Over the last few months, it seemed like the only valid investment around the globe was to buy government bonds, not only the U.S. but also of any country yielding remotely positive yields. Thanks to global central banks bent on pumping even more money into a system that has not really worked for a decade, investors had no choice but to chase that absurd momentum -- even buying 10-year German bunds yielding -0.3%. Today about $13.4 trillion worth of global government bonds yield negative rates, with investors desperate to chase yields further out into the future, be it 20 or 30 years, for close to flat yield. Seems entirely perverse logic, but then again perhaps I am too rational a person to acquiesce to such lunacy.
What does this all mean and why can this be a shock to equity markets in general?
Most investors have triumphed over the last few years following the "buy-the-dip" strategy and refused to believe any intellectual ability or skill was needed to make money. Anyone could do it, they just needed cash, greed and ignorance. In their defence, it worked, only if they managed to hold through all the market corrections, but then again history has taught us most of these investors always chase at the top and panic at the bottom. Now for the more sophisticated of investors who understand global asset classes and how macro shocks can affect pure long/short equity investment models, let's summarize.
Prior to the U.S. nonfarm payrolls report on Friday, the rates market had priced in about a 50 bps cut in rates by the Fed for July. Despite Fed rhetoric to be patient and monitor trade uncertainty and global economic risks, the market refused to believe otherwise. It seemed like a no brainer trade -- and hence investors and momentum funds chased bonds higher and the dollar lower, waiting for Fed to give them their liquidity opioid fix.
On Friday, payroll growth reported for June printed at 224,000 jobs vs. expectations of 165,000 with unemployment rate holding firm at 3.6% -- the best gain since January. Much to the Fed's chagrin, the "justification" of weak data has not come their way, reducing the rationale for them to pass an interest rate cut in July. Should they do so anyway, they would lose whatever little credibility they have left.
So the rates market had to seriously reassess its extreme dovish view of the Fed funds rate, which caused the rates market to collapse, sending bond yields higher. The huge payrolls beat crushed market expectations of two 25 bps cut in July, with bond volatility spiking higher and causing chaos in the U.S. bond markets. The dollar rallied as this hawkish move was priced in, taking gold and commodities lower as the market seriously starts to doubt whether the Fed will cut in July or wait a bit longer. After all, the U.S./China meeting in Osaka did result in a "truce," what's the rush?
As bond markets have rallied strongly this year on the lower-for-longer rates mantra, this has also aided equity markets in staying strong this year thanks to pension funds and risk parity funds. Portfolio combined asset allocation is an extremely important driver for selecting exposure in each asset class. Most risk parity funds need to match their assets and liabilities -- and so invest in a typical 60/40 bond/equity portfolio mix.
As bond prices go up, their bond allocation also moves up, causing them to buy more equities to balance the mismatch. It becomes a self-fulfilling prophecy -- especially with central bank heads such as Draghi, Abe and Powell talking even lower rates going forward. Given the one-way direction of bond markets, volatility dropped and investors invested in more as their VAR (value at risk) was lower.
But anyone who remembers the LTCM (long-term capital management crisis) in 1997 or GFC (global financial crisis) in 2008 should know better than to ever assume volatility can stay low forever.
As mentioned, bond market positioning had been extremely stretched prior to Friday. A sudden reassessment to the Fed's interest rate trajectory can cause a massive knee-jerk reaction to sell bonds, as investors wake up to rates perhaps not going down that fast. U.S. 10-year bond yields spiked back above 2% from lows of 1.94%; some well-needed normalization (aka reality check) perhaps.
Thanks to risk management 101, this move higher in yields was equivalent to a 6-sigma move in volatility. In layman's terms, risk departments will be pulling the plug on all funds holding bonds. Given the sensitivity of even a tiny move higher in yields, these risk parity funds are now forced to sell these same bonds they bought only a short while ago.
Long story short, as bonds move down, rate expectations move higher, equities that have defied all fundamental and earnings driven logic doped up on Fed pumping money to bail them out, will start to also be sold to match that same 60/40 criteria. What goes around comes around?
The market is trading close to highs, tensions between the U.S. and China seem to have simmered down, U.S. economic data shows decent and firm growth. The Fed can't possibly justify rate cuts now and that thesis needs to be re-evaluated. The dollar will rally and stay strong, capping any upside in cyclical equities (mining stocks) and commodities that have already priced in a very rosy scenario for growth rebound. Either the jobs data needs to start deteriorating faster or market needs to collapse 15%+ for them to step in. Until then, the only driver is earnings -- and we all know that this quarter will not be pretty.
And we thought fundamentals were dead..