The Ultimate Game of Chicken
- sebastienpautrot
- Apr 14
- 3 min read
14 April 2025
We are in the ultimate game of chicken. The big picture question is who blinks first? Either something breaks and we plunge lower in risk assets or shorts get steamrolled by the US Administration capitulating. As we have also noted throughout this episode, the poor risk-reward starting point is important context. Even after the 20% drawdown in US equities, the price earnings ratio is still in the 75th percentile of observations over the past 30 years. Moreover, high yield and investment grade credit spreads remain well below average. From a behavioural perspective, the prevailing bias of American Exceptionalism was evident in extremely crowded positioning and market concentration.
While there is a reflexive (self-reinforcing) bid for equities so far today in Asia following evidence of a (partial) pivot by the US Administration, it is important to note that excess margin among levered participants has likely been eroded by recent volatility. From a fundamental vantage point, growth expectations will likely continue to be slashed as global trade and confidence has been undermined by policy. The appetite for US equities and assets more broadly has probably evaporated among large sovereign institutional, pension and insurance allocators. From our perch, it will remain important to monitor the dollar yen and dollar Swiss Franc cross rates and Treasury markets for evidence of stress. Do large global allocators use the headline-driven musical chairs as exit liquidity?
Put another way, has the regime changed where the current episode develops into a disorderly unwind? The signals for a disorderly episode would be when liquidity breaks, the repo market locks up and Treasuries stop behaving like Treasuries (the haven or diversifying asset). The key indicators to monitor are repo strikes and failed bond auctions. The 10 Year Treasury yield is still trading below 4.5% and below the January high. However, over the past week Treasury bonds have been correlated to equities and have not provided diversification on large drawdown days.
According to UBS, the Fed monitors a variety of primary and secondary market indicators including corporate spreads, yields, issuance, and credit quality trends. However, UBS would stress measures of market functioning and capital market volumes over valuations. As we noted last week, there are some disturbing signals in the new issue market and transaction-based spreads. The good news is that the SOFR rate is calm at around 4.3%, Repo is relatively stable (no signs of cash panic) bond auctions are clearing, and corporate credit spreads remain below average. What is disturbing is dollar weakness against the Swiss Franc and the Japanese Yen. In a typical disorderly panic, the US dollar index would spike.
On the negative side, the credit, equity risk premium and implied currency volatility remain below average if the episode leads to a genuine panic and a fundamental shock to global growth, trade, and corporate profits. Confidence is clearly fragile. These risks would be fully appreciated (known) by the Treasury Secretary and the Federal Reserve and likely explains why there has been a partial pivot by the Administration. Credit still has a below average cost of protection for potential pay-off given implied volatility in the sovereign bond, foreign exchange, and equity market. Overall, our sense is that the Administration is likely to pivot under pressure from the ultimate vigilante – the bond market.
Chart 1
Comments