Reversing its relationship with the US stock market! US bonds once again become the favorite hedging asset in the market

Since August, the traditional inverse relationship between US stocks and US bonds has been restored, and the market environment is once again favorable for bond investments.

In August, as US stocks began to decline, the demand for debt security quickly increased, leading to a surge of funds into government bonds, causing the yield on the 10-year Treasury bond to fall to its lowest level since mid-2023 at the beginning of last week.

This rebound has caught Wall Street by surprise, as the relationship between stocks and bonds in recent years (i.e., fixed-income assets offsetting losses when stocks fall) has been questioned. Especially in 2022, when this correlation completely collapsed as bonds failed to provide any protection during stock market declines.

However, the sell-off in 2022 was triggered by an outbreak of inflation and the Federal Reserve's eagerness to raise interest rates to curb inflation, while the stock market decline in August this year was largely due to concerns about the economy possibly entering a recession, leading to a rapid increase in market expectations for rate cuts. In this context, bonds have performed very well.

Bonds as a Hedging Tool

In the first three trading days of August, the S&P 500 index fell by about 6%, while the US bond market rose by nearly 2%. This meant that investors who allocated 60% of their assets to stocks and 40% to bonds outperformed those who held only stocks.

Although in the past few days, as the stock market stabilized, most of the gains in bonds were eventually erased, investors generally acknowledge that fixed-income assets have acted as a hedging tool during market turmoil.

George Curtis, a manager at asset management firm TwentyFour, began increasing his holdings of US Treasuries months ago—partly because of the higher yields they now offer, and partly because he also expects the old relationship between stocks and bonds to be restored as inflation subsides. He stated:

"We have been buying government bonds, as they are meant to serve as a hedging tool."

The Traditional Inverse Relationship between Stocks and Bonds has been Restored

Last week, the one-month correlation between stocks and bonds reached its most negative value since the regional bank crisis last year. A correlation of 1 indicates that assets move in sync, while -1 indicates they move in opposite directions.

According to the traditional inverse relationship, the correlation between stocks and bonds is negative.

However, due to the Federal Reserve's aggressive rate hikes starting in March 2022, which led to simultaneous crashes in the stock and bond markets, the traditional inverse relationship between the two was completely overturned. A "60% stocks + 40% bonds" portfolio lost 17% that year, marking the worst performance since the global financial crisis of 2008. A year ago, the correlation between stocks and bonds exceeded 0.8, reaching its highest level since 1996, indicating that bonds were almost unable to stabilize the portfolio.

Over the past month, bonds have moved in the opposite direction of stocks, returning to the trend before 2022

Market Focus Shifts from Inflation to Concerns about a Possible US Recession

Currently, the market environment is once again favorable for bond investments: inflation is better controlled, and market focus has shifted to concerns about a possible recession in the United States, with bond yields far above the five-year average.

Bill Eigen manages the $10 billion Morgan Stanley Strategic Income Opportunities Fund and does not believe that inflation has been adequately controlled. He stated:

"Rate cuts will be modest and gradual. The biggest issue facing bonds as a hedge is that we are still in an inflationary environment."

However, an increasing number of investors are downplaying the issue of inflation. During last week's most volatile market fluctuations, the yield on 2-year Treasury notes briefly fell below that of 10-year Treasury notes for the first time in two years, indicating serious concerns in the market about economic growth and preparations for a recession and rapid rate cuts. Pacific Investment Management Company's Chief Investment Officer Daniel Ivascyn stated:

"With inflation trending lower, risks are more balanced, even leaning towards more pronounced economic slowdown, and we do believe that bonds will exhibit more defensive characteristics."

In the coming week, the bond market faces multiple risks. The US CPI and PPI for July are set to be released, and any signs of an inflation rebound could push US bond yields higher again. Last Thursday, yields began to rise due to an unexpected drop in weekly initial jobless claims, weakening signals of a soft labor market