“A Glaring Error Of Omission”


VaR shocks. Taper tantrums.

I talk about such things a lot. And with good reason.

Investors have a discernible tendency to dismiss discussions of cross-asset correlations as if the subject should be confined to jet propulsion laboratories. All the while, these very same investors fail to see the connection between cross-asset correlations and the simplest of simple investing concepts: the 60/40 stock-bond portfolio.

If you understand why a 60/40 stock-bond portfolio works, then you’re a fan of negative stock/bond return correlations or, alternatively, positive rates/stock correlations. You just didn’t know it.

One of the most reliable market dynamics since the late 90s is the negative stock/bond return correlation.



Indeed, the last several months (i.e. the post-election period) have shown, beyond a shadow of a doubt, that you need this correlation to be negative in a rising rate environment.



The main concern here is simple: if rates rise to far, too fast, equities may interpret that as a risk-off signal. If that happens, you get a positive stock/bond return correlation or, alternatively, a negative rates/stock correlation. Then everything sells off at the same time.

For more on this, consider the following out earlier this month from Moody’s.

Via Moody’s

The February 1 FOMC meeting minutes noted two interrelated developments. First, the narrowing by “corporate bond spreads for both investment- and speculative-grade firms” to widths that “were near the bottom of their ranges of the past several years.” Secondly, some FOMC members were struck by how “the low level of implied volatility in equity markets appeared inconsistent with the considerable uncertainty attending the outlook for such policy initiatives.”

Thus, some high-ranking Fed officials sense that market participants are excessively confident in the timely implementation of policy changes that boost after-tax profits. And they may be right, according to Treasury Secretary Steven Mnuchin’s recent comment that corporate tax reform legislation may not be passed until August 2017 at the earliest. The ongoing delay at remedying the Affordable Care Act warns of a possibly even longer wait for corporate tax reform and other fiscal stimulus measures.

Treasury bond yields declined in quick response to the increased likelihood of a longer wait for fiscal stimulus. Lower benchmark yields will lessen the equity market’s negative response to any downwardly revised outlook for after-tax profits. Provided that profits avoid a replay of their year-to-year contraction of the five quarters ended Q2-2016 and that interest rates do not jump, a deeper than -5% drop by the market value of US common stock should be avoided.

The importance of interest rates to a richly priced and supremely confident equity market cannot be overstated. In fact, the rationale for an unduly low VIX index found in the FOMC’s latest minutes contained a glaring error of omission. Inexplicably, no mention was made of how expectations of a mild and thus manageable rise by interest rates have helped to reduce the equity market’s perception of downside risk. An unexpectedly severe firming of Fed policy would doubtless send the VIX index higher in a hurry.

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