Long-term US inflation expectations have remained largely anchored. Pflueger's research shows that the rise in the 10-year Treasury yield from 2020 through 2025 was primarily driven by Treasuries becoming more stock-like. Because Treasuries now positively co-move with equities instead of acting as a hedge, investors demand a higher risk premium to hold them.

When inflation risk dominates markets, the traditional negative correlation between stocks and bonds breaks down. Bonds (duration) stop acting as a reliable hedge for equity drawdowns. In this environment, investors must seek explicit convexity hedges, like call options on oil or inflation breakevens, rather than relying on a balanced portfolio.

The reliable diversification from government bonds seen since 2000 is not the norm. For 200 years prior, stock-bond correlation was mostly positive. Investors relying on bonds as a primary equity hedge are using an outdated playbook that is likely to fail in the new macro regime.

The classic diversification benefit of bonds hedging stocks relies on a specific economic pattern: growth and inflation moving in the same direction. When they diverge, as in stagflation, both asset classes can decline simultaneously, breaking the negative correlation.

The currently high correlation between stocks and bonds is temporary. During a significant market shock, like an oil price spike to $130-$150, this relationship would flip. Bonds would then rally on growth fears, restoring their crucial role as a portfolio diversifier exactly when it's needed most.

In a severe oil shock, the traditional negative correlation between stocks and bonds can break down. The resulting stagflationary environment, with rising inflation and slowing growth, causes both asset classes to fall simultaneously, neutralizing a core portfolio diversification strategy when it's most needed.

For years post-GFC, QE created a reliable negative correlation between stocks and bonds, making treasuries a positive-carry hedge. The 2022 joint drawdown, where both asset classes fell sharply, proved this relationship is broken, forcing investors to pay for explicit portfolio insurance via options.

The historical negative correlation between stocks and bonds, which underpins the 60/40 portfolio, breaks down when inflation rises above 2%. In this environment, they tend to move together, making bonds an ineffective diversifier and forcing investors to seek new solutions for equity risk.

The knee-jerk reaction to a geopolitical shock is often a bond market rally (flight to safety). However, if the shock impacts supply (e.g., oil), the market can quickly reverse. It pivots from pricing geopolitical risk to pricing the risk of persistent inflation, forcing yields higher in anticipation of rate hikes.