The QT trade will naturally, even necessarily, be a mirror image of the QE trade.
Just beneath the surface of that apparent truism lies the most disconcerting question investors are compelled to ponder when confronted with the prospect of stimulus withdrawal: What if everything sells off simultaneously?
In fact, so-called “diversification desperation” has been the story of 2022. Q1 was among the worst quarters on record for 60/40 portfolios and as the simple figure (below) shows, virtually nothing is working.
For equities, there’s nothing singularly terrible about a 15% drawdown, but YTD losses for Treasurys and investment grade credit are the worst on record.
The crux of the issue is stimulus unwind and, more to the point, rapid, uncompromising stimulus unwind necessitated by generationally high inflation, a condition that didn’t exist in 2015, when last the Fed attempted to normalize policy. There was no “time constraint” and “no specter of inflation to create the sense of urgency and force the accelerated pace of rate hikes,” Deutsche Bank’s Aleksandar Kocic wrote, in his latest.
The figure on the left (below, from Kocic), illustrates a conventional recovery from a conventional recession. At first, stocks sell off and bonds rally as the downturn materializes. Central banks intervene and the tide eventually turns. Investors become progressively less defensive, favoring stocks over bonds until rate hikes act as a brake on equity gains. As Kocic put it, describing the conventional dynamic, “unwind of the recession trade goes along the grain of the market — its inertia leads naturally into the recovery trade [and] because of this, past recoveries have been generally accompanied with lower volatility.”
But the last two recessions weren’t cyclical and the policy response was unconventional. The deployment of QE pushes us “off-diagonal,” as Kocic put it, as stocks and bonds rally together. That, Kocic wrote, creates the conditions whereby the unwind “goes against the grain of the recovery” in a de-risking trade (figure on the right, above).
Currently, the US is fast approaching the point marked “3′” in the figure, which Kocic called a “bifurcation point” — either we escape the stagflationary event horizon or we don’t. If we don’t, multi-asset investors are in trouble.
“Given the proximity of the bifurcation point and possible slippage into the fourth quadrant along the stagflationary path is making risk parity portfolios particularly vulnerable,” Kocic went on to say. “Under that scenario, their hedges (bonds) would become clear liabilities.”
In Deutsche’s view, the curve hasn’t priced that risk. Markets have fixated on the front-end as a proxy for short-term monetary policy, the only thing to which odds can be ascribed given the total ambiguity enveloping the long-term macro outlook. “The back end is lacking any term premium commensurate with long-term uncertainties,” Kocic said. That’s evident in the relative richness of the 30-year sector and commensurate underperformance of 30-year tenor vol.
It’s through that lens that Kocic contextualized the post-FOMC trade in rates. Recall that the knee-jerk reaction was a violent bull steepener as the market reacted to Jerome Powell’s dismissal of rate hike increments larger than 50bps. Thereafter, though, the back end came alive (figure below).
It’s possible, Kocic remarked, that the awakening (on Thursday and Friday) of the back end, marked the “announcement of the risk premium trade” that’s so far been absent amid the market’s myopic focus on more policy-sensitive sectors.
If long bonds become a flashpoint as we move closer to the stagflationary black hole, all bets are off.
“While central bank actions and the market environment create optimal conditions where every asset class makes money at the same time, the natural question one has to ask is: What to expect after that?”, Kocic wrote. “If unwind of the stimulus is its mirror image, where does one go when everything sells off?”
The context from 2015 is interesting. Powell’s first go at tightening and Yellen’s seem very different on this side of reality.
One goes to cash or vol in that circumstance; the trick is in the timing. Have we come to a juncture where timing the market may be rational? I don’t relish the thought.
H-Man,
I believe as you do, we have not seen the bottom. So managing a portfolio in these troubled times requires one to trade volatility for hedging or speculation purposes. The VIX is currently the barometer of the market which has climbed into 30’s —– when fear turns to capitulation —–it will move into 40’s or 50’s or higher. Right now it is moving north and I see that trend continuing. So if you want to hedge a portfolio of equities or speculate, you will buy UVXY or TVIX call options on a timeline and strike price you feel comfortable with. Alternatively, you simply buy the ETF. If the market continues downward, either position will be in the money which will ameliorate the pain on the portfolio or pocket a profit if done for speculation. But don’t be greedy. Because………
My only caveat about trading volatility is that when the bottom arrives. the VIX will drop like a rock, no matter how high ti has ascended and it will do so quickly, reverting to the mean.
So trade accordingly if you want to stay in the market and reduce your losses. You don’t have to be a deer in the headlights.
“While central bank actions and the market environment create optimal conditions where every asset class makes money at the same time, the natural question one has to ask is: What to expect after that?”, Kocic wrote. “If unwind of the stimulus is its mirror image, where does one go when everything sells off?”
If we look at 30-year USTs as a proxy for pure duration, it’s been selling off since March 2020 (when the 30-year yield bottomed at 1%), which is when the latest round of stimulus was introduced, i.e. the selloff in long bonds are far more advanced that any other asset class, so it might be the first to turnaround during a withdrawal of stimulus?
Charm, the selloff in bonds is just beginning. It will only become a safe haven when bonds on the 10’s hit 3.25
I still have USTs at 6.75 with six more years to run. 3.25%, humbug.
Cash is not edgy, creative, or fun to talk about, and assures a single digit negative real return, but has one large advantage, which is that it is unavailable to the large majority of institutional investors who are forced by mandate or financial incentive to stay fully invested or close.
The other advantage is that at “the bottom”, it is a lot easier to buy bargains with cash than to sell one’s big loser to buy someone else’s big loser.
Do any of you have access to the recent performance results of the risk parity/vol control funds?
For the past few years in the markets, movement up or down seems to be happening extremely quickly. Until supply chains normalize and commodities are not excessively strained, I expect to keep getting hit with rapid fire movements.
I am a glass half full person, eventually we will get past this. Fortunately, I don’t have to sell.