There’s nowhere to hide.
Recent market wobbles have drawn the curtain on a period of eerie calm. But potentially more challenging than the sharp recent uptick in volatility is the surge in correlation between stocks and bonds, writes Joel Lewin.
The two asset classes have been moving in tandem since the start of the month, and correlation between global equities and government bonds has soared to a 17-month high.
The summer lull caved in amid a flurry of concern that central banks have run out of ammunition as the European Central Bank held policy steady. The Bank of Japan’s “comprehensive assessment” of its monetary policy experiments approaches on Wednesday. No pressure.
Usually, a drop in riskier assets gives government bonds a boost (pushing down yields) as investors flock to their perceived safety. But if the same factor (fear of central bank impotence or inaction) is driving equities and government bonds, then the latter lose their haven status.
“QE spawns the so called ‘TINA’ [There Is No Alternative] effect that propels private sector capital out of one overvalued asset class and into another,” says Caroline Miller at BCA Research.
The QE tide may lift all boats, but clearly the danger is that it sinks them all again once it ends.
(Chart: the typical correlation between US equities and Treasury yields has broken down since QE. The prices of both have surged in tandem.)
“Markets are fragile; likelihood of a volatility shock is escalating and complacency is a risk,” warns Bank of America Merrill Lynch.
Strategists at the bank note that the “ultra-low levels of US equity volatility” seen over the summer “do not represent fundamental reality, rather central bank manipulation and a host of related technicals, including yield-starved investors selling volatility for income.”
(Chart courtesy of BAML.)
The historically low volatility seen over the summer could have laid the foundations for an even more painful jolt, they warn:
In a fragile market, low volatility should be more feared than normal, as fragility is akin to a house sitting on a fault line; the more time passes without an earthquake, the more likely it is to occur and the more violent it could be. Low volatility sows the seeds for the next shock, as leverage and positioning creep back into the market, increasing vulnerability.
Since the summer of 2014, markets across asset classes have set multi-decade records in jumping from extreme calm to sudden panic at record speed, but in many cases reversing course equally quickly as central banks have fallen over themselves to remind investors they remain a backstop. This compresses volatility back to unfairly low levels, setting markets up for the next shock.
This phenomenon might provide some explanation for the poor performance of active asset managers, they add:
We have argued that these record-setting market fluctuations, in part driven by low investor conviction and heavy crowding, help explain the extreme difficulty active managers including hedge funds have faced in generating alpha. It’s too easy for investors to get wrong-footed and then be unable to shift positions as liquidity dries up.
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