Shaking The Edifice

Although things had an “all’s well that ends well” feel to them by Friday afternoon, when rates had largely stabilized and US equities were busy logging one of their best sessions of the year, last week offered up some harrowing moments.

March of 2020 was a reminder that “harrowing” is always a relative term, but the hottest US core inflation read in decades (and the hottest headline print since 2009) rattled market participants and stirred the proverbial pot in an environment already ripe for some serious “chop.”

Notably, the stock-bond correlation has flipped positive. In fact, it’s the most positive in decades on one lookback window. Toss in Thursday’s commodity selloff, and a risk parity benchmark slumped the most since the world was spiraling into a pestilent oblivion 14 months ago (figure below).

A reliably negative stock-bond return correlation is the foundation on which balanced portfolios are built and it also underpins risk parity. For years, market participants have debated how much longer the “have your cake an eat it too” environment could persist in a world where bond yields have less room to fall and could become a source of volatility as “tantrum” events become more frequent. Q1’s bond selloff — the worst in 40 years on some benchmarks — underscored those fears.

While the correlation between the two assets has been mostly negative for decades, both equities and bonds have enjoyed simultaneous bull markets. Now, the bond bull is either dead or in peril, and many wonder what that presages for stocks, considering modern market structure was built atop a macro regime characterized by tepid (but acceptable) growth in developed economies and subdued inflation. In short, the question is whether a regime shift is tenable. I talked at length about this in “Is Modern Market Structure Ready For A Macro Regime Shift?”

The “constant ‘Short Vol’ regime based on low nominal interest rates and flat curves meant that strats of ‘Duration Sensitives + Risk’ posted the best Sharpe Ratios,” Nomura’s Charlie McElligott wrote Thursday. “These trending legacy positions ‘worked’ and the feedback loop then fed that further, with more money allocated [and] exposure added through leverage.” 

A new regime characterized by run-it-hot policy conjunctures and the first real inflation many market participants in advanced economies have ever seen, might shake the entire edifice. In other words: It’s not clear that the setup can handle significant macro volatility.

“Normally the bond selloff tends to slow after an ISM peak and, since the 1980s, as inflation pressures have been limited, bond yields have generally declined,” Goldman’s Christian Mueller-Glissmann wrote Friday. “However, this cycle has started with much more reflation optimism and concern about inflation risks, which could keep upward pressure on bond yields for longer,” he added, on the way to reminding folks that “rising rates – especially real rates – can weigh more on equities than in the past due to longer equity duration (especially in the US) and already large declines in equity risk premia.”

We’ve seen that over the past several months, as tech and what’s come to be known as “hyper-growth,” struggled to digest rate rise, while Q1 was the worst quarter for IG credit since the financial crisis. Short interest on LQD (the IG credit ETF) hit a record high this week (figure below).

All of that (tech jitters, big losses for hyper-growth and bets against the IG credit ETF), are manifestations of duration worries and, more broadly, of concerns about unwinds in legacy positions as the macro regime shifts.

“If [rising bond yields] are driven by inflation and policy tightening fears, they can weigh on risky asset returns,” Goldman said Friday, cautioning that even in a relatively benign scenario where stocks are able to digest higher yields with relative alacrity, “longer-duration, secular growth stocks are likely to underperform.”

That’s the narrow context. But, as detailed extensively in the modern market structure article (linked above) and as emphasized time and again by Nomura’s McElligott, there are existential questions worth asking as the macro regime evolves.

“The issue is that the enormous accumulation of leveraged ‘trend’ trades from the implicit central bank-facilitated ‘Long Duration + Short Volatility’ position creates enormous ‘accelerant’ flows on ‘Negative Gamma / Convexity’ unwinds,” McElligott said, referencing the extent to which so many selloffs and rallies tend to feel amplified, as various strats effectively sell into weakness and buy into strength. “As I always say, ‘Volatility is the exposure toggle,’ which means non-normal / non-linear moves,” he added.