Investors looking to hedge equity risk in the event of another US recession may want to start returning to the fixed income market. Stocks and bonds have struggled for a year now, with both asset classes posting their worst performances in six months in decades. This surprised investors, who often held portfolios containing both stocks and bonds to balance risk – historically, bond prices rose when stocks fell. That has changed in this market cycle due to the coronavirus pandemic and the Federal Reserve’s moves to stimulate the economy during the viral recession – including reserve funds near zero and Treasury yields not much higher. But now there may be a turning point in the relationship between stocks and bonds as the US is going through an economic slowdown, which could lead the Fed to switch from a hawkish stance to a pessimistic stance, tempering and eventually cutting interest rates. “Six months ago, it was all about inflation, and it was all about the strong Federal Reserve,” said Ross Koestrich, portfolio manager for BlackRock Global Allocation Fund. While there is still persistent inflation, fears of a recession are also growing. “It is likely that as recession fears intensify, the hedging value of Treasurys will begin to reappear.” Signs of a weak economy have already begun this shift to bonds as compensation to offset equity risks. On Wednesday, the Federal Reserve raised its benchmark interest rate by three-quarters of a percentage point, putting pressure on the price of long-term bonds and raising their yields (bond yields move inversely with their price). On Thursday, long-term bond yields, including 20-year and 30-year bonds, rose, while short-term yields fell when the first reading of Q2 GDP came in negative. Two consecutive quarters of negative GDP are often a strong signal of a recession. Mohamed El-Erian, president and economic advisor for Allianz, said on CNBC’s “Squawk Box” on Thursday. What does a pessimistic bond Fed mean An environment in which the Fed lowers interest rates generally raises bond prices and boosts long-term Treasuries. To prepare for this scenario, BlackRock has returned to its holdings in 5- and 10-year Treasurys, although they are still lower than stocks and bonds, according to Koesterich. “The longer you are on the curve, the more leverage you will have” for any move by the Fed to eventually take its foot off the brakes, said Eric Deaton, president and managing director of The Wealth Alliance. For now, though, long-term bonds have taken a hit from the Fed’s campaign to tighten policy this year. Currently, investors can get higher returns on short-term bonds than on bonds with longer durations and higher risks. “You can get a greater return on a bond with a shorter term than on a bond with a longer term,” said Nancy Davis, founder of Quadratic Capital and manager of the IVOL ETF. “This is not a natural environment.” This means that investors looking to snap up long-term treasuries to hedge against a recession may want to balance the situation. One way to do this, Deaton said, is to use the iron strategy, or buy on both the short and long ends of the yield curve. “We may get hurt in the long run, but we will also be able to reinvest those short, fast maturing bonds at higher rates,” he said. Although investors may be spooked by this year’s losses with more traditional portfolio combinations that include stocks and bonds, there is now more reason to buy in this setup. Morgan Stanley indicated this week that a traditional portfolio split of 60% stocks and 40% bonds could have an annual return of more than 6% over the next decade. For investors who aren’t sold into Treasurys, there are other ways to get steady income in their portfolio, including aggregate bond funds and investment-grade corporate debt, which now offer higher returns. Inflation-linked bonds, or Treasury and inflation-protected securities, might also be a good addition right now. “It’s a cheap time to add inflation protection to portfolios,” said Davis of Quadratic Capital.