With yields barely ahead of inflation and looming interest rate rises threatening to erode capital values, the one reason they have made it into multi-asset managers portfolios is as a diversifier from equities. But could this advantage also be waning?
Peter Toogood, investment director at City Financial, points out that the uncorrelated status of sovereign bonds to equity markets may be shifting. He says: “Sovereign bonds are selling off because interest rates are – potentially – moving higher. That could be negative for a lot of the traditional relationships between asset classes. For investors, a holding in sovereign bonds may not provide the same offset to equity markets.”
This point has also been raised by Gordon Harding, investment director at M&G, who says low yields may mean that gilts offer little protection against equity market volatility, particularly if rates rises appear imminent. This is pertinent as markets wait tentatively for this evening’s release of the FOMC minutes. The widespread expectation is now that the Federal Reserve will hike rates in December.
However, this waning correlation may only be a factor if the equity market also follows a traditional path. The assumption is that the equity market would sell off in response to an interest rate hike because this is what has happened in the past. If sovereign bonds sold off as well, investors would lose their correlation advantage.
But the response of the equity market is not clear. The relationship between central bank policy and the equity market used to be well-established: The equity market rose as central bankers announced more monetary loosening and sold-off on rumour or reality of monetary policy tightening. While markets have still proved receptive to monetary policy loosening in Europe, the Federal Reserve’s deferral of rate rises brought a less enthusiastic reaction and markets now appear to favour further tightening.