For most of the last 30 years, bonds were the go-to shock absorber when stocks cracked. In that regime, core bonds reliably protected against equity drawdowns. From 1997 to 2020, the S&P 500 saw 10 pullbacks of more than -10%; in nine of them, U.S. Treasuries rose, delivering an average total return of about +7%.
This pattern had a simple engine: Most sell-offs were triggered by growth scares, not price shocks. When growth deteriorated – or markets feared it would – the Federal Reserve was expected to cut benchmark interest rates, so yields would fall and bonds would rally, cushioning equity losses. That’s the key: What drives the slowdown shapes correlation: Bonds can be a good hedge in growth shocks; during inflation shocks, bonds and stocks can fall together.
Then the regime flipped. Post-pandemic, the dominant shock was inflation, not growth. As the pace of price increases ran to highs not seen since the late 1980s, the Fed tightened aggressively. Higher policy rates pushed yields up (sending bond prices down) while compressing equity valuations – so stocks and bonds weakened together. That’s why stock-bond correlation moved higher, and the old “bond-as-insurance” playbook stopped working as well.
Now bond yields have reset higher to reflect inflation risk. At the 2020 trough, the Bloomberg U.S. Aggregate bond market yielded about 1%; today it’s about 4.5% – an approximate 350 basis points step-up.
Bonds have benefited from the reset in inflation and policy expectations. The Bloomberg U.S. Aggregate is up over 4% year-to-date and has outpaced cash. To the extent economic growth slows even more than expected, yields should fall further and bonds should continue to rally. Look no further than the disappointing payrolls report on August 1: The S&P 500 fell over -1.5%, while the U.S. Treasury index gained nearly +1%. That’s why we still view core bonds as the second-best protection asset against equities.
But what if the next equity drawdown is inflation-led, not growth-led? For most of the last 30 years, inflation sat below the Fed’s 2% target, so growth scares (“too cold”) dominated and bonds usually rallied when stocks sold off. Today, factors like deglobalization, U.S. fiscal deficits and labor supply raise the odds that inflation spends more time above target (“too hot”) – even if it still averages about 2% over time. This would mean bonds – while still being a key hedge against recession risk – could experience more episodes of negative returns at the same time as equities. In our view, that’s why positioning for a regime where inflation is something we have to look out for – and where stock-bond correlation goes through stretches of being positive – matters now.
How Can Investors Protect Against Bond Correlation Risk?
So, how can investors protect against the risk that bonds won’t always cushion equity drawdowns? One potential solution is to add exposures that, like bonds, diversify equities but tend to do better when inflation is firm. Based on our Long-Term Capital Market Assumptions, the opportunities worth exploring fall into three buckets:
Commodities, including gold
Core real asset alternatives: Real estate, infrastructure and transport
Less-correlated hedge fund strategies (e.g., macro hedge funds)
These strategies carry their own risks – including higher volatility and, for the latter two, less liquidity – so they should be sized to fit broader objectives and risk tolerance. In general, no more than 25% of a traditional core fixed income allocation should be shifted into these diversifiers. We still think bonds remain the cornerstone, and if you’re using them to get income and don’t plan to buy or sell them, then they should still play their part in your portfolio in the long run. But adding complementary assets can help portfolios weather both growth- and inflation-led shocks.
