Bonds Not Providing the Hedge

Bonds aren't providing the usual risk hedge during stock market selloffs like it used to.  Part of that is because of the already low interest rates and the Fed's reluctance to go below zero interest rates, but it seems like most of this is because of investors' reluctance to buy too many bonds ahead of the election.   

For bond investors, they don't have fond memories of the 2016 Presidential election.  It was probably the biggest bond selloff from an election result that most people have witnessed.  That is naturally in the back of these investors' minds as they decide whether to buy bonds when stocks are selling off.  Usually bonds are the safe haven and a risk-off asset, but since the current market is mainly focused on the election, even bonds are considered too risky here.  

This inability to rally off of a stock market correction doesn't signal bond market weakness.  It just means that the bond market won't have many explosive rallies from current levels of 10 year yields below 0.7%.  To put it another way, the US Treasury market is half way to becoming Japan.  The JGB is a dead market controlled by the BOJ with low trading volume and low volatility.  Japan has killed volatility in their bond market.  The Fed is doing the same.  

This has negative long term implications for stocks because the 60/40 portfolio will no longer be as attractive when 40% of the portfolio in fixed income isn't providing much yield and doesn't provide much of a hedge for equity weakness.  This will in turn mean more portfolio volatility and make it more likely that investors panic sell stocks when they are plunging because bonds aren't providing the negative correlation hedge that sheltered portfolios from the storm.  

You can see the bearishness slowly building up as the put/call ratios are steadily rising but not yet at panicky levels, and the option volume this week is somewhat low compared to the past 2 weeks.  

We are on day 16 of the selloff.  Usually when a selloff goes past 13 trading days, it usually goes on for a full month, so we are likely looking at lower lows until early October.  However, we are short term oversold and near strong support at SPX 3200, so I expect a bounce in the coming days up to perhaps 3300-3320 by month end, and then probably the final flush out in the beginning of October down towards the 3100-3140 zone.  Next week is the first Presidential debate and that will officially kick off the all day every day election coverage which will only make investors even more nervous, as Trump will probably not go out quietly if he loses the election, and poll numbers and lack of undecided voters makes it highly likely that he will lose.