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What just happened? On Monday, we have seen the biggest sell-off for US stocks since 2011, amid the heaviest trading volume, or the second heaviest trading volume we've seen this decade. Volatility, as measured by the Vix index, has suddenly spiked higher even than it was immediately after the Brexit referendum or during the Greek exit crisis.
Now why is this? If we take a look at what's happened to the 10-year Treasury yields and the stock markets so far this year, you can see that we saw a very sharp rise in stocks to begin the year, even as yields steadily rose. As interest rates began to rather menacingly add on, as people saw that there might be a risk of inflation. Last week, yields finally got to a point where people began to reconsider their stock positions. And today, we've seen a very startling follow through as stocks have sold off so aggressively that they've lost all their gains for this year. And meanwhile, the money has flown back into bonds. Bond yields have fallen very sharply.
Now to be very clear, if we take a look at inflation breakevens, this is a measure of expected inflation from the bond market. It's not that worries about inflation have increased. Today, the reverse. Inflation forecasts have actually fallen back. This is about the knock-on effects from last week's trading and who is going to be hurt by it. In particular, people are worried by those who have been deliberately betting against Vix, betted that it was going to fall, which last year, was just about the best trade there was.
If we take a look at ProShares' exchange-traded note that goes short the Vix, you can see it's had a disastrous time so far. And it's fallen much further in after hours trading. There are concerns that this is going to create wider losses, that there were bets against this ETN and other short Vix products like it. There are also concerns that the banks that are involved with underwriting them will also come under pressure as the week moves on. That is where the immediate focus lies.
The longer focus, once we've got through that, is on the central banks, and particularly the Fed. This is what happened to the odds of three rate rises this year. You can see that, at one point, it was a two in three, roughly, after the Fed's meeting last week. Since then, it's gone back to a 50/50 shot, despite the increase in concerns about inflation. The reason for that is twofold. Firstly, if you do have stocks selling off like this, many are going to bet that the Fed will blink. They won't want to do something that could push stocks down, even if they're worried about inflation.
Secondly, we have a new Fed chairman in town. This is Jay Powell's first official day in office. Markets want to test him. That means that at the first meeting which he chairs of the FOMC in March looms as a very important date when people can begin to assess whether central banks' behaviour really has changed after almost a decade of great leniency.
That is where we lie now. People have started to worry about inflation. That has caused serious problems for those who had been betting otherwise. We need to get through those difficulties, and then we need to find out what central banks are going to react to it.
