Are US Treasuries still a hedge? Citi Australia CEO says the bonds are losing their edge

If more investors share Woodruff’s view, demand for longer-dated Treasuries as portfolio insurance could weaken, adding upward pressure on the term premium, the extra yield investors demand to hold long-term bonds. That would leave yields more exposed to supply and inflation news. It could also support alternatives that investors have been using as hedges, including commodities. Goldman Sachs has said oil is attracting demand as a portfolio hedge, and it sees central bank buying as structural support for gold. Energy is central to the inflation story: higher oil prices linked to the Iran war helped push the US 10-year yield to its highest since 2007 in September, so any renewed spike in crude would reinforce the case that bonds are a weaker shield. The opposing view, from BlackRock, is that today’s higher yields offer more protection than in years.--- A 5% Treasury yield used to be the perfect insurance policy for a stock portfolio, but Citi’s Australia chief argues inflation and heavy borrowing have made the policy less reliable, and not everyone on Wall Street agrees.Summary:Citi Australia CEO Mark Woodruff says rising bond supply, persistent inflation and higher neutral interest rates are reducing the appeal of US Treasuries as a portfolio hedge.He said a 5% 10-year yield would usually make Treasuries an ideal hedge for equities, but higher prices and rates have weakened demand.Speaking at Citi’s Australia and New Zealand investment conference in Sydney, he said demand for hedging products has risen, but this cycle is different.The US 10-year yield hit its highest since 2007 in September as rising energy costs pushed inflation higher.Some investors are turning to alternatives such as hedge funds, credit and commodities as stocks and bonds have moved more closely together.BlackRock takes the opposite view, having upgraded Treasuries on the grounds that higher yields offer a bigger cushion.US Treasuries are becoming less effective as a hedge against falling stock prices, according to Citi Australia Chief Executive Mark Woodruff, who said rising government bond supply, sticky inflation and higher neutral interest rates are undermining their traditional role in portfolios.Speaking to reporters on Tuesday on the sidelines of Citi’s Australia and New Zealand investment conference in Sydney, Woodruff said a 10-year Treasury yield of around 5% would normally make bonds an ideal hedge for equity holdings. But rising consumer prices and interest rates have weakened demand, he said. While interest in hedging products has increased, he said this cycle is different.Woodruff pointed to three challenges for the bond market. Supply is rising as governments borrow more. Inflation has remained elevated. And neutral interest rates, the level at which policy neither stimulates nor restrains the economy, have moved higher at central banks around the world. Together, he said, those forces make bonds a less effective hedge than in previous cycles. He added that it is important to keep inflation expectations from becoming embedded.The comments reflect a broader rethink about the role of government bonds. A hedge works best when it rises in value as stocks fall, but in recent years stocks and bonds have increasingly moved together, particularly when inflation is the main worry. That has led some investors to consider alternatives including hedge funds, credit products and commodities.The backdrop explains the concern. The US 10-year yield reached its highest level since 2007 in September as global bond markets came under heavy pressure, partly because higher energy costs pushed up inflation. Goldman Sachs made a similar point this week, saying higher starting yields have made bonds a genuine source of return again but not always a reliable hedge for equities. Goldman has also noted that oil is attracting demand as a portfolio hedge.Not everyone agrees. BlackRock upgraded US Treasuries last week, arguing that higher starting yields provide a bigger cushion against further rate increases and that markets may be pricing in too much Federal Reserve tightening. Morgan Stanley Investment Management has said yields are rising for the right reasons, reflecting strong growth rather than stress, although it remains underweight bond duration and prefers credit.The debate is likely to hinge on inflation. If price pressures ease and the Fed’s tightening cycle ends, Treasuries could regain their defensive appeal. If inflation stays high, particularly with energy costs elevated by the Iran war, investors may continue to look elsewhere for protection.  This article was written by Eamonn Sheridan at investinglive.com.