Thursday, July 6, 2017

Relentless Bond Selling

They are crushing them again today in the bond space.  Led by the Bund, which is leading this selloff as the Europeans are starting to freak out about ECB tapering.  Draghi opened up a little crack in the door for tightening and traders have busted it wide open.  The equities keep reacting negatively to the higher rates, a bad sign considering where we are in the cycle.

This is reminiscent of what happened in May and June of 2015 as a German Bund bull market came screeching to a halt, at 7 bps, and rallied into the 90 bp range.   It was a preview of the risk parity fiasco of August 2015.  By the way, the SPX topped out in May of 2015 at 2134.  After that, stocks really couldn't go anywhere, and chopped around for another 3 months.  This is something that has been on my mind all year, the similarities to a 2015 type market, as the market tops out and chops for months on end, and then drops suddenly.

I don't know why those financial experts on CNBC think that low Treasury yields are something to worry about.  We had Treasury yields going lower for most of this year till last week, and the indices were doing great.  Now that you get this bond selloff since Draghi opened his mouth last week, you have a more volatile stock market that can't find any upside.  No, it is higher rates that stocks have to worry about.  And also a bunch of other things, which are a bit less urgent.

The recent price action is a signal that there are way too many assets in risk parity strategies.  Stocks are very fragile at these price levels, considering its sensitivity to what is happening to bonds.  I was listening to a podcast the other day and I heard a pension fund asset allocator talk about risk parity as a risk mitigating strategy that they use as a hedge for equities.  How about just having less equities and more cash in the portfolio?  Oh yeah, they need to meet their target annual return of 8%.  Good luck with that at these asset price levels.

There are way too many funds using long bonds as a hedge for their equity holdings.  It leads to these short term dislocations when bonds don't go up when stocks go down.  As volatility has died out, VIX as an equity hedge is now frowned upon, especially with its heavy negative carry.  The fund managers have smartened up, and gone to bonds as a hedge.  But this sets up vulnerabilities that you have seen recently.

The biggest pain trade right now is an explosion higher in VIX, which would lead to a cascade of selling in stocks, and muted upside in bonds.  The VIX sellers would be panicking as volatility exploded only exacerbating the situation.  That is what happened in August 24, 2015, but this time, the move could actually be much bigger with so many more assets in risk parity and so many more bearish on VIX.

In the long term, the stock market weakness on weaker bonds will keep the Fed from tightening much more, because they will be much less hawkish when stocks are going down.  So while I view this stock market price action as bearish for stocks, I think it is long term bullish for bonds.  These bond selloffs tend to last about 2 weeks, and then peter out.  So we could be getting closer to a bond bottom by early next week, depending on what happens with nonfarm payrolls.  A strong nonfarm payrolls number will probably make the bottom come quicker, perhaps even by tomorrow.

By the way, Nasdaq is going down much more than the S&P 500 on down days recently.  Also, biotech has been popular.  Chasing high beta sectors is late cycle behavior.  The fund managers chased tech stocks higher to catch up to the averages.  Now they are loaded up to the gills and have to sell when they start feeling the pain.  I expect volatility to increase this summer as the topping process continues, setting up a nasty correction in late summer/early fall.


MM111 said...

Worth a long here?

Anonymous said...

When will trump nuke north korea? This week or next?

Market Owl said...

Not interested in playing the long side till I see more blood on the Streets.