Risk Parity Needs NIRP

Risk parity was the dominant paradigm ruling asset markets during the ZIRP and QE era of the 2010s.  Can it rule again now that we're back at ZIRP with QE?  It depends on if the stock and bond markets want to push the Fed into a corner.  The neg corner.  Yes, the much dreaded negative Fed funds rate. 

Risk parity is backed up into a corner, because of the zero lower bound, and the Fed's insistence that it won't bust through it like Europe.  Without negative interest rates, there is very little upside now for bonds, and hence, they won't provide much of a hedge when stocks starting going down big.  That's a problem because the basis for the average portfolio is the 60-40 stock/bond model, which is still the most popular strategy among long term investors. 

What happens when bonds don't go up much when stocks are going down a lot?  You get more panicky moves in stocks, because stock investors don't have much of a hedge with bonds anymore, so they will need to sell stocks to reduce their risk, instead of just relying on bonds to reduce their risk for them.  

Unlike ZIRP and QE from 2008 to 2015, the ZIRP and QE now is a totally different monster.  Just look at the yield curve change from 10 years ago.

In 2010, you had 5 year yields north of 2%, now they are trading at 0.35%.  10 year yields were trading above 3% back then, now they are trading 0.70%. 

Bond investors are now fighting for scraps, a few more bps lower yield, because Powell has said he won't entertain negative interest rates.  The stock market doesn't care right now, but what happens when risk parity doesn't perform because bonds can't go up when Fed refuses to lower rates anymore?  A tantrum, that's what happens.  The market will have a tantrum until it gets what it wants. 

If you think the market pricing in negative interest rates was just a technical fluke or the market's way of testing the Fed, you are underestimating the power of the market.  The market controls the Fed.  The Fed follows the market because it is beholden to stocks and tries to please the stock market at all times.  Forget Volcker and the old way of doing business.  The stock market is the king.  The Fed and Congress are its slaves.  

What difference a day makes.  Yesterday's nasty close on the MRNA vaccine reality check lasted just a couple of hours.  It is all uphill since then, and shorts are being squeezed again.  Holding off on averaging up until tomorrow, we are close to a blowoff top as retail pile into junk small caps, beaten up airlines and cruise companies.  The end of the risk rallies are usually signified by speculation in risky names, and that's what's happening.  Risk reward is very favorable for shorts here.