The protection capability of Treasury Notes against large and sudden equity declines has fundamentally remained intact despite the rise in interest rates this year.
Treasuries have been considered a good hedge against equities because during significant market downturns there is often a flight to the safe-haven Treasury asset. However, this year we have seen periods of simultaneous declines in both equity and bonds as a result of rising interest rates and inflation expectations. This has led many to speculate that treasuries (and bonds in general) may not be a good hedge or diversifier to equities in the coming years.
Correlation statistics show how likely two investments are to move together. If the two investments are perfectly correlated +1, they increase or decrease in value simultaneously. Conversely, if they have a perfectly negative correlation -1, then they will move in opposite directions.
The 7-10 Year Treasury Note correlation with US equities is -0.36 for 2018 YTD which is the same at -0.36 for the 2017 calendar year.1 This shows that, so far, the rise in rates has not weakened the negative correlation observed last year and on average the tendency is still for Treasuries to rise on days when the equity markets declined.
The negative correlation measured over just the US trading day is even stronger at -0.48.2 This better isolates the relationship between Treasuries and US equities by partially excluding the impacts of pre-market data releases, some of which were inflation related.
Most importantly, Treasury Notes experienced gains on each of the 11 largest US down market trading days of 2018. This indicates that Treasuries may still provide an effective offset to equity risks in times of significant market stress particularly when the decline is not associated with potential inflationary impacts.
Conversely, Treasuries declined on each of the 6 largest up market days which add to the strong negative correlation observed under extreme moves.
While Treasuries may underperform in a rising interest rate scenario, the statistical evidence suggests no material change to the observed recent historical negative correlation.
1 The 7-10-year Treasury Note is represented by the iShares 7-10 Year Treasury Bond ETF (IEF) daily return. US Equity is represented by the daily return of the S&P 500 TR index. Data through May 31, 2018.
2 US trading day for the S&P 500 TR Index measured from market open to close. 10 Year Treasuries is represented by the 10 Year Treasury Note future active contract measured intra-day from 9:30 to 16:00 EST. Data through May 31, 2018
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