Risk Parity Troubles

No one mentions risk parity anymore.  But the risk parity nightmare is slowly creeping back as both stocks and bonds are down this week. In particular, the long end of the yield curve has taken the biggest hit.  It reveals the underlying supply/demand problems that Fed QT and an ending of ECB QE and reduction in BOJ QQE are wreaking on the bond market.  If the ECB pulls the plug on QE, there are no willing buyers of European government debt that yield deeply negative interest rates.  Same goes for the BOJ, although they are stuck with quantitative easing due to the huge amounts of JGBs outstanding, and they are just trying to walk back from doing anymore damage to the liquidity in the JGB market, which is already a near zombie market.  

The central banks, who have driven the bull market in bonds, are not willing to push yields even lower here unless something bad happens in the economy.  The hurdle for central bank intervention has gotten quite a bit higher over the last year.  And it will continue to get higher as Draghi has just one year left in his term, and odds are high that he will be replaced with an anti QE governor, probably someone German.  So this is bad news not just for bonds but for stocks as well.  The magic carpet ride of higher stocks and higher bonds that we've witnessed from 2009 to 2016 is over.  Of course, if stocks take a big plunge, bonds will go a lot higher.  But you no longer have that free lunch of being able to just buy bonds to hedge your stock portfolio and expect it to make money under almost any circumstances.  That makes risk parity strategies riskier, and it is one of the reasons the market dropped so hard in February, as yields were going higher, something we rarely saw in the last 10 years.  

The nonfarm payrolls number didn't come in that hot, although the average hourly earnings number was better than expected.  Yet both stocks and bonds dropped on that number.  The big fear in the market is that the dollar will continue to rally based on strong US economic data and cause emerging market contagion.  I doubt that is a long term concern, because I don't think the dollar will keep rallying, but in the short term, with seasonal headwinds, there is a window of about a month where we could see some capitulation among weak longs.  The divergence between the US and Europe/emerging markets is too wide for it to continue much longer.  

With the weakness in bonds, it makes me a bit more comfortable to hold a short in stocks.  I was originally planning on covering at 2870, but will see if we can get one more leg lower in the coming days.