Meanwhile, from the “things you don’t see everyday” file, TLT fell 50bps on three consecutive days last week with the S&P down simultaneously during all three of those sessions.
That’s anomalous. In fact, according to Macro Risk Advisors’ Dean Curnutt, it’s only happened two other times in history, both during the financial crisis.
The concurrent declines (figure below) are a simple way to conceptualize of “diversification desperation” — a straightforward illustration of the idea that greater macro volatility triggered by the collision of pandemic distortions and an unprecedented policy experiment, could ultimately derail the negative correlation that investors of all shapes and sizes have been able to take for granted over the last two decades.
This is no small matter. Over the years, I’ve broached the subject any number of times, often asking whether 60:40 is “dead” and/or what consistent co-movement between stocks and bonds would entail for risk parity.
For market participants, this is a topic that never gets old, precisely because the assumption of a negative relationship between stocks and bonds is built into so many portfolios. I talked at length on Saturday about it in “Shaking The Edifice.”
I’ve said it time and again: At some point, when yields run out of room to fall (and one mistake over the years has been proclaiming that “This is the low!” only to see yields keep falling, in some cases deeply into negative territory) bonds will morph into a source of volatility due both to a grossly asymmetric risk-reward profile and heightened sensitivity to “tantrums,” as yields become hyper-sensitive to even the most harmless utterances from developed market central bankers.
For years, those of a fretful persuasion were in the habit of suggesting that the point beyond which bonds morphed from reliable hedge into source of risk was near at hand. Those predictions never panned out. Or not really anyway, in part because they lacked a catalyst strong enough to bring about an epochal shift in the macro regime. That catalyst may have been the pandemic or, more accurately, the policy response to the pandemic, which finds developed market policymakers delving as deeply (and overtly) into monetary financing as they’ve ever dared tread.
MRA’s Curnutt made many of the same points in a Friday note documenting the risk posed to markets by the interplay between inflation expectations, realized inflation and the Fed’s reaction function. “From a market stability standpoint, if investors face a widely shared risk, you would prefer a healthy supply of the insurance for that risk [but] with respect to inflation, this appears to be the opposite,” he said. “Stocks are vulnerable to inflation because bonds, the very instrument often used to hedge stocks, are highly vulnerable to inflation.”
Therein lies the problem. And the talking point du jour.
“What happens when the bond market, instead of being a part of the solution, is the source of the problem?,” Curnutt asked, rhetorically.
In a “tantrum,” bonds are the proximate cause of the turmoil and “the equity market, having long benefitted from extremely low rates, suffers from the uncertainty about the ultimate magnitude of the increase,” Curnutt went on to say. “The result: lower share prices, increased volatility and a positive correlation in stock and bond prices.”
The bond exposure that’s long served as a stabilizer and risk dampener is suddenly the locus of the pain and a risk amplifier.