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Risk Parity Is Slammed as Bonds and Stocks Move in Lockstep

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(Bloomberg) -- A quantitative strategy with $400 billion in play is headed for its worst week since the pandemic hit after inflation fears rocked assets across the spectrum.

A benchmark of risk parity, the systematic investment method pioneered by Ray Dalio, has dropped 3% in the past four days. The strategy, which seeks to spread risk by allocating to different assets based on their volatility, has been upended as investments like stocks and bonds increasingly move in lockstep.

Like many multi-asset trades, risk parity depends on those two asset classes in particular hedging one another. That hit a snag this week when higher-than-expected U.S. inflation sent a shock wave across Wall Street and spurred fears that rising rates could hurt a slew of investments.

After more than a decade mostly in negative territory, the 60-day correlation between Treasuries and the S&P 500 Index has now reached the highest since 1999, according to data compiled by Bloomberg.

“The deeply negative correlation of stocks and bonds that has persisted for most of the last two decades is not a permanent feature of markets but in fact is contingent on a certain macro regime of low and not volatile inflation,” Sanford C. Bernstein strategists led by Inigo Fraser Jenkins wrote in a note Thursday. “That regime may be coming to an end.”

Even as nerves eased on Friday, the benchmark U.S. equity gauge and the 10-year Treasury both rose, demonstrating the increasingly positive link between the two.

Despite a bounce since Thursday, the S&P 500 remains down roughly 1.7% this week, the most in three placid months. Meanwhile, 10-year Treasury yields are up about 5 basis points.

Inflation-linked bonds are down this week, too. Even commodities -- another common part of risk-parity funds, and an asset class that’s been surging in recent weeks -- slumped on Thursday.

Bond declines tend to raise more alarm for risk-parity strategies, which typically have higher-than-average allocations to debt owing to its lower volatility. In this view, the selloff in Treasuries this year has been especially concerning because it signals investors are demanding higher yields after a decade of falling rates.

With stocks also slumping in the first half of the week, the $1.2 billion RPAR Risk Parity exchange-traded fund posted its worst three days since March 2020. Inflows to the fund have faltered recently after it lured cash almost every single week last year.

“Any semblance of an inflation impulse will always act to stoke volatility -- as market participants had become utterly cynical as to the prospects for a sustained ‘hot’ economy and its implications for interest rates,” Nomura Holdings strategist Charlie McElligott wrote in a note. “You’re now combustible for brief but violent deleveraging and momentum shocks.”

(Updates prices throughout.)

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