A Surprise Rout in the Bond Market

At the time of writing, the stock market is recovering from a fairly steep (by recent standards) intraday sell-off. We have no idea where it will close, but we would argue that even a recovery into the close won’t alter the status of today’s action – it is a typical warning shot. Here is what makes the sell-off unique:

 

30 year bond and 10-year note yields have broken out from a lengthy consolidation pattern. This has actually surprised us, as we felt that the large speculative net short position in bonds and notes was prone to trigger a short covering rally. Alas, the opposite has happened.

 

Since the 1998 Russian crisis, the prices of stocks and bonds have been negatively correlated most of the time (note that they were positively correlated from 1970 to 1998, so the negative correlation is a fairly recent phenomenon from a longer term perspective). We did not really expect bond yields to break out, mainly due to the legacy CoT report, which recently looked as follows:

 

According to the legacy CoT report, large speculators recently held a record high net short position in 10-year treasury note futures. Usually these traders are wrong at extremes.

 

It is of course possible that the breakout in yields turns into a “false breakout”, in which case this position would be quickly unwound. However, in a recent post by Macro Tourist (Kevin Muir) it was pointed out that the disaggregated CoT report indicates the situation is not as simple as it appears at first glance. Here is a chart  illustrating the disaggregated data:

 

Net positioning in treasury futures by trader group according to the disaggregated CoT report – asset managers actually hold a very large net long position – only leveraged funds and non-reportables (small speculators) hold large net short positions.

 

In other words, the breakout could easily be “legit” and yields may have even more upside from here (perhaps after a retest of the breakout).

 

A Potentially Dangerous Situation

In recent years a popular investment strategy has been built around the negative correlation between stocks and bonds that is in place since 1998. The strategy is known as “risk parity” and has a towering amount of assets under management by now. Funds employing the strategy are reportedly usually leveraged between 1:2.5 to 1:4.

The principle behind the strategy is that gains in bond positions are going to counter any downside volatility in equities. One could say it is a very primitive version of the “permanent portfolio”, or better, simply a mixed stock/bond allocation strategy with leverage. Obviously, whenever bonds and stocks suddenly decline at the same time, this strategy can get into considerable trouble.

The last time this happened to an appreciable extent was in August 2015. Bonds declined due to capital outflows from China and a sell-off in stocks started at the time, initially driving the major indexes below their 50- and 200-day moving averages. This move very likely caused CTAs and other trend followers to reduce their equity exposure.

Their selling in turn seems to have triggered stop loss orders at risk parity funds, which then induced volatility targeting strategies to sell due to the upward spike in the VIX (these funds reduce equity exposure when volatility increases). Trend followers then had even more reason to join the fray. Three days and 10 minutes of mayhem ensued:

 

The August 2015 rout in the DJIA – down 12.5% in three trading days and 10 minutes.

 

We should point out that the technical position of the market is quite different at present, as most indexes are (or rather were) recently extremely overbought and traded far above their 200-day moving averages. In 2015 the stock market had moved sideways for quite some time – hence it didn’t take much to push prices below  the 50- and 200-day moving averages at the time.

In today’s trading the Russell 2000 Index – which is the current downside leader – stopped falling and started to bounce right after hitting its 200-day ma. This moving average has contained every correction in the past two years, so traders (and algos) are now “trained” to buy declines to this level:

 

The Russell 2000 and the 200-day moving average over the past two years.

 

We would guess that it is probably widely expected based on recent experience  that the still relatively mild stock market decline of the past few days is just another buying opportunity. That may well turn out to be true, but the concurrent rout in the bond market is a new wrinkle that should perhaps not be dismissed too lightly.

There is a good reason why it may be relevant apart from the potential problems posed by issues related to market structure and the positioning of various funds and systematic strategies. We are referring to the effect of the bond rout on the yield curve, which is yet another warning sign:

 

 

The 10-year minus 2-year treasury note spread as a proxy for the steepness of the yield curve. After tightening precipitously for a long time, the spread is suddenly widening quite rapidly.

 

Note that the 10-2 year yield spread last widened this quickly during the sell-off in early February. A steepening yield curve at this late stage of the boom is a clear negative for risk assets and the economy – regardless of the “reason” for the steepening. Possible reasons are either an increase in inflation expectations, or a deterioration in economic confidence (which will tend to lower rate hike expectations).

Neither is positive for stocks and the former is negative for stocks and bonds.

 

Conclusion

This is not the time to throw caution to the wind.

 

Bonus Chart – Cash Allocations

We have recently come across the following chart, which shows investor cash positions according to several surveys – this is relevant for the long term outlook:

 

Cash allocations according to several surveys – not what you want to see if you are up to your eyebrows in stocks.

 

Charts by: StockCharts, SentimenTrader, Macro Tourist, Topdown Charts.

