The credibility of UST as a diversifier against large US equity drawdowns has been severely dented since their failure to meaningfully hedge the S&P 500 Index selloff in 2022. Investors depend on bonds to achieve a balanced and resilient investment strategy, by offering a predictable source of income and capital preservation while diversifying equity risk and economic downturns. But in 2022, during one of the steepest equity drawdowns in memory, bonds failed in their role as an equity hedge: from its peak in Dec 2021 to its trough in Sep 2022, the S&P 500 Index lost 24%, while a balanced portfolio 60% in equities and 40% in bonds lost 19% - less damage, but not by much.
Exhibit 1: Time series of rolling 12m returns: SPX and UST (1973-2024)
Source: Bloomberg, Bank of Singapore.
In previous US equity drawdowns, the same allocation to bonds would have easily cut the drawdown loss by half, thereby speeding up the return to the previous high-water mark by an average of 14 months. 2022 was aberrant: not only did bonds barely mitigate the equity loss, but the return to the high-water mark for a balanced portfolio took longer than for a portfolio 100% in US equities (See Appendix).
What happened? Can investors still rely on UST as a hedge for their risk exposure? We think that bonds not only provide a ballast to a diversified portfolio, but continue to serve as a useful hedge to equity risk, in most circumstances, and especially over longer holding periods.
Exhibit 1 shows the rolling 12m return for USTs and the SPX over the last 50 years (note the two different axes). It clearly shows negative performance in 2022 for both, with the bond performance of -15% over a 12m period, which was the worst in its history. However, in other instances when US equities collapsed, positive bond returns prevailed: the 1973 stagflation, the early 2000s recession and bursting of the dot-com bubble, and notably the Global Financial Crisis in 2008-2009 were all examples of bonds well positioned to hedge such major equity drawdowns.
Just how rare was 2022? The answer is: very.
Exhibit 2 shows the same rolling 12m return data as above, but as a scatter plot of S&P 500 Index returns on the horizontal axis and UST returns on the vertical.
Exhibit 2: Scatter plot of rolling 12m returns: SPX and UST (monthly,1973-2024)
Source: Bloomberg, Bank of Singapore.
There are a total of 613 observations using monthly data from 1973-2024. Since our focus is how bonds perform when equity returns are negative, we focus on the data points to the left of the vertical axis, which represent instances when 12m equity returns were negative; this is 20% of the overall sample. Of these, only 13 observations (or a mere 2% of the total sample) represent episodes when both equity and bond returns have been negative.
Exhibit 3 telescopes into the unusual instances when equities and bonds both declined in value (i.e., the bottom left quadrant of the chart) and highlights when they occurred. Most episodes occurred in the 2022 period (for instance, the 12 months ending on 31 Oct 2022, is when UST experienced their worst performance of almost -15%).
Exhibit 3: Scatter plot of rolling 12m returns: SPX and UST when both are negative (monthly,1973-2024)
Source: Bloomberg, Bank of Singapore.
In 1994, both UST and US equities also sold off in tandem. Reviewing these two episodes can help to isolate the conditions that drove both stocks and bonds lower.
1994 and 2022: Aggressive monetary tightening sparked selloffs in bonds, spilling over to stocks
The “Great Bond Massacre” of 1994 is one of the most significant events in bond market history, wiping out over USD1t in global bond values. While historic at the time, the magnitude of losses was significantly surpassed by the bond rout of 2022 (see Exhibit 3). In both cases, the sharp and unexpected tightening of monetary policy by the US Federal Reserve (Fed) served as the trigger.[1]
Exhibit 4: US leading economic indicator index and PCE deflation YoY change (monthly,1973-2024)
Source: Bank of Singapore using https://www.conference-board.org/topics/us-leading-indicators and Bloomberg data.
At the beginning of 1994, the Fed, under Chairman Alan Greenspan, initiated a series of interest rate hikes to avert any potential upsurge in inflation arising from a robustly growing US economy (illustrated in Exhibit 4 by steady gains in US leading economic indicators) through 1993. Inflation had been trending lower since the early 1980s and remained well behaved, and the Fed was eager to consolidate these gains.
The Fed increased the federal funds rate by 25bps in Feb 1994, marking the first rate hike since 1989. Over the course of the year, the Fed raised rates six more times, totaling 300bps (see exhibit 5). The rate hikes took investors by surprise, particularly considering such well-behaved inflation. Bond prices fell sharply as yields spiked higher.
Exhibit 5: 10Y UST yield and Fed funds rates (monthly,1973-2024)
Source: Bloomberg, Bank of Singapore.
In 2022, the Fed commenced tightening cycle, at an unprecedented pace that again shocked the market. Unlike 1994, the catalyst was an exceptional surge in inflation. After several decades of relatively low and stable inflation, in 2021 the US experienced a sharp spike in the pace of price increases. The annual inflation rate, as measured by the PCE deflator, registered at 1.8% in Feb 2021, and continued rising through the next 18 months, peaking at 7.2% in Jun 2022, its highest level since 1981. Inflation surged due to a combination of factors, including pandemic-related supply chain disruptions, alongside fiscal and monetary stimulus which put upward pressure on wages and prices. Rising prices of food and energy added meaningfully to inflation.[2]
The Fed responded with one of the most aggressive tightening cycles in its history. The federal funds rate increased from near zero in Mar 2022 to over 4% by the end of the year, a total change of 425bps in just nine months. 10Y US rates rose nearly in lockstep. 2022 marked one of the worst years ever for bonds. The Bloomberg US Aggregate Bond Index fell by about 13%, its largest annual decline since its inception in 1976. Long-duration bonds were particularly hard hit, as their prices are highly sensitive to interest rate changes. Some long-dated UST bonds lost over 20-30% in value.
