Fixed-Income Selloff Gathers More Steam, Risks Cross-Asset Volatility by Charlie McElligott, RBC
Summary
BoJ seemingly ready to commit to go deeper negative rates and experiment with their curve, the Fed is seemingly locked-and-loaded on a hike as global growth rolls over, a deluge of supply into a suddely wobbly rates backdop (and a world ‘stuffed to the gills’ on duration via NIRP and QE forcing real money / AML community into deeper “yield seeking” / “yield compression” behavior), and a loaded-coil of synthetically low volatility across asset classes…as cross-asset correlations trickle back near multi-year / crisis extremes. SEEMS LEGIT….
Commentary- Markets don’t like getting hit four sides at once…
The “Draghi Disappointment / Brainard Bogeyman / BoJ NIRP-ier / IG Supply Tantrum” we shall call it—elegant right?! Global rates markets continue to bear-steepen on account of four “developments”:
1) Draghi’s ECB presser disappointed the crowd with no increases, no extensions and no tweaks—“ECB did not discuss extension of asset purchases plan.” There also was a very slight “upgrade” to inflation as well, as the 2018 forecast was NOT dropped as expected, while stating the expected inflation will be more stable than before. Geez.
2) The bizarre Fed / Brainard speech episode, where an (initially understood to be) “impromptu” scheduling of Fed’s Lael Brainard to give a speech next Monday evening—immediately before the Fed’s blackout period—was interpreted by the market (and conspiracy theorists) as a sign that Yellen was rolling out the increasingly high-profile and UBER-DOVE Brainard (remember, she was the “international factors are impacting US rates” proponent who helped start the R-Star discussion) to actually be the person with the best chance to communicate a HAWKISH message on the September meeting. In turn, by having the “person least likely to speak hawkishly” then make a case / at least say that the committee is confident on achieving its mandates, that you could get market probability north of 50% “required” to pull the trigger. From speaking with folks close to the situation, there is a real belief that the Fed is adamant on at least one-hike this year, data be damned. Apparently they are keenly aware that they could be driving financial asset instability. : / Nonetheless, it came out later in the afternoon that Brainard had been scheduled at the event in question for weeks…so head-scratching abounds.
3) The point I made reference to in yesterday’s “Big Picture” w.r.t. the BoJ being equally adamant on going even MORE negative with rates while also investigating “curve tweaks” (from a change in the composition of their JGB purchases to the potential for a reverse operation twist) has gained steam, with multiple media outlets floating these “trial balloons” ( http://reut.rs/2c4zgi5 ). The concerns here are many: even more negative rates is an enormous risk after the way the market treated them post the initial move, which saw a counterintuitive strengthening of Yen and a flattening of the JGB curve which sent the Topix Banks index -25.5% to its current YTD performance. And again, as stated yday, an outright “reverse op twist” could be interpreted as a “backing-down” from a market that knows the BoJ is married-to the perma-stim / perma-easing path for the rest of its days. If markets smell weakness, “things could get weird” (flipside of course being a potentially very POSITIVE reaction to a steeper curve, esp w/ banking sector…I know it’s noncommittal, but we simply can’t gauge how mkts respond).
4) A final factor driving the move in UST (absolute) yields (and as noted a few weeks ago as a risk to what had been low rate vol) is the insane supply being pumped out of both US IG corporates, now standing at $52B on the week….and then next week, with a HUGE calendar of Treasury issuance, with potential of ~$100B in bills, ~$50B in coupons and another $50B in more US IG! For those of you keeping track at home, that’s potentially ~$200B of supply. Per IFR, Monday alone could see $76Bt-bills at 11:30am, and then $24B 3s plus $20B 10s both at 1pm ET.
The spook story for low-volatility equities for years has been a spillover of rate vol—see all of our various “tantrum” episodes. Why? Because of the painful grind higher in cross-asset correlations as the market has become more macro–thanks to both 1) global central bank policy that is essential based around controling one asset (USD) and tamping-down volatility through unprecedented asset-purchases…along with 2) the enormous growth of systematic strategies, especially those which target volatility and / or use leverage to “balance risk” across asset classes based on historical volatility.
Volatility
Risk-Parity as you all know has been a favorite “bad guy” to mention during these episodes (otherwise the strategy is a ‘home run’ the rest of the time in a global QE environment), because (being painfully simplistic here) they run leveraged long fixed income as it is a historically “low volatility” asset. But under certain economic condition “buckets” (inflation / growth) you too can run very long risk assets too…ESPECIALLY with HISTORICALLY DEPRESSED TRAILING VOLATILITY. I.E. RP / target vol / CTAs are most likely REALLY REALLY long equities right now bc of this, which is SPX 30 day historical vol sitting at its 10 year lows, with 50 day historical vol on the same cusp:
So the punchline is that many systematic macro, risk-parity or vol targeting funds are very long both equities and fixed-income (helping drive the recent correlation)…and when a “butterfly flaps its wings” in one leg of the trade, suffering a “macro drawdown,” we have seen in the past “VaR shock” selling episodes as other positions are taken-down as well.
In turn, the long-end of fixed-income took it in the face yday and today, from Bunds to Gilts to Treasuries:
Two Day Move In German 30Y Bund Yields A 5 Standard Deviation Event:
Markets are paralyzed with uncertainty—and I’m not even including Trump’s recent resurgence. How can you get more aggressive with your growthier / reflationary / cyclical outlook when not only is global economic data turning south again, but you have a month ahead with so much event risk–btwn ECB / BoE / BoJ / Fed / first US Presidential debate? Pile-on four different banks downshifting on growth / saying to get more defensive this week (most notably Trahan / Lazar at Cornerstone), you have a real pivot forming….especially as so much performance has been “gained back” (certainly within the equities complex) on the shift back into the “reflation” thesis.
EQUITY L/S HF PERFORMANCE SEES GAIN OF +4% SINCE SHIFTING OVERWEIGHT CYCLICALS / UNDERWEIGHT DEFENSIVES: Upper panel shows correlation of “high hedge fund concentration” equities holdings basket against the ‘cyclical / defensive’ equities ratio. In turn, the below panel shows the % performance in the HFR Eq L/S HF index.
…THIS THEN GETS PRETTY SCARY WHEN YOU LOOK AT THE SWOON IN GLOBAL DATA: Global developed market surprise index plummeting, against the same ‘cyclical / defensive’ equities ratio from above, which is trading back at extremes. Ruh-roh.
So here we go: BoJ seemingly ready to commit to go deeper negative rates and experiment with their curve, the Fed is seemingly locked-and-loaded on a hike as global growth rolls over, a deluge of supply into a suddely wobbly rates backdop (and a world ‘stuffed to the gills’ on duration via NIRP and QE forcing real money / AML community into deeper “yield seeking” / “yield compression” behavior), and a loaded-coil of synthetically low volatility across asset classes…as cross-asset correlations trickle back near multi-year / crisis extremes.
Get ya popcorn ready….
Charlie McElligott
Managing Director
Head of US Cross-Asset Desk Strategy
