The ‘Blind Spot’: Traditional Portfolios’ Biggest Risk
What happens to the US equity market if macro volatility rises as a result of untethered inflation that forces monetary policy to be less predictable?
That seemingly straightforward question admits of more nuance than you may think.
The obvious answer is that if inflation remains elevated, causing expectations to become unmoored, the Fed will have to be proactive. A proactive Fed that hikes preemptively to manage inflation is not a "friendly" Fed, or at least not vis-à-vis markets. An unfrien
Your story is the reason many advisors are looking at the cash or near cash asset as a substitute for bonds and possibly even stocks. The FOMC may be in a position of tightening into a slowdown. If that is the case, then US Treasury bonds will look like bargains not bubbles!!!
Maybe we get back to some kind of normality. Equities retreat, bonds retreat, interest rates gradually increase, inflation slowly goes back to a an acceptable value and the USD dominates again!. Works for me.
Cash is a reasonable substitute for UST and IG bonds in the current environment. Give up a whopping 50-220 bp of yield. Assuming one is looking for a temporary substitute (for months not years), I think the 4-18 bp/month is pretty cheap for portfolio derisking.
Most institutional and wealth portfolios are required by rule or custom to stay “fully invested”, so carrying elevated cash levels is often maligned as “market-timing” or some similar character flaw.
In reality, the fact is that, as H shows, there are market environments in which nothing much works, so why burn up performance hunting for the best house in a bad neighborhood?
Before we even get to what the Fed’s actions might be re: reversal of QE, raising rates, the Fed’s balance sheet, inflation etc. – it seems that first and foremost, the Fed must fulfill its unwritten and unspoken primary purpose to assist in anyway possible supporting the USD as the global reserve currency, refinancing existing US government debt and helping to finance current US spending in excess of taxes collected. Once that primary purpose has been satisfied, then and only then can the Fed attempt to take other actions.
Up to now- everything is just talk. Reversing the trend over the (almost) past 4 decades is not a flip of the switch.
We’ll, hate be that guy, but… you can make money in the lower left quadrant with a portfolio of cash used as collateral to sell uncovered put and call options. Time value erosion becomes your best friend. If you can read pivots and head fakes (up or down) to any reasonable degree you can do pretty well. Most institutional funds require staying invested. They pay up to hedge.
Sorry emptynester. Didn’t mean to post that as a reply to your comment. It was intended as a general response to the article.
I guess I disagree with the view that a combination of low risk appetite and tighter policy is bad for treasuries, especially the ultra long end (20y+), as such a quadrant is arguably what we’re seeing right now and long bonds have been outperforming.
If tighter policy entails tighter financial conditions more broadly, then we should expect a flattening of the back end and if the tightening goes far enough, an inversion. What that means for the absolute levels of long bond yields is hard to say, but it could be higher or lower (depending on the speed of the tightening with respect to the market’s estimate of the “terminal rate”). Credit, TIPS and short/intermediate term treasuries will be more likely to suffer in such an environment than long term nominals in my view.
I guess a lot of this comes down to whether or not you believe that current fed policy alone can materially raise the pricing of the terminal rate, given secular disinflationary forces still remain.
I’ve long been in the secular disinflation camp. But whether Biden is reelected (or another Dem is elected in 2024) or the GOP manages to pull off a soft coup and installs its candidate in the WH, I think the U.S. and China are headed for a major economic cold war, which (if it develops) will be a major inflationary development going forward.
It’s not surprising to see people grabbing volatility in an environment where nothing is safe.
H-Man, makes for a rather interesting trading market for the next couple of months. Everyone seems to be confused about the winners and losers. I guess that is why God invented vol.
I have ridden the “bond bubble” for the full 40 years, using the carry trade for the first 20. I earned 50-60% in some years. I’m reaching my sell-by date so prices don’t really matter any more; only income does so rising rates just mean I can reinvest my coupon earnings for better income. I’ll get par for everything at maturity. My FI portfolio now earns 4%+, with a quarter of the income being tax exempt. I have bond funds, CEFs, CLOs, MBSs, TIPS, individual USTs (@7%), munis, preferred stocks and all the individual bonds are currently in the green, selling above my basis. The TIP fund is yielding 5%. What’s not to like?
That is absolutely fantastic- but what is your investment advice to your daughter?
Generally speaking our current situation has a “walls closing in” feel to it … precious metals could be a good cashing parking spot, as well as the Yen … imho …