The question, Has Goldilocks died?
Has recently been asked worldwide
If this is the case
Prepare for the pace
Of selling to be amplified
OMG! Well, yesterday was certainly an interesting one in the markets. And to think, all that digital ink was spilled over Friday’s much smaller decline! Here’s the deal folks, markets can fall, and they can fall a long way without any obvious catalyst.
Remember Goldilocks and her economy? You know, strong global growth without inflation would allow central banks to continue to leave rates at rock bottom levels thus fostering further economic growth, spectacular earnings and a never-ending bull market in both stocks and bonds. Yeah, well not so much after all. She was always most likely to be slain by inflation and once again I will point to Friday’s AHE number as the sign that markets are getting a bit more nervous over future inflation readings. But when markets get going like this, they decouple from the underlying story and become the story themselves. That is classic market behavior and I see no reason for it to change now.
Funnily enough, I do think this time is different, just not different in a good way. This is because over the past three to five years, there has been a significant increase in the number of algorithmic strategies and the amount invested in them. As well, the idea that the retail investor was actively trading implied volatility movement is another true difference from previous bouts of market disruption. And the upshot is that all of those, and other, systematic strategies that have been instrumental in leading the great bull market higher are very likely to be what leads the market lower now that it has turned when it turns. The hallmarks of this type of behavior were seen just after 3:00pm yesterday, when the decline accelerated sharply and the Dow fell an additional 2.1% in just minutes before rebounding slightly into the close. That was very clearly machine algorithms being triggered by some signal like a moving average or a relative strength indicator or something else, and responding exactly as programmed. The thing is, this type of market behavior can be self-reinforcing, and so several more days of sell-offs is quite realistic. Being different in this case is a distinct negative. The magnitude of the ramifications of those strategies being unwound is hard to determine, although the direction is easy.
A moment about the volatility trading I mentioned above. Let me explain that trading volatility is extremely difficult. I spent some fifteen years trading and running options businesses and I know from whence I speak. In order to be effective, one needs to be deeply involved in the underlying market, which for me was mostly FX but also commodities and government bonds, as well as in the day-to-day activity in the options market. Understanding how the second derivatives impacted positions and profitability was critical to any level of success. The point is, the popular strategy of buying the XIV or SXVY (short volatility ETN’s) and leaving them in your account was never going to be a long run success. It appears that both of those ETN’s may actually disappear today, which means that despite closing at 99.00 yesterday, the XIV could actually be delisted today as its value approaches 0.00! I have not read the prospectus so am not certain that will be the case, but if you were counting on gains in that security as part of your portfolio, things just got a lot worse.
Back to the market. So we know that stocks fell sharply, and in what cannot be a great surprise, Treasury prices rallied alongside the dollar. That whole risk-off, flight to safety concept remains a fundamental part of the market, and as risk was being jettisoned yesterday, the true safe havens were highly sought after. So, 10-year Treasuries saw prices rise 1-½ points and the yield fall 15bps. The dollar rallied vs. most of its counterparts with only the yen, also a traditional haven currency, rallying further. On the flip side, aside from equity market declines, we saw commodity prices fall sharply too. And I would be remiss if I did not mention that Bitcoin, the erstwhile digital gold, fell sharply as well, on the order of 15%. Meanwhile, gold, as a traditional haven, rallied slightly, about 0.5%, showing that when it comes to a store of value, the barbarous relic has it all over the digital variety.
In this market environment, there is no room for a story about a particular currency or country. We continue in the midst of a significant readjustment and quite frankly, I believe there are only two things that can change this. The first is if we get central bank reaction such that the market believes that QE is not going to end. If, for example, the Fed halted its balance sheet roll-off, or Jens Weidmann started talking about the benefits of further QE, the decline would stop in its tracks. But I think we are a long way from that happening. The other thing is time. Essentially, sharp movements in the market tend to peter out not so much because anything has changed, but because time has passed and positions have finally been adjusted. That however, portends further pain for risk asset holders to come.
One last thing on bonds. It is somewhat ironic that Treasury prices rallied so far given that much of the blame for the equity market’s undoing can be laid at the feet of the fact that Treasury prices were falling so rapidly. Of course, the decline was based on changes in inflation expectations, while the rally was pure risk-off behavior. The thing is, if equity prices continue to fall, I expect that Treasuries will continue to rally. But when we finally settle down, inflation continues to be on an upward trajectory and Treasury prices are very likely to give back all these gains and then some.
Looking at today’s activity, we do get the Trade Balance (exp -$52.0B) and we hear from St Louis Fed President, and uber-dove, James Bullard just before 9:00. However, if Bullard is dovish, that is not news. On the other hand, if KC President Esther George is dovish when she speaks Thursday evening, the market would immediately take notice. Certainly equity markets are going to open lower again this morning. My guess is they maintain those losses at the end of the day, although in intra-day rally is likely as well. As to the dollar, if panic resumes, look for it to gain further. This is a risk situation, not an economic one for the time being.