Government bonds, an asymmetric hedge that has become more attractive - April 28, 2025
In this turbulent environment, investors are wondering how best to make their portfolios more resilient without compromising performance when equity markets rebound. In this context, sovereign bonds – including US Treasuries – could regain an important role as an asymmetric hedge asset.
After staying pretty much out of the sovereign bond market since 2021, we're changing our strategy. While we think long-term rates should average much higher than in the previous decade, the current phase gives us some reasons to bring them back into diversified portfolios, at least for now. We believe that their asymmetric hedging quality against the equity market has been reinforced: sovereign bond prices should be able to appreciate in the event of bad economic news, but should not depreciate, or only slightly, in a stabilization scenario. However, the arguments differ depending on whether we are talking about European or US bonds.
In Europe, it is the combination of a flattening yield curve – short-term rates are now back below long-term rates (Chart 1) – and a downward revision of inflation expectations that is changing the picture. At an average of just over 3%, long-term sovereign bond yields in the eurozone are now 1% above money market rates. If current market expectations are correct, monetary rates will fall again by at least 50 basis points this year, which, with long-term rates unchanged, will further increase the relative attractiveness of long-term bonds.
Market expectations are all the more credible given that the ECB has clearly changed its tone since Donald Trump launched his trade war. Against a backdrop of widespread disinflation, the rise of the euro, falling energy prices (Chart 2) and the threat of a global slowdown quickly convinced the ECB to take action. Fears of a low-cost redirection of Chinese products initially destined for the US market are also among the motivations. The latest rate cut on April 17 was unanimous, and some ECB members, such as Mr. Rehn, are talking about the possibility of faster rate cuts. In short, the ECB is clearly positioning itself in favor of supporting growth in order to avoid the risk of persistently low inflation, below 2%, as was the case in the 2010s.
We draw two conclusions from these developments. One is fairly constructive regarding growth in 2025 and especially 2026 in the eurozone, as it will be supported by the ECB, by purchasing power boosted by disinflation, and by Germany's budget plan. The other is practical: long-term eurozone bonds offer a favorable asymmetric profile. If, as we believe, growth holds up (even if it remains mediocre in the short term), long-term rates are likely to remain close to the current 3%. And if growth slows too much, long-term rates will fall significantly. Gains on eurozone bonds would then offset some of the losses on equities. Rather than focusing solely on German bonds, we believe that a portfolio of different issuers is warranted in order to capture higher yields. In the event of an external shock to growth, the ECB will be particularly attentive to preventing a significant rise in credit spreads relative to Germany.
In the US, the diagnosis is different but the practical conclusions are similar. The US yield curve is virtually flat and the Fed is in a wait-and-see mode given the risk of stagflation (slowing growth and rising inflation) triggered by the trade war. Investors are also concerned that foreign creditors will dump US Treasuries due to a loss of confidence in the US administration and, therefore, in the dollar. A risk premium has therefore been built into US long-term rates, which has prevented not only nominal long-term rates but also real rates from falling (Chart 3) despite the gloomy growth outlook.
We believe this underreaction presents an opportunity, provided that currency risk is hedged. Firstly, despite Donald Trump's verbal attacks on Jerome Powell, we do not believe that the US administration will allow the idea of challenging the central bank's independence to take hold. Secondly, the Fed will not stand idly by if the economy slows down significantly, especially since its current policy is, according to its own assessment, restrictive. This has been indicated recently by some Fed members, including the highly influential Mr. Waller. Faced with an economic downturn, lowering rates from 4.5% to, say, 3.0% would not undermine the Fed's credibility in any way, even if inflation were to rise temporarily as a result of tariffs. Finally, inflation-linked Treasury bonds currently offer a real yield of over 2%, their highest level since 2007, which is a godsend for US domestic investors in the event of a growth slowdown.
In our diversified global portfolios, we have therefore initiated positions in European government bonds (EU, Italy, and France) and then US bonds (with a futures option strategy) in recent weeks. These positions are partly intended to improve returns, as European long-term rates are now higher than money market rates. However, the increase in the bond duration of our portfolios also allows us to maintain sufficient exposure to equities, with sovereign bonds now acting as an asymmetric hedge limiting portfolio volatility in our view.