The equity rally is the greatest-of-all-time, the V-shaped macro recovery is the greatest-of-all-time, [and] the bond bear market [is] now one of greatest-of-all-time,” BofA’s Michael Hartnett wrote, in the latest edition of the bank’s popular weekly “Flow Show” series.
For many market watchers, the bond “bear market” (and some would quibble with that characterization) is on the verge of becoming acute enough to dent the equity rally.
Thursday’s dramatic selloff in rates undercut stocks, leading to the dreaded “diversification desperation.” Bonds weren’t your hedge. Instead, they were the proximate cause of the pain. They also amplified losses and volatility in your portfolio. That’s a bad combination.
Measuring since August 4, BofA’s Hartnett noted that the “annualized price return from +10-year US government bonds is -29%. For Australia, the figure is -19%. In the UK, it’s -16%.
Investors should “watch bank stocks,” he said. They’ll be a “tell” in the event the bond rout begins to hurt liquidity and growth expectations. The bank index hit its highest levels since the eve of the financial crisis this week, just prior to Thursday’s tumult.
To be clear, it’s far too early (and it’s not obvious that it even makes sense, considering relatively low leverage) to fret over a risk parity unwind. For years, those inclined to campfire ghost stories warned that a risk parity de-leveraging event could be an existential moment for markets in the truest sense of the word “existential.”
Last March, during the pandemic rout, the risk parity ghost story was realized. And it was, in fact, bad (see here and here, for example).
But here we are a year later, still alive. Well, not all of us, but those who tragically perished succumbed to a viral scourge, not an apocalypse brought about by multi-asset de-leveraging.
Still, you do want to take note when bonds and stocks sell off together. To employ the more technical terminology favored by the financial media (because it has to sound complicated, otherwise what’s the point, right?!), you should be wary when the benign negative correlation that underpins balanced portfolios suddenly flips positive, as it did on at least one look-back this week.
All sarcasm and jokes aside, this week’s events should be considered in the context of the ongoing debate about the future of 60/40 and balanced portfolios more generally.
When yields are as low as they (still) are, bonds’ capacity to serve as a hedge for equities is theoretically limited, even as policy rates clearly aren’t any kind of lower bound for yields.
This concern has prompted some fixed income investors to look to equities vol for hedges amid what many perceive to be a growing risk that the tried-and-true, decadesold, negative stock-bond correlation mentioned above will no longer hold coming out of a forty-year bond bull, and into a reflationary regime characterized by massive stimulus, potentially combustible monetary-fiscal policy “partnerships,” and pent-up demand that could be released into the economy once vaccine rollout is complete.
Read more:
Reports Of 60/40’s Demise Were Greatly Exaggerated (Laphroaig Bottle)
Are 60:40 And Risk Parity Funds Doomed? (And The Two Weeks Gold Bulls Like To Forget)
Yesterday was not “fun”- but it did provide one of those days where you can re-confirm whether or not you believe in your investment portfolio.
Carry on.
Story is on point. RIght now it is perilous to run balanced portfolios these days. UST bonds at least are not a reliable hedge- and the causality is flowing from bonds to stocks. A curve steepener kills the hedge value of intermediate to long ust bonds. A reasonable approach is to figure out ways to lower your volatility absent UST bonds- think gold stocks, and possibly spread bond product- you are taking credit risk this way but it might mitigate some equity risk. At least you spread your bets a little bit better. It is not easy these days… I do this for my living- trust me on that one.
You might ponder floaters and TIPs. But if higher rates choke off the economy, who knows?
At what level do bonds, 7s and 10s, once again become an effective hedge for equity exposure? This afternoon, Zervos on CNBC mentioned 2%. I’m thinking that might be a little low — more like 2.50. Maybe the more important question is, how fast do we get there? I’m optimistic about the vaccine rollout and the reopening of the economy this summer and think we could see a 2 handle on 10s by Memorial Day. Thoughts?
Bonds selling off on growth and inflation expectations accelerating shouldn’t be a surprise. The fact that stocks might be collateral damage amid “good news” (especially high multiple growth names) is more a poor reflection of stocks (particularly the SPX and NDX) than USTs.
Given yield curves are quite steep now, if the risk to equities is instead a growth scare (reflation failing) or corporate earnings rolling over, government bonds may still provide decent a offset, depending on the duration.
This is a great topic. In 1994, I shorted bonds and shorted extra stock against my hedged convetible postions. Bonds sold of steadily till may. Bust the stocks I was short only went down 5%. The premium on the stuff I was long collapsed. So, the key was we had the rest of the year to recover my 10% drawdown and make a good return. I think whatever happens in 2022, real growth will give up a full percentage point for the next 20 years. I think there is a large long 5yr short 30yr trade out there, and perhaps it will be replace by long 2 short 5.
West Coast Stoic, given the relative performance of the 2’s, 5’s and 30’s over the two-day Thursday/Friday timeframe, it seems like the 5s30s unwind into a 2s5s steepener may have already occurred.