US Treasuries Remain an Effective Portfolio Hedge

By Walter Kurtz, Sober Look

With all the talk of the so-called Great Rotation, evidence points to investors still pumping billions into fixed income. And in spite of a fairly broad conviction that rates will be rising in the near future, investment portfolios are loaded with treasuries. Demand for US government paper continues to be strong in spite of the worst risk/return profile in decades (see post) and implied real yields deep in the negative territory (see post).

The obvious explanation is the public sector purchases by the Fed as well as other nations with significant dollar reserves. Traders continue to call the 10-year treasury the “widow-maker”, given how painful it has been to short that paper. Nobody wants to get in front of the freight train in figure 1.

But there is another reason. As investors move into equities while market indices hit new records, investors need an effective hedge. And over the past few years, long-dated treasuries have delivered precisely that. As discussed in this post, the right mix of treasuries with equities dramatically reduced the daily volatility of the portfolio. That quality of longer dated treasuries persists through today. The anti-correlation between the Barclays Long U.S. Treasury Index and the S&P500 index remains quite strong at -0.7 (see figure 2).

What’s particularly interesting about long-dated treasuries as a hedge is that the anti-correlation increases during periods of stress in the financial markets. In fact the hedge effectiveness was the strongest during the Italy fears flareup in the fall of 2011, followed by another dip last summer when Spain was in the crosshairs (keep in mind the chart above shows correlation over the previous 90 days). Very few hedging instruments have the “optionality” that kicks in at the time when one really needs it. Equity options and credit instruments (such as CDX) were not nearly as effective, particularly given the cost of decay/negative carry.

Investors are therefore willing to pay the premium of negative real rates and limited upside of treasuries in order to minimize portfolio volatility. It’s unclear if this relationship will hold or ultimately revert to historical levels. For now however, as Europe continues to spook investors who are piling into equities, treasuries remain in demand as an effective hedge.



Figure 1 – Securities held outright by the US Federal Reserve (source: FRB)

Figure 2 – Daily returns, 90 day rolling window


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Sober Look

Sober Look

Sober Look was founded by Walter Kurtz, a New York based hedge fund manager and credit markets specialist.

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  1. long dated gov bonds WERE an hedge for an important equity position. From now on, equity is an hedge for an important long dated gov bonds position. It seems that what the points that follow are not potentially bad outcomes but 0% possible events:
    1) euro crisis in full speed again
    2) china hard landing (look at electrical energy consumption patterns)
    3) destructive crisis in the middle east and/or korea
    4) bad surprises from US economy
    Probably US gov bonds are no more the perfect safe heaven but still the best of an awfull lot… and at 3,1% 30y real interests are still positive.

  2. OK, my display is so small that sometimes I’ writing incomprehensible statements. This is better:

    “…It seems that what follows are not potentially bad outcomes, but discounted 0% possible events:”


  3. Whilst you have a guy like this making statement like this then US treasuries will stay attractive.

    “The rescue program for Cyprus reached on Monday is a new template for addressing banking problems in the euro zone, said Dutch Finance Minister Jeroen Dijsselbloem, the chair of the Eurogroup of euro-zone finance ministers, according to Reuters. “If there is a risk in a bank, our first question should be ‘Okay, what are you in the bank going to do about that? What can you do to recapitalize yourself?’ If the bank can’t do it, then we’ll talk to shareholders and the bondholders, we’ll ask them to contribute in recapitalizing the bank,

    and if necessary the uninsured deposit holders”

    Yes, we know that last part may exist as a possibility,but really would you be such an idiot as to broadcast that in this way? I mean give me strength,what does the guy think will be the public response?
    Whenever I think I have just seen the EU do the most stupid thing I can think of they surprise me by reaching new heights.

  4. Of course he is an idiot BUT if the EU adopted the swedish solution 4 years ago, now EU would be the safest place on earth. But German banks were (and still are) full of crap so Ms. Merckel did all wrong and now EU is exactly the opposite. Very good work Angela, you will be remembered. Of course all the western banking system is still insolvent, the EU banks a little more and more visibly than the others, but crap is crap.

  5. Is it time to pull out the chart of who is most exposed to a bail-in to restructure Spanish and Italian banks?

    Might it be German banks?

    Might it be the ECB through Target 2?