Investors Are Losing Faith in the Fed
By Christine Hughes, Canada. Chief Investment Strategist, OtterWood Capital:
The recent market drop revealed a change in market dynamics that I find particularly troubling. Historically when the stock market crashes, U.S. Treasury bond prices tend to rise simultaneously (remember when bond prices increase, the yield decreases). The bond market loves when bad things happen because it drives investors into bonds out of fear and/or on expectations of lower economic growth.
The following charts show the close relationship between the 2-year yield and the S&P500 during three recent significant market selloffs, although the relationship goes back much longer.
Note how in each instance bond yields move down (bond prices up) in sympathy with the stock market selloff and stay down. In the history of our markets, we have never seen stock and bond prices drop together during a market selloff until a few weeks ago.
The relationship initially held when stocks fell but immediately after the market drop the 2-year yield jumped back to new highs. The cushion from yields was only momentary. I do not take this as a positive development for the markets.
Some commentators have pointed out that yields are increasing due to expectations the Fed’s will hike interest rates but this isn’t correct. In fact the federal funds futures market, which is used to estimate the probability of a Fed rate hike from current market prices, is only showing a 28% chance of liftoff next week.
Treasury yields are currently increasing for the wrong reasons; mainly large investors don’t want the bonds anymore and are selling. A couple of large holders come to mind, mainly China, and technical selling from black boxes like risk parity funds. As I’ve covered on our blog, which you can read here, China has been selling Treasuries to stabilize its currency. They have been selling their vast Treasury holdings since last year, check out the chart below.
The other factor dominating trading recently is risk parity funds. These funds have added selling pressure during market drops and aggravated the moves to the downside. See our post here for more information on these enormous funds.
This recent divergence between bonds and stocks is radical and is a knock to confidence in the financial system. An environment when bond and stock prices fall together is an indication that investors are losing faith in the Fed, the government and debt in general, which is a very negative development. In my video next week I will explain this whole phenomenon more fully. By Christine Hughes, OtterWood Capital
What we’re seeing is the beginning of a massive reserve unwind in China. Read… China’s Record Month
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