“Return OF, not return ON capital trade remains in full force”, Nomura’s Charlie McElligott wrote Wednesday morning, as markets remain in a state of turmoil thanks in no small part to the fact that attempting to price things in an environment where the world’s largest economies are either shut down or in the process of shutting down, is an exercise in abject futility.
Overnight, yields rose on the heels of the worst day for US bonds in decades, with traders now staring down the prospect of governments trying to fund what may well end up being trillions (plural) in combined global stimulus.
“We actually now see global DM Bonds recovering moderately towards ‘unch’, reversing the earlier overnight extension of [the] ‘sell everything, go to cash’ trade”, McElligott goes on to write.
But whatever happens with bonds on Wednesday (and there’s no telling, really – a look at last week’s range is all you need to know that liquidity is severely impaired and swings of 20bps or more are likely to be a fixture at least until the Fed’s purchases across the curve have a chance to calm things down), the past several sessions have been a wild ride for anyone depending on bonds to hedge an equities portfolio.
This speaks to the proliferation of “faux” risk parity over the past decade, all the way down to “safe”, “idiot-proof” expressions of 60/40.
Last Wednesday and Thursday witnessed grievous losses for the simplest of simple portfolios, illustrated below (and do note how the “EKG”, if you will, just goes nuts there on the right-hand side – you don’t need to be a derivatives strategist to draw conclusions when it comes to the likely ramifications for multi-asset investors using volatility as an exposure toggle).
The Wealthfront Risk Parity Fund – announced in early 2018 – is having an awful go it.
“For the past week and a half, ‘Treasuries as your hedge’ has gone horribly wrong for bond-stock correlation investors, as the rolling vol-shock rippling through assets over the past month+ has accelerated the ‘VaR-down into Cash’ behavior from investors of all types”, Charlie goes on to say Wednesday, flagging “obvious deleveraging capitulation in even the purported ‘safe-havens'”.
As a reminder, gold is down 5% this month, as folks are clearly tapping their stash of carefully-polished, yellow paperweights to meet margin calls.
The vaunted “duration infatuation” – which has been building this year as the virus panic deep-sixes growth and inflation expectations – is precariously teetering after a convexity-event-inspired downside overshoot (on yields) now collides with the prospect of massive supply to fund global stimulus.
That’s an explosive cocktail.
“Investors have hidden in the ‘Everything Duration’ trade over the last few years [and it’s] now seeing remarkable liquidation in recent days”, McElligott goes on to say, noting that this was “especially the case seen late yesterday in UST trading with Real Money, Leveraged and Risk Parity all selling, in conjunction with $27 billion of Corp issuance and utterly-atrocious liquidity with traders on all-sides being ‘VaR’d down’/’de-risked'”.
Consider that although stocks and crude are down sharply over the course of this month’s historic tumult, ZROZ is down double-digits over the past eight sessions.
McElligott drives the point home. “From the perspective of a Risk Parity or 60/40 Fund, you’ve suddenly lost your fixed income anchor”, he writes, adding that “just one month ago at this time, 20-day realized vol. for the WNA Ultra Bond (active contract) was 12.5 vols – this morning, it was at 77”.
Here’s what it looks like “when risk parity goes wrong”, to quote Charlie again:
And the irony of it all is that any duration selloff comes just as the Fed embarks on massive new asset purchases and central banks globally double, triple, and quadruple down on accommodation, rate cuts and liquidity provision.
This is what happens when an across-the-board VaR-down into cash collides with the sudden realization that the day may be fast approaching when fiscal policy veers off the highway and onto the exit ramp marked “This way to AOC/Bernie/Kelton“.
McElligott says as much. “I believe that investors are realizing that, in fact, this dual ‘Left Tail’ is now clearly about to dictate a ‘new world order’ of experimental fiscal stimulus”.
God only knows what that means for a market that has spent the better part of a decade gorging on duration, not all of which was very liquid even before things fell apart this month.