A wild week for stocks has bonds playing defense again for first time in years

By Joseph Adinolfi

Treasurys rallied during a volatile stretch for markets that culminated on Monday in the worst day for U.S. stocks in more than two years

Bonds have returned to playing defense over the past week for the first time since the Federal Reserve started raising interest rates more than two years ago.

Treasurys rallied alongside other classic "risk off" trades as a selloff in global stocks gathered pace, driven by signs of a "growth scare" in the U.S. Other safety trades, like gold, the Japanese yen and Swiss franc also benefited as investors sought protection from the tumult in stocks.

That so-called safe-haven assets and currencies would rally as investors fled stocks might seem obvious to some. But as far as bonds are concerned, swings in prices largely haven't offset losses in equities since the Fed first got serious about combating inflation.

A 'textbook' relationship

Now, that could be changing.

"It's back to where textbooks would tell you it should be," said Eric Stein, head of investments and chief investment officer of fixed income for Voya Financial, in an interview with MarketWatch.

Assuming the U.S. economy continues to cool, and the Fed cuts interest rates in September for the first time since the COVID-19 pandemic, bonds could reprise their role as a reliable buffer during periods of stock-market volatility. To be sure, Stein said a lasting return of this relationship isn't guaranteed - another bout of inflation could emerge to scramble the association once again.

Still, it is notable that over the past week, bonds did a better job of offsetting losses in stocks than at any point since the pandemic.

During the five-day stretch through Monday, which included the worst three-day stretch for U.S. stocks since June 2022, the iShares 20+ Year Treasury Bond ETF TLT rose 5.7%, according to Dow Jones Market Data. Meanwhile, the S&P 500 index SPX fell 5.1% during the same period.

This was the first time since March 2020 that the Treasury ETF had rallied by 5% or more, while stocks fell by a similar amount, Dow Jones data showed.

Moving in stereo

After more than a decade where interest rates and bond yields were largely at rock-bottom levels, bond prices cratered in 2022 as the Fed raised interest rates aggressively.

Concerns about inflation and a potentially imminent recession also upended U.S. stocks, resulting in their biggest calendar-year loss since 2008. The result was that investors with balanced portfolios saw their worst year since the 1970s, Dow Jones Data showed.

While stocks have mostly climbed since then, Treasury yields have seesawed, offering little respite during tumultuous stretches for markets.

In October, when the S&P 500 briefly entered correction territory, yields on the 10-year BX:TMUBMUSD10Yand 30-year Treasurys BX:TMUBMUSD30Y touched their highest levels in more than 15 years. Bond prices, which move inversely to yields, also declined when stocks stumbled in April.

The changing relationship between stocks and bonds reflects a shift in investors' priorities. For the first time in years, concerns about the state of the U.S. economy have outweighed worries about inflation, according to Sébastien Page, head of global multiasset and chief investment officer at T. Rowe Price. Page has published extensive research on the trading relationship between stocks and bonds.

Return of 60-40 portfolios

Bonds have been looking more compelling in another sense. In addition to playing defense on price, bonds also have been offering compelling yields. Taken together, this has helped rebut criticisms of the 60-40 portfolio that have become more commonplace over the past two years. As cash offered higher yields than bonds, and stocks rallied following their wipeout in 2022, some argued that dedicating such a large share of a portfolio to bonds no longer made sense.

Now that interest rates look poised to fall, returns investors can expect to reap from cash will likely decline as well. Because of this, some investment strategists said investors should consider buying bonds to lock in high yields before it is too late.

Todd Schlanger, a senior investment strategist at Vanguard, told MarketWatch that based on Vanguard's models, forward returns for bonds currently look more attractive than forward returns for stocks.

After all, bond yields have been high relative to where they had been since the 2008 financial crisis. And impending Fed rate cuts could mean investors benefit from price appreciation in bonds as yields fall.

U.S. stocks, on the other hand, have recently looked expensive relative to companies' expected earnings and sales growth.

"We view bonds as an essential ingredient to a well-balanced and diversified portfolio. We've seen in recent periods that they have provided that diversification. We would expect that to continue in to the future," Schlanger said.

Major U.S. stock indexes bounced back on Tuesday, and were extending those gains on Wednesday. The S&P 500 was up 52 points, or 1%, in recent trading at 5,290, according to FactSet data. The Dow Jones Industrial Average DJIA had gained 214 points, or 0.6%, to 39,216. The Nasdaq Composite COMP gained 183 points, or 1.2%, to 16,555.

TLT, meanwhile, was down 0.4% at $96.26, while the yield on 30-year Treasury bonds rose 3 basis points to 4.224%, FactSet data showed. The yield on the 10-year Treasury note was up 4 basis points to 3.943%.

-Joseph Adinolfi

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08-07-24 1231ET

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