Loading ...Expectations are that when stocks fall, bonds rally (prices rise and yields fall). As shown, in 2014 and 2015, Treasuries and other high-quality bonds did just that. But in January and February of this year, that was not the case. Uncharacteristically, the returns on high quality bonds actually fell and yields rose alongside a stock market under duress. There was no evidence of a “flight-to-quality” response from investors.
The market may be taking into account that accumulated debt and forecasted deficits portend much heavier supply of Treasuries in the future along with a looming question of who will buy them. Treasury supply and demand dynamics appear uniquely troubling as recently noted in Deficits Do Matter.
Summary
Despite the recent correction, the U.S. equity markets still easily lead all major global markets in terms of valuation. This is not cause for optimism, it is a sign of extended risk. The outlook for earnings has improved due to tax reform and other recent fiscal policy measures, but even with that boost, earnings do not support these valuations. There is also a clear tension between the Fed and their monetary measures and those of the Congress undertaking new fiscal stimulus. Those paths will overlap and it will be bumpy at best with tightening Fed policy opposed by the forces of fiscal stimulus buttressed by tariffs and the threat of retaliation from other countries.
The markets appear to have sent an early warning to equity holders with the spike in volatility, but with the sustained optimism of the market since, it does not appear as though many have taken heed. Since early February, volatility has dropped back to less elevated levels but it remains significantly higher than the single digit readings commonly seen in 2017. Even if VIX stabilized to average 15 for the next few weeks, that would still be 36% above the average level of 11 for all of 2017. If interest rates remain elevated, to say nothing of rising, it will create further portfolio deleveraging pressure especially on the $1 trillion in funds managed under risk parity strategies.
Despite the bounce from the lows seen on February 8, the market seems uncomfortable and edgy. At the same time, it appears unconvinced that anything could be wrong. Investors have enjoyed such a long period of extreme central bank accommodation and the easy returns that have gone along with it, they are reluctant to modify for the changes clearly taking place. Risks, both implied and explicit, are large and growing but investors seem mostly unaware despite the early warning signal.
A fair characterization would be that it’s like living next to the city dump, if you’re there long enough, you eventually stop noticing the smell.
https://www.zerohedge.com/news/2018-04-04/contours-correction