It's Time To Throw Out The Old Risk-Off Playbook

The dollar, Treasuries, stocks and commodities cannot be expected to behave as in prior risk-off periods, according to Bloomberg macro strategist, Simon White.

When stress is high or time is short, rules of thumb are handy cognitive shortcuts.

The problem is that many of them no longer work.

Elevated inflation and the composition of US capital inflows have changed the calculus for the standard risk-off response employed in periods such as recessions or the current conflict with Iran.

Treasuries and the dollar may see more selling than buying, while stocks and commodities are poised to adhere closer to supply constraints and inflation than growth risks. Investors should tread carefully.

Yesterday’s price action was illuminating. Every market opened as expected, with oil and gas up, the dollar stronger, stocks down and yields slightly lower. But the latter rose all through the day, US stocks closed up (although futures are lower today), and the dollar’s rally was relatively modest.

In an inflationary world, slavishly following well-worn rules could become costly. Start with the dollar, which is laden with hoary belief that it is risk-off’s best friend. But that isn’t always the case. In almost half of post-1970 recessions, for example, it sold off.

The 2008 financial crisis, as the apotheosis of a risk-off period, still informs risk-off playbooks. But things are now different.

The dollar rallied in the GFC, but not for the commonly assumed reason of foreign capital rushing into the US seeking a haven. Instead, overseas investors reduced their buying of US bonds (even though they bought Treasuries) and stocks, selling the dollar as they did so. But the currency nevertheless rallied, as US investors sold stocks and bonds held abroad, pulling capital home. Without that repatriation, the dollar would have sold off.

As highlighted by Brad Setser, US mutual funds stopped lending to Europe, and US banks that had lent money to dollar carry traders asked for their money back.

Sales of foreign assets and the repatriation of dollars overwhelmed selling pressure from foreigners and allowed the dollar to rise, especially as foreign bond flows were more likely to be FX hedged.

The composition of flows today, however, can’t be counted on to trigger a notable dollar rally in a risk-off episode. For a start, foreigners see Treasuries as less of a haven, and net bond inflows have fallen in recent years.

At the same time, foreign inflows into US stocks have soared. Equity flows are less likely to be FX hedged than bond flows, so foreign capital taken out of the US will hit the dollar more.

Further, US capital outflows are smaller now, so they have less potential to bolster the dollar, while inflows to the US on a one-year basis are 30% larger than they were before the GFC, which could lead to more dollar selling. Thus in a classic risk-off move where foreign and domestic investors repatriate capital, the dollar is more exposed to a selloff (or at least a diminished rally).

Treasuries too might not behave as expected. Even during the current conflict, they have already eliminated all their gains after Friday’s rally.

The culprit is inflation. Wars are typically inflationary, as government borrowing rises to pay for defence and there are constraints to the supply of goods and commodities. That’s especially the case when structural drivers of inflation are already in the ascendant.

Treasuries today face three interlinked issues:

1. (many) foreigners no longer see them as a reliable haven;

2. domestic and overseas holders see heightened inflation risk;

3. and they are a less effective portfolio hedge.

The first can be seen in the steady decline of foreign holdings of Treasuries, especially from central banks. The blue line in the chart above shows the one-year net inflow to US bonds peaked in 2022. It can also be seen in the counter-factual: the decline of the dollar over the last year would normally have led to much stronger reserve buying. Not this time.

There are manifest signs that price pressures are brewing again, with money growth sending one of the strongest signals. Key is that savings deposits have been falling. This is normally a sign that animal spirits are frothing. Even if the war with Iran subsequently tempers that somewhat, inflation is lagging and that money growth is already in the system.

Unchecked price growth is offputting for buyers of government debt, with that made all the more acute in the current conflict by the threat to energy prices.

Rising inflation is also to blame for Treasuries no longer being reliable as a portfolio hedge, as the stock-bond correlation has become non-negative.

That brings us to commodities. They are typically risk assets and sell off in risk-off episodes as there is expected to be a growth shock. But don’t expect that to apply when price pressures are elevated.

As highlighted in previous columns, commodities have been waving their arms that inflation was likely to reaccelerate, as inflows to the asset class surged. They have been rallying steadily since last summer, but energy commodities have been laggards.

That’s not the case now as oil and gas rise amid supply disruptions. It’s too soon to know where energy prices will end up, but for now the bid behind them will broaden the commodity rally, further supporting it.

And let’s not forget commodity investment across metals and energy in this cycle was slow to increase, as returning money to shareholders was given primacy over capex.

Even if rising commodities trigger a recession, that’s only likely to be bad for them initially. In previous recessions induced by commodities, they sold off at the start of the contraction, but that eased the growth shock, allowing them to rally through the bulk of the downturn.

Stocks, like yields, ended the day higher yesterday. With Treasuries seen as less of a recession and inflation hedge, the alternative — however unwise — may be to be replace Treasury exposure with more stocks (or corporate bonds). That might keep equities better supported through risk-off episodes.

In the end, stocks as a Texas Hedge could prove very costly, as in the 1970s when they were the worst performing asset class in real terms at the index level. But the perception that equities are a hedge will be enough to drive reality, at least in the first instance.

Shibboleths across the market are being overturned in recent years. Investors who thumb their nose at rules of thumb will be better able to navigate risk-off episodes.