With the wild gyrations in the stock market this week, it is hard to talk about anything else. I will leave the trading ideas for equities to my fellow Real Money writers, but I think taking a look at what happened (and is happening) in bonds gives us some clues about how long this might last and what kind of intermediate-term opportunities might arise. Here are my observations, plus some tips for trading through volatility:
Bonds are showing zero signs of panic
Typically, when there is a large selloff centered around stocks, volume dries up in all bond sectors except Treasuries. Remember that bonds are an over-the-counter market, meaning that if you want to sell a bond, you have to find an actual human being willing to buy it. On days like Monday, dealer trading desks, who are the de facto market-makers in bonds, are loath to take risk. They want to do a little price discovery before committing large dollars in their own books. On Monday, we saw very little trading in corporate bonds at all. On Tuesday, despite continued volatility, traders started to come out of their caves and make markets.
What we are seeing is no sign of panic, and few real money sellers of credit. Bids weaker, to be sure, but in most cases investment-grade bonds are five to 10 basis points wider and high-yield up to two points lower in price. That's about what you'd expect from a Dow -200 day, not a Dow -1,000 day. In addition, if you want to be a buyer of bonds, it isn't easy. There aren't too many sellers, period, and dealers are mostly just widening their bid/ask spreads (see more on that below).
This is important, because if credit investors thought this volatility portended an actual bear market, there would be much more selling. Ultimately, credit only sells off hard when investors start fearing actual losses. Right now, they aren't seeing, it, so most people are just standing pat with the positions they have.
Don't be the patsy at the table
You've probably heard the saying that if you can't figure out who the patsy is at your poker table, it's you. A classic move by sell-side bond traders is to keep their offer levels steady and widen their bid levels. Why? So they can pick off bond buyers who aren't paying close attention. If you are shopping for a corporate bond, the yield spread (the gap between Treasury yields and your bond's yield) should have increased between Friday and today. For corporate bonds, you can check here for recent trading activity on a bond. For munis, the same data is here.
Was it ever about interest rates?
Prior to Monday, most people were blaming interest rates rising for the stock market pullback. Now we can see that the issue of interest rates, like communism, was a red herring. Or at the very least, it was only the catalyst that blew up the short volatility trade.
This is notable, because it means you should be very careful doing pair trades on stocks and bonds looking forward. If it wasn't really about rates in the first place, then that whole correlation could break down very quickly. I've been saying consistently that bond yields wouldn't keep rising while stocks kept falling. One of two things will ultimately happen. The economy could keep growing, which might justify higher rates, but would allow stocks to resume rallying. Or else the economy weakens, which would cause continued pain in stocks, but bond yields would start falling.
What about the Fed?
The March fed funds futures were pricing a 100% chance of a hike on Jan. 31. Today that is down to 85%. I get that. If stocks were to fall another, say, 5% from here, it might be enough to get the Fed to pause and see what happens. But right now, there is absolutely no reason why the Fed's ultimate trajectory has changed at all. Indeed, if we look at the December fed funds contract, it is only five bps different than before the Monday meltdown.
This is a major reason why the whole rates/stocks correlation can't sustain. If indeed stocks are pricing in weaker earnings, the Fed won't be hiking as aggressively. If it is just technical, a VIX trade unwind, then the Fed doesn't care.
But I thought stocks were a forward indicator?
In other words, why doesn't this big sell-off portend a weaker economy? All kinds of people are declaring the bull market is over. I could be wrong, but I just don't see it. An economy as large as the U.S. turns slowly. Even the 2008 recession, which felt sudden, wasn't so at all. Housing was showing signs of weakness in 2006, and job growth was meaningfully slowing by mid-2007. At the time, it was debatable whether this weakness would persist or whether housing woes would hit the rest of the economy. But there were definitely signs of possible weakness.
Right now, there's nothing like that. By almost any measure, the economy is accelerating. How long that acceleration can last, whether the Fed will hike too far and choke it out, whether exogenous events could derail the economy, etc., are all good questions. But jumping to a bearish conclusion here is purely speculative.
This commentary originally appeared on Real Money Pro at 10:00 on Feb.7. Click here to learn about this dynamic market information service for active traders.