If you get the feeling markets are dysfunctional, it’s not just your imagination.
Over the past week, both bonds and stocks have been a mess, for lack of a more sophisticated adjective.
To a certain extent, this isn’t new. Pain and abject confusion has been the story of the year for rates, while unpredictable twists and turns on the road to re-opening engendered episodic factor volatility and thematic reversals in equities for most of 2021.
That said, the last month was especially nauseating for some, and it seems to be getting worse as we approach year-end.
“The environment remains shockingly dysfunctional,” Nomura’s Charlie McElligott said Thursday. At 155, vol of vol notched its second-highest closing level of the entire year Wednesday (figure below), a level exceeded only during the meme stock mania and associated hedge fund short book chaos.
While retail investors plowed billions into ETFs and individual shares during the Black Friday rout and again during Tuesday’s swoon, the “smart” money is packing it in for the year. Or at least it seems that way.
According to Goldman’s prime desk, net leverage dropped to the lowest in a year this week. Bloomberg quoted Dennis DeBusschere. “Many have mentioned hedge fund pain leading to weird internal moves,” especially “among speculative tech stocks,” he said, adding that “this latest negative Omicron news leads to just closing the books up and moving on.”
I’ve mentioned the “moving on” bit (i.e., protecting the year or just getting out of the year) on several occasions amid the latest bout of volatility in rates and equities. McElligott on Thursday called Wednesday’s factor moves “staggering.” Almost all of more than three-dozen factor pairs and legs tracked by Nomura witnessed at least a one-standard deviation move. Out of more than two-dozen individual factor legs, “the median move was -1.9 z-score (lower) on impulse de-risking into year-end illiquidity,” he said.
Much of the drama is associated with a painful repricing in some richly-valued, hyper-growth corners of the market. There are any number of ways to visualize the situation. Charlie noted (with some alarm) that hedge fund crowded longs have underperformed the Nasdaq 100 by more than 12% this year, which doesn’t sound entirely crazy until you consider that the entirety of the shortfall has come over the past month (figure on the left, below, from McElligott).
On the right (above) is a near six-standard deviation one-day move in the the Bloomberg US Pure Trading Activity Factor, which measures long-short total returns sorted by trading volume relative to shares outstanding. It was the second-worst one-day return for the factor in a decade.
The reason for all of this is fairly straightforward. Last weekend, in “Nosebleed Markets Ponder Uncertain Year-End In Latest Virus Panic,” I wrote that the read-through of a steep decline in breakevens for real yields is risk-negative. The figure (below) illustrates the dynamic.
That’s problematic and it’s indicative of an environment in which the outlook for growth is clouded not just by pandemic concerns, but also by worries that the Fed’s response to pandemic-inspired inflation will exacerbate any growth drag from restrictions associated with the new variant.
As McElligott put it Thursday, “inflation proxies and forwards have been crunched, resetting real yields in pure ‘tightening of financial conditions’ fashion, as the market pulls forward the slowdown impact of the Fed’s policy actions.”
That pretty much sums up it all up. The next question is whether we forgo the slowdown phase and skip straight to contraction.
Some have suggested the current “cycle” is no different from historical cycles. But you could easily argue it was entirely engineered. The risk is that we engineered a rapid recovery and a rapid expansion and now, having overshot, are compelled to embark on an equally panicked effort to engineer a contraction before inflation spirals.
Between two parties, it is not uncommon for there to be a gap between what party A tells party B they are going to do (often what party A thinks party B wants to hear) and what party A actually desires to do. Often party A will act in a manner just below the point where party B would become upset by Party A’s actions.
I continue to doubt that the Fed will do anything that would cause a significant problem for the US stock market – because if they do tighten too much- fungible investment money will move to another, more accommodative country and/or equity market. This would not be a desirable outcome for the US government. It is not just wealthy people who are invested in the US equity markets. Anyone who has a pension (teacher, public servant, police, firemen, union member, etc.) indirectly depends on the stability and long term upward direction of the US equity markets.
It will be easier for the US government to supplement the finances of lower income people through less taxes, more credits or outright grants. Public healthcare for all?
I agree. Our consumption economy definitely depends on rising home equity, stability/depth/liquidity in our capital markets and cheap credit(that’s readily available to people who generally don’t need credit due to the strength of their personal balance sheet). Public healthcare is definitely a much bigger necessity than pre-K “education” and many other programs we could all list. But the health insurance industry and Big Pharma are “cash cows” whose generous “donations” support political campaigns which guarantees that we will have no public health care. I think the easiest approach would be to lower the age for Medicare eligibility to 50 for those who choose to “opt in” as a first step. That would be very popular with a large segment of the electorate.
H-Man, tomorrow could be a big day on how we look forward. Hot print on payrolls + 700,000 = tapering acceleration is a done deal. Couple that with a K prediction Omicron may be bullish and we may see a run in equities that catches everyone flat footed.