BlackRock Portfolio Manager, Russ Koesterich, CFA, JD discusses his preference for the US dollar over a long Treasury hedge in the current markets.
Global stocks continue to grind higher. And it is not just stocks. A broad list of risky assets, from commodities to Bitcoin, are posting record gains. In this sense 2021 is shaping up to be remarkably similar to 2020.
But while risky assets continue to advance, assets used to hedge risk are struggling. Unlike 2020, when stocks and bonds rallied together, this year hedges have cost you. Both Treasury bonds and gold are down as investors wrestle with inflation and the prospect of less benign monetary policy. To the extent this is likely to continue, I would reiterate my preference for a long dollar rather than long Treasury hedge.
Shifting correlations
A few weeks back I discussed why gold prices have remained rangebound. While there are several explanations, one is shifting correlations between different asset classes (see Chart 1). This same framework matters in evaluating the role of Treasuries and the dollar in a portfolio.
Correlation matrix of asset returns
Daily % change correlation over 90 days – with conditional formatting applied.
Source: BlackRock Investment Institute, as of 11/9/2021.
In the year leading up to last November, U.S. long duration Treasuries and stocks had a correlation of -0.47, in-line with the post-GFC average. That started to change about a year ago, coincident to the vaccine news and growing optimism for a return to normal. During the past year the stock-bond correlation has moved closer to zero, around -0.10.
Correlations have also been shifting for other pairs of asset classes. For example, in the year leading up to last November there was close to zero correlation between the dollar and stocks. However, during the past year the correlation between the Dollar Index (DXY) and S&P 500 has become more negative, around -0.28. Focusing on just the past six months, the correlation has become even more negative, approximately -0.35.
Why the shift? The simple answer is because the economy shifted. Growth has surged; the Fed has evolved their policy framework; inflation has accelerated to a three-decade high. And as investors have pivoted from worrying about too little growth to being afraid of too much growth pushing inflation higher, bonds and stocks have been more likely to move together. At the same time, the potential for a more aggressive Federal Reserve, while tending to occasionally unnerve equity investors, has helped the dollar.
Hedging tripod
What is the bottom line for investors? Overweight the dollar while considering other types of hedges as well. With short-term rates still at zero, simply holding cash in dollars produces no returns. Another challenge: The dollar is now negatively correlated with stocks but on most days it is not volatile enough to compensate for a big correction. This suggests investors adopt a multi-prong approach, one that takes advantage of some cash, a dollar overweight and, with volatility low, equity options as a partial substitute for stocks. In the past few years stock gains have become easier to come by; hedging them is more challenging.
Russ Koesterich, CFA, is a Portfolio Manager for BlackRock's Global Allocation Fund and the lead portfolio manager on the GA Selects model portfolio strategies.
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Source: BlackRock Investment Institute, as of 11/9/2021.
