(Bloomberg) -- Government bonds are no longer working as an effective hedge against risky assets, creating a challenge for global investors and spurring a search for asset diversification, according to KKR & Co.
Bigger fiscal deficits and stickier inflation suggest that bonds will not always rally when stocks sell off, breaking down the traditional relationship between the two assets, Henry McVey, KKR's head of global macro and asset allocation, said in a research note.
"During risk off days, government bonds are no longer fulfilling their role as the 'shock-absorbers' in a traditional portfolio," McVey wrote.
The alternative-asset manager also sees the risk of a "structurally" weaker dollar as President Donald Trump seeks to reshape global trade. The dollar is about 15% overvalued, the third most expensive level since the 1980s, according to McVey.
The rare simultaneous selloff of US bonds, stocks and the dollar in early April when the Trump administration slapped tariffs on major US trading partners has prompted investors to question whether Treasuries have lost their status as a haven.
While the markets have stabilized since Trump eased trade tensions, concerns remain if foreign investors will look to move away from US assets after pouring in trillions of dollars over the past decade. Moody's Ratings on Friday stripped the US of its top credit rating, reflecting investors' concern that ballooning debt and deficits will damage America's standing as the preeminent destination for global capital.
"Many CIOs are considering moving assets out of the United States toward other parts of the world," McVey said.
Diversification will be challenging for stock investors because the US equity market is twice the size of Europe, Japan and India combined, according to KKR.
In the bond market, however, there's more room to move away from the US because Treasuries are becoming less correlated with the fixed-income assets in the rest of the world, according to McVey.
"The traditional role of U.S. government bonds in many global portfolios will become more diminished," he said. "The reality is that the US government is burdened with a large fiscal deficit and high leverage, and its bonds are likely over-owned by many global investors who have benefited from both positive interest rate differentials and a strong US dollar."
What Bloomberg strategists say...
"The downwards trend in Treasuries will persist, especially if the new tax and spending bill, which looks fiscally profligate in its current shape, passes. However, that needs to be weighed up with shorter-term positive risks from possible modifications to the supplementary leverage ratio and a tariff-driven economic slowdown."
— Simon White, Macro Strategist.
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