In both 1994 and 2022, the bond market rout spilled over into the US equity market, which started each tightening cycle at lofty valuations (see Exhibit 6), around the highest ranges on record.
Exhibit 6: S&P 500 Index P/E ratio (monthly,1973-2024)
Source: Bloomberg, Bank of Singapore.
Besides equities’ high starting valuations, rising interest rates dampened their comparable attractiveness to bonds. Exhibit 7 illustrates the S&P 500 Index earnings yield (equal to the inverse of the P/E ratio), 10Y UST yields, and their difference. This difference was bouncing around historically negative levels going into the unexpected hiking cycle in 1994, reflecting the relative dearness of stocks vs bonds, which rendered equities precariously sensitive to the sharp spike in bond yields.
Exhibit 7: S&P 500 Index earnings yield – 10Y US yield (monthly,1973-2024)
Source: Bloomberg, Bank of Singapore.
In 2022, equity earnings yields were comfortably well above bond yields. But as bond yields rose, they began to offer a more compelling investment option, triggering some rotation out of stocks to lock in higher rates in fixed income markets. The S&P 500 Index fell nearly 20% in 2022, marking its worst annual performance since 2008. The Nasdaq Composite Index, heavily weighted toward tech stocks (arguably more reliant on long-term earnings being discounted at higher rates), dropped by more than 30%.
In both 1994 and 2022, the sharp tightening in Fed policy precipitated bond market volatility and yield spikes which drove equity markets lower. If Fed tightening during these episodes resulted in poor performance across bonds and stocks, why didn’t this occur during the other instances of monetary tightening?
Why bonds and stocks sold off during the 1994 and 2022 monetary tightening episodes but not during others
There have been seven full tightening periods since the Fed began targeting the federal funds rate as a policy lever in 1982.[3] Exhibit 8 summarises key characteristics across all seven episodes, and underscores 1994 and 2022. What these two instances have in common are (1) a rapid pace of tightening (25bps and higher a month), and elevated average equity valuations in the 12m preceding the initial tightening. Additionally, the low starting bond yield in 2022 made bonds particularly susceptible to a selloff arising from the sharp withdrawal of central bank liquidity: there was less of an income cushion to blunt the impact from falling prices. Returning to Exhibit 3, the rolling 12m bond total returns (income + price change) were a quantum more negative than the comparably modest negative bond returns in 1994.
Exhibit 8: Summary of key characteristics of Fed tightening cycles (1982-2024)
Source: Bloomberg, Bank of Singapore.
Implications for investors
Over the relatively short (12m) horizon that has been the focus of this analysis, investors may need to assess the reliability of traditional 60-40 portfolios as bonds may not offset equity losses under certain circumstances: rapid monetary policy tightening, elevated equity valuations and low bond yields can signal increased risk of bonds disappointing as a hedge. However, with US yields having moved meaningfully higher (by a few hundred bps!) since 2022, a significant yield buffer has been established to help mitigate any potential bond losses.
Exhibit 9: Scatter plot of rolling 36m returns (annualized): SPX and UST (monthly,1973-2024)
Source: Bloomberg, Bank of Singapore.
Moreover, if investors have horizons greater than 12m, history shows that bonds have fulfilled their hedging function: negative equity returns over three years, for example, have consistently corresponded with positive performance in bonds (see exhibit 10). Moreover, over a rolling 3y period, very rarely are bond returns negative (represented by the few observations below the horizontal axis): this is because over longer periods, income drives a more notable portion of bond total performance than price returns.
Over even longer horizons (10 years, which is the suitable term for a strategic allocation), bonds contribute meaningfully to averting portfolio drawdowns. Exhibit 10 illustrates combinations of equity/bond portfolios, their average 10Y return since 1973 (y-axis) and the worst 5% of their 10Y returns (x-axis). A portfolio invested 100% in equities posted an average decadal return of just under 12% since 1973, but with the worst 5% losing 1% annualised over a decade. Diversifying 20% into bonds reduces tail risk of loss, with a 100bps cost to annual performance. Risk preferences of investors will determine where they reside in the continuum of balancing tail risk of loss with reward.
Exhibit 10: Sample portfolio worst performance vs average returns (10Y returns annualized, Jan 1973 – Dec 2024)
Source: Bloomberg, Bank of Singapore.
Summary
Appendix: Summary of S&P 500 Index drawdowns
Source: Bloomberg, Bank of Singapore.
[1] See https://www.bis.org/publ/work32.pdf
[2] See What Caused the US Pandemic-Era Inflation?
Olivier J. Blanchard & Ben S. Bernanke summarized in https://www.nber.org/digest/20239/unpacking-causes-pandemic-era-inflation-us.
[3] See When Did the FOMC Begin Targeting the Federal Funds Rate? What the Verbatim Transcripts Tell Us
FRB of St. Louis Working Paper No. 2004-015B found in https://papers.ssrn.com/sol3/papers.cfm?abstract_id=760518
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