We didn't know what we thought we knew

Summary

• The global economic recovery continues to rest on a shaky foundation.

• Trade uncertainty adds to global uncertainty.

• A rundown of what happened during the sell-off.

• The VIX futures curve will always invert when investors are shorting volatility.

• Slippery markets are something that's here to stay, at least until monetary policy normalizes.

Global equity markets were mostly driven by event risk this week. Stocks were down and bond yields shifted lower with the market beginning to price in renewed trade risks (more on this below). Yield curves were broadly steeper, driven by the fall in short rates, implying further easing from the Fed. Safe-haven currencies like the Swiss Franc and the Japanese Yen saw heavy inflows. Gold was also up over the period, highlighting the broad rotation into safety. The US dollar was flat despite lower bond yields and renewed trade tensions, which should have resulted in USD weakness. On the data front, there was relatively little to speak of, we had several prints in Europe, none of which were market moving. Chinese exports were fairly disappointing, falling year over year, flipping positive talk from the previous month's releases on its head. Although the recovery in China is underway, the recent export data highlights that things are still fragile. Adding to that concern, Bloomberg was out with a piece earlier last week highlighting that corporate bond defaults in China are on pace to beat last year’s record numbers. Mind you, this is the result of the funding squeeze in China, which is part of a broader effort to reduce leverage in the economy and promote financial stability. North Korea was also in the mix last week, launching 2 short-range missiles. South Korean stocks were down on the week due to a combination of the North Korean missile tests and the broader risk-off sentiment.  Everything that could have gone wrong with respect to allaying fears of a renewed trade war went wrong this past week. When the dust settled, the US had raised tariffs on Chinese goods and China had responded with retaliatory tariffs. The trade spat began following a report that surfaced on Wednesday stating that China had made “systematic edits to a nearly 150-page trade agreement”, undoing months of trade progress (article here). The market was blindsided with the news. The escalation of trade threats last year had led to a steady news flow of recycled headlines on “progress”, to which the market understandably started to tune out (you can only read the same headline so many times — think Brexit). Although hindsight is 20-20, I do think we should have seen this coming. It’s no secret that Trump views the stock market as a scorecard for his presidency, and with equities screaming to new highs, it’s almost as if Trump viewed this setback with China as an opportunity to “play with house money” so to speak. China was in a similar situation with the rise in equities (up nearly 40 percent) definitely reducing the incentive for Beijing to make further concessions to the US. Thanks to the fact that Trump’s political base rests on the perception of him “fighting the good fight”, it’s never entirely clear if he is pursuing the stock market or a “win” for his base, which is probably why the market got this one so wrong. Markets and foreign governments have had a hard time understanding the President’s reaction function. Although this is probably intentional, it creates scenarios where markets become overly insensitive to trade headlines, with the effect of driving up cross-asset volatility. Against all of this, these developments have definitely made Fed policy far more uncertain. It is hard to imagine the US economy would not ultimately slowdown as a result of the higher input prices from tariffs -- supporting the case for a rate cut. On the flip side, if the economy does manage to hold up, It would be probable that the rise in input prices would feed through consumer prices, raising inflation as well as the odds of a Fed increase. The first chart highlights work from Goldman Sachs that shows how higher tariffs have fed through to consumer prices. The second chart shows that, under an absolute worst case scenario, we could see at most a 0.9 percent impact on a year over year inflation.

With all of this in mind, the Fed funds futures market is now pricing in about a 70 percent chance of at least one cut by year end (up about 30 percent from a month ago). On a separate note, a tweet from the editor-in-chief of the Global Times hints that China may begin dumping US Treasuries, which would put significant upward pressure on yields given China’s size in the market. There was speculation of this activity at last weeks Treasury auction which results in a 5 bps move in the 10-year. This would be one of the two “nuclear” options Beijing could use against the US, with the other being a blatant devaluation of the Chinese Yuan.  The market's witnessed some strong selling over the past week from systematic trading funds. As highlighted in my previous email (Market update #10 Trade truce no more), the selling last week kicked off with profit taking from asset managers, which had built up long positions in the futures market since February. Given the rapid rise in equities, it was likely that even the threat of tariffs would be enough news for asset managers to flip short. This selling on Monday caused the index to close below the sell triggers for CTA’s (Commodity Trading Advisors/momentum trading funds) which then sparked the second wave of selling on Tuesday (the day of reckoning). The continued grind lower in equities throughout the week was associated with a more subtle deleveraging process from these systematic investment strategies (in an effort to avoid large price moves). Risk parity funds (funds that have a target portfolio volatility) also rotated from equities into bonds, creating the classic stocks down, bonds up environment. Risk parity funds had allocated more weight to equities due to the rapid unwind in global cross-asset volatility. The chart below features an aggregate volatility index across commodities, interest rates, equities, and currencies.

The shaded area on the above chart highlights periods in which short-volatility strategies would have been the most profitable (generally in a downward trending volatility market). Short volatility will almost inevitably result in an inverted VIX (1-month implied volatility on S&P500) curve once volatility returns to the market. The chart below shows the VIX futures curve before tariffs were announced (blue and orange lines) and after tariffs were announced (green and red). 

A fund shorts volatility by “rolling down the curve”. If we focus on just the blue line on the chart above, as long as the curve Is upward sloping, an investor can sell the September contract for just over $17 and then buy the spot contract when September comes around for the spot price of just under $15. The difference between the two prices is the return. Now some of the more astute readers would realize that this depends on the assumption that the curves shape and level does not change (which is unrealistic). When market volatility spikes, there’s an upward shift in the curve (in this case from blue to green) which immediately wipes out any positions. In order to offset the losses (hedge), the investor would need to buy the spot contracts, which then forces the curve to invert (become downward sloping). I’m assuming I have lost the majority of you but for those interested in more, there is an interview here with Charlie McElligott from Nomura's cross-asset strategy team. For completeness sake, these hedging dynamics I described above tend to lead to the type of recoveries we saw yesterday (S&P500 up nearly 1.5 percent) as these hedges become profitable and the market participants begin monetizing them.

In a world where we see no more high-speed collisions, stability breeds instability. The central bank playbook post-financial crisis has created a world of lower interest rates, flatter curves and suppressed asset volatility. Growth has stagnated and regulation has made it harder to put capital to work. This benign environment has forced investors to move into riskier assets in a search for yield. Institutions have shifted from buyers of volatility to sellers of volatility, all in an effort to generate yield in a world void of yield. These short volatility strategies I outlined above are just one example of yield enhancement strategies. Think of these strategies as equivalent to me lending someone my umbrella when I know there is rain in the forecast. I can make some extra cash doing this, and as long as I don't get too soaked when it does rain, everything is ok. So why does stuff like last week happen? Well, investors are being forced to pick up pennies in front of a steam roller. They know they are going to get burned eventually, but until that day comes they have to dance, they have to try and get that extra yield. I think we are going to continue to see these slippery,  seemingly unnatural moves in markets until central banks make a successful push to normalize policy. I’ll end with a quote from one of McElligott’s notes “If you’re short vol, you make money but eventually die. But if you’re long vol, you die before you make money”. Tiago Figueiredo