The broad-based sell-off that has faced investors since the start of this year has been all the more painful because of the breakdown in traditional correlations, which has put conventional hiding places out of reach.
Given the scale of the moves it is worth a bit of a recap; the S&P 500 and Euro Stoxx 50 are down 17.5% and 15% respectively year-to-date, while the Nasdaq is down an extraordinary 27%. The usually less volatile fixed income indices have not fared much better, with the US high yield and investment grade indices also down 10% and 13% respectively YTD. The real difficulty though has been the underperformance of rates; 10-year US Treasuries have given losses of 10% YTD, which means the safe haven asset of choice for most investors has only inflicted more pain.
Of course, the source of this underperformance is obvious. Inflation has gone from being a big problem to potentially an out-of-control one, as the war in Ukraine and further shutdowns in China have contributed to a global commodity shock, on top of already too-high inflation. This in turn has forced central banks to act by aggressively hiking rates, which seems likely to make rates markets ground-zero for volatility for much of the year.
This week however, there have been tentative signs that correlations are returning, with Treasuries rallying strongly as equity markets sold off, despite the latest US inflation data again coming in above consensus. This would be a welcome change for investors, but what is behind the move?
There are a number of factors that have probably contributed to the strength in rates, and the yield available is certainly one of these. Ten-year US Treasuries started the year at a yield of just 1.5%, which wouldn’t look hugely enticing too most even without runaway inflation. After a rise of over 150bp in a little over four months, however, 10-year USTs now provide a more reasonable yield for investors, especially when you consider that the US high yield index was only offering 3.75% as recently as September. In addition to this, the fear of substantial additional losses have also abated, with yields now reasonably above the Fed’s likely neutral rate (~2.5% based on the central bank’s dot plots).
This week there has also been a slight shift in the narrative, which is now focused on a potential recession rather than just inflation. There is an ongoing debate over whether the Fed would hike into a recession, and the answer probably depends on what kind of recession the US would be facing (would there be high or low unemployment, high or low default rates?). However, given the number of hikes already being priced in by the markets, we think Treasuries would likely provide a safe haven if growth turned negative. As asset managers begin to transition for late-cycle – as we currently are – this is also likely to lend further support to risk-off assets.
When rates become the source of risk and correlations break down, the environment becomes very difficult for investors. Thankfully periods like this do not tend to last very long, though the last five months has certainly felt like a long and arduous period. However, the most recent move in USTs appears to be a return to some degree of normality, and if this holds it should add a bit more confidence to a market that has lacked it for much of the year.