Asset allocators are always seeking diversification, but especially during volatile equity periods when investors demand “safe havens”. Traditionally, bonds have provided negative correlation to stocks, serving as a buffer when markets turn volatile. However recently, from 2022 to 2024, this relationship broke down, with stocks and bonds moving in tandem. This unusual positive correlation highlighted the risks of relying solely on historical norms for diversification. The nearby chart highlights the last 25 years of bond-stock correlation as measured by the returns on the S&P 500 Index and the Bloomberg US Aggregate Bond Index:
But Wait, There's Something Not Normal Here!
All but one of the observations where bonds did not provide negative correlation were when the yield curve ended the year in an “inverted” or abnormal yield curve shape. Even in that instance (2024), for almost the entire year the yield curve was inverted. Most recently in Q1 2025, the yield curve has moved from inversion towards a more typical (upward sloping) yield curve (as measured between the difference between the 10-year and 2-year Treasury securities). Not surprisingly, bonds provided meaningful diversification in Q1 with the Aggregate Bond Index up +2.78% while the S&P 500 fell -4.28%.
Key Takeaways for Asset Allocators
- A steeper yield curve signals a return to more normal market conditions, where bonds can increase their likelihood of once again providing both income and diversification.
- Allocation to some longer-duration bonds (i.e. out of cash and into higher yielding maturities throughout the curve) as the curve steepens can enhance portfolio resilience, especially if equity volatility rises or economic growth slows.
- The yield curve’s shape should inform asset allocation decisions, with a focus on balancing risk, return and the need for true diversification in changing market environments.
Conclusion
In summary, a steeper yield curve environment is not just a technical market development—it’s a structural shift that restores the traditional role of bonds in a diversified portfolio, making them a more attractive and effective tool for asset allocators going forward.
Important Disclosures & Definitions
Bloomberg US Aggregate Bond Index: a broad-based benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, fixed-rate agency MBS, ABS and CMBS (agency and non-agency).
S&P 500 Index: widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
One may not invest directly in an index.
AAI000936 05/06/2026
