The Fed’s Gift To Seekers Of Uncorrelated Assets

On Wednesday afternoon Fed Chairman Powell delivered a strong message. To quote, “We are not even thinking about thinking about raising rates.” In my opinion, Powell painted a picture that looks nothing like a V-shaped economic recovery. By all estimates, rates are expected to be near the zero bound through 2022 (it remains to be seen if the market will take them beyond that boundary). With treasuries set to produce little income for investors for the next roughly two years, should we give up on them as an asset class? My initial thought is absolutely not. 

Yes, the yield is an important element to the portfolio construction process but there is also another important aspect. One that is sometimes viewed as the “holy grail” when constructing a portfolio…uncorrelated assets. Holdings that zig when the equity market zags. I put together a list of broad ETF options that can be used when constructing a diversified portfolio: US Equities, Foreign Equities, US Fixed Income, Global Fixed Income, Broad Commodities and Gold. I then looked at these investment options based on correlation over the past 252 days. 

What jumps off the page is the fact that treasuries have an inverse relationship to equities to varying degrees. Interestingly, this inverse correlation is roughly the same regardless of the duration of the treasuries used. The Vanguard Extended Duration Treasury Fund (EDV) is at -0.43 and the iShares 3 – 7 Year Treasury Bond Fund (IEI) comes in at -0.50. 

At the same time the Fed remains committed to purchasing $80 billion / month of treasuries. Don’t fight the Fed comes to mind, especially when they are committed to buying assets that are inversely correlated with the equity market. Do we really want to fade that trade? Can I talk you into taking the other side of this balance sheet, that is seeing exponential growth in both absolute and rate of change terms?

Given these dynamics, I looked at the ETF ratings for four treasury bond funds to determine which were likely to be the best options for inclusion in a diversified portfolio. 

As of today (June 11th), the long duration funds have Neutral ETF ratings. In the intermediate term, In the short-term (IEI) and the intermediate-term (IEF) the key treasury bond funds have Very Bullish ETF ratings.

Yes, yield is important. My colleague, Marc Gerstein, just wrote a great post highlighting three ETFs that provide yield in the current market environment.But I also value performance. I place a premium on assets that will allow portfolios to be down less than the equity market in periods such as February and March of this year. I believe that smaller drawdowns are what will allow a diversified portfolio to outperform over an extended period of time.

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