From Harvey Bradley, Head of Global Rates, Insight Investment
Between March and June, we saw an unusual situation where government bond yields became positively correlated with oil prices.
US Treasury yields rose as the oil price increased from $70 to $105 over the course of March, stabilised in April, then rose together again in May, before falling for most of June as negotiations between the US and Iran made progress. Rather than government bonds offering a flight to safety, they were chiefly an expression of inflation and interest rate fears.
This is largely due to markets pricing in the future effects of higher energy prices on global inflation, and the anticipation that central banks would react by raising interest rates. However, leaving this aside, positive correlations generally become more likely when investors’ faith in government bonds as a hedge is eroded, and this is now undeniably the case for three key reasons:
- Gross government debt-to-GDP levels surpassed the psychologically important 100% level for the US, Canada, the UK, France and Spain in the past 15 years. Both Italy and Japan surpassed this level in the 1990s.
2. High indebtedness exerts pressure on governments as interest costs become a larger proportion of spending, reducing flexibility and leaving governments more exposed to bond markets.
- Duration becomes less appealing when the sustainability of government debt is widely questioned, which can lead to steeper curves. When curves are steep, the transmission mechanism of monetary policy does not work as well, meaning central banks may need to hike or cut more aggressively as they manage growth and inflation.
When will positive correlations come to an end?
When inflation becomes anchored near central bank targets again, yields are likely to stabilise or fall. In this environment, growth is the dominant macro driver and correlations become negative again.
However, we appear to be in an environment of structurally higher inflation, due to higher trade tariffs, geopolitical risk and a reversal of the forces of globalisation, increasing the likelihood that bonds and risk assets move together. We therefore expect a higher frequency of positive correlation as geopolitical and inflationary concerns persist.
To preserve the defensive role of bonds, we believe investors should broaden the scope for managers to build portfolios that are less reliant on traditional sources of return and more resilient overall.
