Citi Australia CEO argues US Treasuries are fading as portfolio insurance

Should more investors adopt Woodruff's view, demand for longer-dated Treasuries as portfolio protection could soften, driving up the term premium — the additional yield investors require for holding long-term debt. Yields would then be more sensitive to supply and inflation data. Alternative hedges that investors have already turned to, such as commodities, could also get a boost. Goldman Sachs has pointed to oil as a portfolio hedge that is drawing demand and treats central-bank buying as a structural support for gold. Energy sits at the centre of the inflation picture: oil-price gains tied to the Iran war helped lift the US 10-year yield in September to its highest level since 2007, so another surge in crude would strengthen the argument that bonds have become a less sturdy safeguard. BlackRock, for its part, takes the opposite line, arguing that current yields leave investors better cushioned than in earlier years.

A Treasury yield of 5% was once regarded as the perfect insurance policy for equity portfolios; Citi's Australia chief, however, argues that inflation and heavy borrowing have made that safeguard less reliable, and Wall Street is split.

Summary:

• Citi Australia CEO Mark Woodruff argues that higher government debt issuance, stubborn inflation and elevated neutral interest rates are eroding the appeal of US Treasuries as a portfolio hedge.
• He said a 10-year yield of 5% would generally make Treasuries an ideal hedge for equities; however, higher prices and interest rates have dampened demand.
• Speaking in Sydney at Citi's Australia and New Zealand investment conference, he said demand for hedging products has climbed, but the present cycle is different.
• In September, the US 10-year yield reached levels not seen since 2007 as climbing energy costs lifted inflation.
• With equities and bonds trading more in tandem, some investors are shifting toward hedge funds, credit and commodities as alternatives.
• BlackRock, by contrast, has upgraded Treasuries, saying that higher yields provide a larger buffer.

US government bonds are losing some of their effectiveness as protection against equity declines, Citi Australia Chief Executive Mark Woodruff said, citing higher bond issuance, sticky inflation and higher neutral rates as forces undercutting their usual portfolio role.

A 10-year Treasury yield of about 5% would normally be an ideal hedge for stocks, Woodruff told reporters Tuesday on the margins of Citi's Australia and New Zealand investment conference in Sydney. Rising consumer prices and higher rates have weakened that demand, he said. Hedging products have drawn more interest, yet the current cycle departs from previous ones, in his assessment.

Woodruff identified three pressures facing the bond market. Government borrowing is expanding supply. Inflation has stayed high. And neutral interest rates — the level where policy is neither stimulative nor restrictive — have moved higher at central banks globally. Combined, those forces leave bonds a weaker hedge than in earlier cycles, he said. Keeping inflation expectations from taking hold is also essential, he added.

Those remarks feed into a wider reassessment of what government bonds are for. A hedge is most valuable when it gains value as equities drop, yet stocks and bonds have lately shown a stronger tendency to move in step, especially when inflation is the dominant concern. That has prompted some investors to weigh substitutes such as hedge funds, credit products and commodities.

The broader market backdrop accounts for the anxiety. Global bond markets came under severe strain in September, taking the US 10-year yield to its highest point since 2007, with rising energy prices feeding inflation. Goldman Sachs weighed in along similar lines this week, observing that the higher yields at the start have made bonds a genuine source of return once more, if not a reliable hedge for equities. The bank has also pointed to oil drawing demand as a portfolio hedge.

There is dissent, though. BlackRock upgraded US Treasuries last week, saying the higher yields at the outset offer a bigger buffer against further rate increases and that markets may be pricing in too much Fed tightening. Morgan Stanley Investment Management, meanwhile, has argued that yields are climbing for sound reasons tied to strong growth, not strain, even as it stays underweight on bond duration and favors credit.

Inflation will probably determine where the debate lands. Should price pressures subside and the Fed conclude its tightening cycle, Treasuries could recover their defensive qualities. If inflation remains elevated — especially with energy prices boosted by the Iran war — investors might keep searching for protection elsewhere.