 

 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • Is the Canary in the Gold Mine Coming to Life Again?
      A Chirp from the Deep Level Mines Back in late 2015 and early 2016, we wrote about a leading indicator for gold stocks, namely the sub-sector of marginal - and hence highly leveraged to the gold price - South African gold stocks. Our example du jour at the time was Harmony Gold (HMY) (see “Marginal Producer Takes Off” and “The Canary in the Gold Mine” for the details).   Mining engineer equipped with bio-sensor Photo credit: Hulton Archive   As we write these...
  • Oil Mania Redux
    Positive Energy By now, late September of 2018, it has become increasingly evident that something big is about to happen. What exactly that may be is anyone's guess.  But, whatever it is, we suggest you prepare for it now... before it is too late.   Art auction energizer: Norman Rockwell's portrait of John Wayne. You can't go wrong shelling out top dollar for me, pilgrim, can you? [PT]   Several weeks ago, if you haven't heard, an undisclosed rich guy enthusiastically...
  • Fed Credit and the US Money Supply – The Liquidity Drain Accelerates
      Federal Reserve Credit Contracts Further We last wrote in July about the beginning contraction in outstanding Fed credit, repatriation inflows, reverse repos, and commercial and industrial lending growth, and how the interplay between these drivers has affected the growth rate of the true broad US money supply TMS-2 (the details can be seen here: “The Liquidity Drain Becomes Serious” and “A Scramble for Capital”).   The Fed has clearly changed course under Jerome Powell...
  • The Gold Standard: Protector of Individual Liberty and Economic Prosperity
      A Piece of Paper Alone Cannot Secure Liberty The idea of a constitution and/or written legislation to secure individual rights so beloved by conservatives and among many libertarians has proven to be a myth. The US Constitution and all those that have been written and ratified in its wake throughout the world have done little to protect individual liberties or keep a check on State largesse.   Sound money vs. a piece of paper – which is the better guarantor of liberty?...
  • Fed President Kashkari Hears Voices – Are They Lying?
      Orchestrated Larceny The government continues its approach towards full meltdown. The stock market does too. But when it comes down to it, these are mere distractions from the bigger breakdown that is bearing down upon us.   Prosperity imbalance illustrated. The hoi-polloi may be getting restless. [PT]   Average working stiffs have little time or inclination to contemplate gibberish from the Fed. They are too worn out from running in place all day to make much...
  • Switzerland, Model of Freedom & Wealth Moving East – Interviews with Claudio Grass
      Sarah Westall Interviews Claudio Grass Last month our friend Claudio Grass, roving Mises Institute Ambassador and a Switzerland-based investment advisor specializing in precious metals, was interviewed by Sarah Westall for her Business Game Changers channel.   Sarah Westall and Claudio Grass   There are two interviews, both of which are probably of interest to our readers. The first one focuses on Switzerland with its unique, well-developed system of  direct...
  • US Stocks and Bonds Get Clocked in Tandem
      A Surprise Rout in the Bond Market At the time of writing, the stock market is recovering from a fairly steep (by recent standards) intraday sell-off. We have no idea where it will close, but we would argue that even a recovery into the close won't alter the status of today's action – it is a typical warning shot. Here is what makes the sell-off unique:   30 year bond and 10-year note yields have broken out from a lengthy consolidation pattern. This has actually surprised us, as...
  • Decapitation Strike -  Elon Musk in the Crosshairs of the Bureaucracy
      The Most Expensive Tweet of All Time He finally done did it this time – this is to say, he did himself in. It was already widely known that Elon Musk sent out one tweet too many in early August. But it seems now that what he posted on that fateful day may well end up as the most expensive sequence of nine words ever blasted over the intertubes. For those who haven't followed the story, this is the tweet in question:   Elon Musk's fateful tweet – here is a link to the thread...
  • Are Credit Spreads Still a Leading Indicator for the Stock Market?
      A Well-Established Tradition Seemingly out of the blue, equities suffered a few bad hair days recently. As regular readers know, we have long argued that one should expect corrections in the form of mini-crashes to strike with very little advance warning, due to issues related to market structure and the unique post “QE” environment. Credit spreads are traditionally a fairly reliable early warning indicator for stocks and the economy (and incidentally for gold as well). Here is a...
  • Choking On the Salt of Debt
      Life After ZIRP Roughly three years ago, after traversing between Los Angeles and San Francisco via the expansive San Joaquin Valley, we penned the article, Salting the Economy to Death.  At the time, the monetary order was approach peak ZIRP.   Our boy ZIRP has passed away. Mr. 2.2% effective has taken his place in the meantime. [PT]   We found the absurdity of zero bound interest rates to have parallels to the absurdity of hundreds upon hundreds of miles of...
  • How Dangerous is the Month of October?
      A Month with a Bad Reputation A certain degree of nervousness tends to suffuse global financial markets when the month of October approaches. The memories of sharp slumps that happened in this month in the past – often wiping out the profits of an entire year in a single day – are apt to induce fear. However, if one disregards outliers such as 1987 or 2008, October generally delivers an acceptable performance.   The road to October... not much happens at first - until it...
  • Yield Curve Compression - Precious Metals Supply and Demand
      Hammering the Spread The price of gold fell nine bucks last week. However, the price of silver shot up 33 cents. Our central planners of credit (i.e., the Fed) raised short-term interest rates, and threatened to do it again in December. Meanwhile, the stock market continues to act as if investors do not understand the concepts of marginal debtor, zombie corporation, and net present value.   The Federal Reserve – carefully inching forward to Bustville   People...

Support Acting Man

Item Guides

Austrian Theory and Investment

j9TJzzN

The Review Insider

Archive

Dog Blow

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com