Hugh Hendry once quipped “we recommend you panic.” From our perch, investors ought to be deeply uncomfortable again today. Markets are in a very dangerous place. Systematic (vol targeting/CTA) driven strategies are flashing red. Bank equities are trading down near the 2020 trough. Credit spreads have started to widen from complacent levels and commercial real estate is starting to unwind. The greater risk in this cycle is in the valuation of unlisted assets.
A related risk is that the value of US Treasuries – the source of collateral for the entire system – has collapsed. The TLT long bond ETF, is now down over 50% from peak. Put another way, the drawdown in bond values is approaching Volcker-like levels. The magnitude of the drawdown is similar due to the extremely low starting point for yields in this cycle. Clearly one of the important points in this cycle is that sovereign bonds have not provided diversification for equities. That is probably due to the nature of this cycle. It has been an inflationary bear market, rather than a deflationary one (chart 1).
As we have noted recently, the recent price action in fixed income probably reflects a capitulation in consensus beliefs. Our sense is that long only institutional investors had extended duration over the first half of the year as a hedge for the “hard landing” and now feeling the pain. In contrast, CTAs, and speculative investors have been net short recently.
The rise yields (fall in bond prices) are probably not a simple function of increased supply but also reflects underlying resilience in the economy and the prevailing bias that short term interest rates will likely be required to be higher-for longer. As we have also noted, the United States is a “long rate” economy. The rise in long rates has increased mortgage rates and corporate debt yields that are (mostly) priced in reference to the long end of the yield curve. That has contributed to a renewed tightening in broad financial conditions, including an appreciation in the US dollar and tightening in dollar liquidity. In that context, implied equity volatility appears too low compared to broad financial conditions (chart 2).
We also fear that the credit risk premium is insufficient for potential risk. While US sub-debt Investment Grade spreads have widened recently, the weakness in bank equity prices implies that the spread ought to be materially wider still. The time series on bank equity (light blue line) is inverted below so that a fall in bank equity prices is correlated to the price of financial risk (the sub-debt financial OAS spread chart 3).
Our big picture anxiety is that the increase in bond volatility itself (in a Sharpe ratio world) is probably not bullish for equities. Both recent episodes of bond volatility (UK GILT pension fund and the US regional bank episode) contributed to a major value-at-risk shock (de-grossing and forced reduction in leverage) when the Bank of America MOVE index spiked 75%.
We also can’t help but feel that the recent move might be related to or an unintended consequence the shift in the Bank of Japan’s YCC target (peg) amplified by the other contributing factors above (Treasury supply, trough cyclical inflation and questionable fiscal policy). The UK pension and US regional bank episodes might have been a preview of the horror movie to come. The good news in this region is that risk assets already trade at distressed valuations. Of course, that is at least partly a function of US dollar strength. However, that is also why remain “light and tight” in our tactical positioning.