios are loaded with treasuries. Demand for US government paper continues to be strong in spite of the worst risk/return profile in decades (see post) and implied real yields deep in the negative territory (see post).
The obvious explanation is the public sector purchases by the Fed as well as other nations with significant dollar reserves. Traders continue to call the 10-year treasury the “widow-maker”, given how painful it has been to short that paper. Nobody wants to get in front of the freight train in figure 1.
But there is another reason. As investors move into equities while market indices hit new records, investors need an effective hedge. And over the past few years, long-dated treasuries have delivered precisely that. As discussed in this post, the right mix of treasuries with equities dramatically reduced the daily volatility of the portfolio. That quality of longer dated treasuries persists through today. The anti-correlation between the Barclays Long U.S. Treasury Index and the S&P500 index remains quite strong at -0.7 (see figure 2).
What’s particularly interesting about long-dated treasuries as a hedge is that the anti-correlation increases during periods of stress in the financial markets. In fact the hedge effectiveness was the strongest during the Italy fears flareup in the fall of 2011, followed by another dip last summer when Spain was in the crosshairs (keep in mind the chart above shows correlation over the previous 90 days). Very few hedging instruments have the “optionality” that kicks in at the time when one really needs it. Equity options and credit instruments (such as CDX) were not nearly as effective, particularly given the cost of decay/negative carry.
Investors are therefore willing to pay the premium of negative real rates and limited upside of treasuries in order to minimize portfolio volatility. It’s unclear if this relationship will hold or ultimately revert to historical levels. For now however, as Europe continues to spook investors who are piling into equities, treasuries remain in demand as an effective hedge.
Figure 1 – Securities held outright by the US Federal Reserve (source: FRB)
Figure 2 – Daily returns, 90 day rolling window