Stocks and bonds fall together. That's the problem

Ten-year US Treasury yields rose by roughly 50 basis points in five trading days this week while share prices fell. Balanced 60/40 portfolios at big institutions took heavy losses. The oldest rule in modern risk management, that government bonds cushion a portfolio when equities drop, stopped working.

The sequence was striking. When the White House announced its reciprocal tariffs on April 2nd, Treasuries initially behaved as textbooks say they should: yields fell as money fled shares. Within days that reversed. By the start of this week share prices were still falling, the dollar was weak, and long-dated Treasury yields were climbing fast. For investors used to buying bonds as insurance, the premium was paid and the policy did not pay out.

When bonds stop hedging

If shares fall purely on fears about growth, yields usually drop as investors buy long-dated bonds for safety, and a balanced portfolio holds up. A shock that raises costs from outside the economy, such as sweeping tariffs, works differently. Shares and Treasuries fall together. Higher input costs squeeze company profits, and bond desks have to price in more inflation and a tighter Fed.

The negative correlation that investors take for granted is a fairly recent habit. From the late 1960s to the late 1990s, stocks and bonds tended to rise and fall together, because inflation was the dominant risk and it hurt both. Only after inflation settled at low levels did bonds become a reliable hedge, and that relationship held for two decades until 2022, when rapid rate rises by the Federal Reserve pushed both assets down at once and a standard 60/40 portfolio had its worst year in decades. Tariffs threaten to bring back the older regime.

What else is selling Treasuries

Inflation fears are not the only force at work. Hedge funds have built large positions in the so-called basis trade, buying cash Treasuries and selling futures against them to capture a small price gap, financed with borrowed money in the repo market. When volatility rises, lenders demand more collateral, and some of those positions have to be unwound by selling bonds. Signs of strain in the swap market this week suggest that leveraged holders are cutting exposure.

A further worry is foreign demand. Foreign governments and investors hold a large share of the Treasury market, and a trade war in which America penalises its partners gives them less reason to recycle their dollars into American debt. There is no hard evidence yet of a deliberate foreign strike on Treasuries, and it would be costly for any holder to try one. The mere possibility, together with a falling dollar, adds a risk premium to American yields that was absent a few weeks ago.

Risk parity funds sell everything

When stocks and bonds move together, risk parity funds are forced to cut their positions mechanically. These quantitative strategies count on the two assets moving in opposite directions, which lets them borrow heavily to hold government bonds. When both fall at once, portfolio volatility breaks through the funds' risk limits and their models sell across every asset class.

The feedback loop is easy to trace. A fund targeting a fixed level of volatility measures risk from recent price swings. When swings widen, it must reduce its positions to bring measured risk back to target, and it sells the most liquid holdings first, which are Treasury futures and large-cap equity futures. That selling widens price swings further, triggering more selling by other volatility-targeting funds, trend-followers and leveraged multi-asset strategies. The loop stops only when volatility falls or buyers with fresh capital step in.

Lessons from 2020 and 2022

Two recent episodes show how such spirals end. In March 2020, as the pandemic struck, investors sold Treasuries along with everything else in a scramble for cash, and the market for the world's safest asset seized up until the Federal Reserve bought bonds on a vast scale. In September 2022, British pension funds using leveraged liability-driven strategies were forced to sell gilts after the government's unfunded tax-cut budget, and the Bank of England had to step in with temporary purchases to stop the rout.

Both episodes ended with a central bank acting as buyer of last resort. That option is less straightforward now. With inflation still above the Fed's 2 per cent target and tariffs set to push prices higher, a Fed rescue of the bond market would look like easing into an inflation shock. The central bank would probably intervene only if the market stopped functioning, and falling prices alone would not qualify.

Who is exposed

The losers are institutions that rely on bonds to offset equity risk: pension funds, endowments and the multi-asset products sold to retail savers as low-risk options. Leveraged funds face margin calls. Borrowers are hit too, because mortgage rates and corporate borrowing costs follow Treasury yields, so the tariff shock is tightening financial conditions at the same moment it threatens growth. The Treasury itself, which must refinance a large volume of debt this year, will pay more at every auction if yields stay high.

The winners are harder to find. Holders of cash and very short-dated bills, whose yields are anchored by the Fed's policy rate, have been spared. Gold, which does not depend on any government's promise, has held its value far better than either shares or bonds this year.

What would restore the hedge

The strongest counterargument is that this is a brief dislocation caused by forced selling rather than a lasting change in how bonds behave. If the economy slides towards recession, growth fears should eventually dominate inflation fears, and Treasuries would rally again. Watch the auctions of three-, ten- and thirty-year notes and bonds scheduled for this week, the spread between Treasury yields and swap rates, the inflation expectations embedded in index-linked bonds, and any sign that the administration is willing to delay or soften the tariffs.

With stocks and Treasuries falling together, multi-asset investors have lost their main hedge, and forced selling by leveraged funds could keep feeding on itself until tariff-driven inflation fears ease. Unless the White House retreats on tariffs, expect pension funds and balanced funds to report their worst quarterly losses since 2022, and expect long-term borrowing costs for American households and firms to stay higher even as the economy slows.