Inflation challenges US Treasuries' traditional role in portfolios

* Rising inflation and deficits weaken bonds' role as portfolio diversifiers

* Analysts highlight diminished negative correlation between stocks and Treasuries

* Some investors favor shorter maturities, but Treasuries remain key global asset

By Karen Brettell

May 28 (Reuters) - A selloff in government bonds is testing one of the most basic assumptions in markets: that Treasuries and other high-quality debt will cushion portfolios when stocks fall. Long-dated bonds have come under pressure since the Iran war started, as investors demand more compensation for inflation, U.S. economic strength and expected increases in bond supply driven by deficit spending.

The 30-year U.S. Treasury yield rose further above 5% than analysts expected this month before drawing buyers. The 60-day correlation between the S&P 500 and Treasury returns is now the highest in over two decades, meaning that bonds are tending to amplify market swings rather than hedge them.

That is undermining the traditional 60/40 portfolio model that relies on fixed income for both income and diversification. Typically, investors expect Treasury prices to rise when stocks fall, which is what Wall Street calls a negative correlation.

"The value proposition of bonds in a portfolio is really quite challenged with the negative bond-equity correlation non-existent," said Jonathan Cohn, head of U.S. rates desk strategy at Nomura.

CORRELATION SHIFTS

The issue has been building since 2021, when inflation surged in the wake of COVID-related business disruptions, and has regained momentum with rising oil prices amid the Iran war.

Together, those forces have kept investors focused on the possibility that inflation will stay above central bank targets, limiting policymakers' ability to cut rates if growth slows.

For many portfolio managers, the more troubling issue is not the level of yields alone, but what the move reveals about bonds' diminishing role as a portfolio stabilizer.

"Bonds aren't going to necessarily hedge your portfolio when inflation is high and volatile," added John Luke Tyner, head of fixed income and portfolio manager at Aptus Capital Advisors.

Fiscal concerns are adding further pressure at the long end of the curve. Investors have grown more sensitive to the cost of servicing U.S. debt, future Treasury issuance and the risk that persistent deficits require higher term premiums - the additional compensation investors demand to buy longer-dated bonds when they see more risk.

The term premium on 10-year notes recently reached around 0.86%, after falling below 0.50% in February.

George Catrambone, head of fixed income for the Americas at DWS Group, said there are "certainly more questions about the safety of the dollar and U.S. deficits than there were five years ago."

U.S. BONDS REMAIN CORE HOLDING

Still, few investors are ready to declare the end of Treasuries as a core global asset. The U.S. bond market remains the world's deepest and most liquid, and the question for many is less whether to own Treasuries than whether to buy shorter-term bonds or longer-term ones.

Catrambone and Cohn point to shorter maturities for now.

"I don't think this is the death knell of the dollar or the Treasury," Catrambone said. "I think actually Treasury yields are attractive as a way to start to get back in and diversify your portfolio."

For longer-dated debt, the calculus may be shifting. In a world of sticky inflation, fiscal strain and volatile policy expectations, long bonds may need to offer higher yields than before to draw buyers from more risky but much better-paying asset classes such as stocks. That is especially the case as market participants price in more aggressive growth and earnings expectations from record corporate spending on artificial intelligence.

"Bonds are certificates of confiscation in terms of your real purchasing power," said Tyner. "On the other hand, everyone's looking at stocks and asking why they don't own those - they're going up 20% a year."

(Reporting by Karen Brettell in New York; Editing by Colin Barr and Matthew Lewis)