Rates Spark: Bonds losing their edge as a hedge | articles

Despite a bumpy opening of markets this week, investors are still positioned for a near-term resolution of the Middle East conflict, and overnight headlines seem to offer new hope again. We’ll likely see more volatility around the front end of the curve and oil moves around, but the long end still does not show signs of inflation expectations being unanchored. Also, if we look at the spread between 10Y Bunds and swaps, we don’t see signs of significant risk-off sentiment.

Although one could argue that Bunds are not as obvious a hedge from a renewed escalation, given this would likely be paired with higher inflation. Besides, as long as growth concerns are contained, equities may offer a more attractive proposition. And this seems to be the view of broader markets, with the S&P 500 holding strong at less than 1% from its peak. Iran and the US have already proven a willingness to open the Strait of Hormuz and, therefore, investors can turn their focus to the more optimistic stories such as AI and still strong underlying macro data.

The unattractive value of bonds as an equity hedge can also be seen when looking at the record-high correlations between the STOXX index and Bunds. The high correlations seem to have a structural element too, with the five-year correlation now close to zero. Inflation concerns will linger, even if oil prices find their way lower, and also the impact of AI on near-term inflation remains up for debate. As such, bonds may remain unattractive from a portfolio perspective, which can keep longer-dated rates elevated even if oil were to ease lower.

Meanwhile, in the UK, markets are finding a distraction from the Middle East in domestic politics, adding to the volatility in the long end. The upward pressure on gilt yields on Monday was triggered by renewed challenges to Prime Minister Starmer’s leadership. In a world where bonds are already under threat from inflation, the addition of political risk does not bode well. And markets have already singled out the UK as being more sensitive to inflation compared to the US and eurozone. For every $10 rise in Brent oil, markets are adding almost 30bp of Bank of England tightening over the next 12 months.