Given that US Treasuries have lost a not insignificant amount year-to-date is not great for a ‘risk-free’ asset, but it is somewhat inevitable after a 40-year bull run in bonds. More importantly perhaps, going forward, should we expect bonds to provide a diversifying balance to equities, or is the traditional equity-bond model dead? 
Indeed, since 2000 bonds have consistently provided some diversification to equities. Yes, falling bond yields have broadly helped equities, by reducing the discount rate, but equity market weakness has generally led to a bond market rally, as central banks ride to the rescue, thereby providing some diversification. But it’s not always been like this.
Importantly, inflationary pressures were minimal over the post-2000 period, in fact deflationary pressures were more front of mind.
However, there have been periods where inflation expectations were less anchored. Indeed, the decades preceding 2000 were characterised by more volatile inflation expectations and shifting central bank policy. This period saw a very different relationship between equities and bonds (see chart below), where they were largely positively correlated, rather than acting as diversifiers.
Correlation between US 10-year Treasuries and S&P 500
Source: Bloomberg, data between 30 Sep 1975 and 23 Mar 2021
If, and it is an if, we see a change in the inflationary regime, from broadly disinflationary to materially inflationary, it is reasonable to question the assumption around the equity-bond correlation regime. This might prove critical as that assumption seems hard-wired into the short-term memory of many investors.
Of course, many things are different now compared to that period, not least experimental monetary policy, including yield curve control in certain economies, and this might lead to that traditional relationship between higher inflation and positive equity-bond correlations breaking down. However, even if we don’t get a change in the correlation regime, we should assume that, with compressed yields, bonds hold much less of a cushion for equities.
Indeed, we often get asked by clients what would happen to asset classes if rates moved higher?
Well, it very much depends on the how and the why, for example it would be different if rates were edged up pre-emptively, or ratcheted up with the Fed perceived to be playing catch up.
Also, a back-up in real yields (growth expectations) would be much more benign than a back-up in breakeven yields (inflation expectations). And, if it is inflation driven, is it perceived to be transitory, or more secular in nature? Looking at the different break even yields currently, market expectations imply it is likely to be more transitory.
It’s also worth pointing out that even if the post-2000 world has not seen inflation force the Fed’s hand, Fed surprises can still be painful across assets, take the 2013 taper tantrum and more recently in 2018. Indeed, fast forwarding to today, higher US yields have already been adding to the pressure on some of those economies that were vulnerable even before Covid, such as Turkey and Brazil, expressed through their financial assets.
For our part, we don’t forecast, inflation or other indicators, but we do recognise that inflation and inflationary pressures have increased. As a result, we have ensured our portfolios are more inflationary-friendly. In equity, we have some exposure to macro recovery, such as real assets like industrial metals, oils and agricultural commodities, as well as some exposure to longer term themes in our equity, which should have less sensitivity to the economic cycle, and a degree of balance if inflation proves more transitory.
In bonds, we have reduced our risk, both from an interest rate and credit perspective, so they are more cash-like than they have been for some time. Outside bonds and equity, we have some exposure to gold, a classic inflation hedge, though again, scaled appropriately, as that relationship might not hold this time round.
Stepping back, markets have been liquidity driven for some time but higher US Treasury yields, if sustained, will increasingly challenge this and fundamentals might become more relevant. Either way, it increasingly feels like regime change is on the way, whether that’s inflation, equity-bond correlations or the relevance of fundamentals. Regime change doesn’t have to be bad for markets but the ‘everything rally’ looks increasingly threatened.
Anthony Rayner is a multi-asset fund manager at Premier Miton Investors. The views expressed above are his own and should not be taken as investment advice.