Squirrely Market Action Upends Consensus Trades
Bloomberg notes that there have been a number of “mysterious” and rather large moves in a number of markets of late (dollar down, bonds down, stocks weakening, crude oil and copper prices soaring).
These moves are perhaps less mysterious than they appear. In essence nearly every consensus trade is recently getting blown out of the water – and the consensus has been huge in some of these trades (e.g. only a few weeks ago a continued rise in the dollar was deemed certain by nearly everybody; note that this particular consensus is so far barely diminished).
As the Bloomberg article notes in closing:
“There doesn’t seem to be any single driver that would explain all of these moves, though plenty of analysts are pointing to the unwinding of consensus positions such as trades built around the expectation of continued deflation and quantitative easing in Europe. Others have highlighted more technical factors and illiquid markets that have amplified the moves.
Whatever the reason, the recent seismic activity in these markets has, no doubt, been painful for some big investors.
The sentence we have highlighted is quite important. Normally one would e.g. expect treasury bond yields to fall on days when the stock market is weak. Lately this hasn’t happened at all – instead, the two markets appear to be exhibiting growing positive correlation. We would submit that this is precisely because there are so many players heavily exposed to consensus trades. As soon as one or two of these trades begin to blow up, inter-market correlations begin to increase, as margin calls force leveraged traders to sell whatever they can.
The 10 year Bund yield was widely expected to be the next euro area yield to go negative – instead it has soared from 8 basis points to 75 basis points within not even three trading weeks – a move of 837.5% (!). The convexity phenomenon ensures that this move has produced very large losses for those who bought Bunds near their highs – click to enlarge.
Leverage is ubiquitous, especially in “safe” bonds that have become a “sure bet”. How does one make money when bond yields are closing in on zero? One way is by capital gains as they keep falling, but to enhance the return from the paltry yield, the answer is usually leverage – and plenty of it. Margin requirements for zero risk weighted sovereign bonds are very low indeed. It doesn’t take much to completely wipe out a fully leveraged position.
The FT was sure in mid April that “below zero” levels were imminent for Bunds.
While we don’t blame anyone for thinking Bund yields were heading below zero as well, just think about how perverse such convictions are. No-one – repeat, no-one – predicted that €2 trillion worth of euro-land government bonds would sport yields-to-maturity below zero by Q1 2015. Recently nearly everybody has begun to accept this state of affairs as “normal”, but it is anything but normal. It is a sign that markets have become completely distorted by central bank policies and regulations, even under the assumption that many people expected mild price/CPI deflation.
Incidentally, the US treasury yield curve has begun to steepen rather dramatically. You’ll never guess why. Below is a chart of the 2/10 spread illustrating the situation:
Even while money supply growth has soared across the globe (with the exception of China) and the prices of stocks, bonds, high-end real estate, works of art, etc. have been going wild – indicating that the demand for money is plummeting among the well-to-do – there has been a persistent drumbeat of concerns about imminent deflation. The markets suddenly think otherwise.
Inflation Expectations Rise Sharply
About three weeks ago we noticed that a small rise in euro area inflation expectations had taken place. We took this as an early warning sign of sorts, because euro area inflation expectations have been leading US inflation expectations over the past two to three years. At the same time, we weren’t overly alarmed by the signal, as the lead time was previously very long. Not so this time, as it turned out.
Incidentally, here is a brief article about the sharp decline in US productivity and the sudden perkiness in wage costs, which may have had a hand in the changing expectations backdrop (along with rising crude oil prices). Below is a chart showing US 5 year inflation breakevens:
As to why euro area inflation expectations are perking up – euro area narrow money M1 (=TMS) is recently increasing at more than 12% annualized. The annualized growth rate has once again accelerated as a result of the ECB’s QE operations:
It is noteworthy that euro area bond markets are suffering a vicious sell-off in spite of the fact that the ECB remains fully committed to QE. We would actually argue that they are selling off because of it – recall that the same happened in US treasury markets during QE operations by the Fed. Still, one wonders what will happen once the ECB hints at “tapering” or ending its debt monetization spree. It will sooner or later do so, since the program is disputed and important ECB council members (such as the BuBa’s Jens Weidmann) are plainly opposed to it. Note in this context that the ECB usually doesn’t worry much about what European stock markets are doing – it is different from the Fed with respect to that.
Speaking of stock markets, it appears as if a setback of China’s newest bubble has just begun. Due to its steep rise to date, the market has very little by way of nearby technical support:
China’s stock market normally tends to exhibit very little correlation with other stock markets due to China’s closed capital account and the fact that the market usually moves for no good reason anyone can name. Neither China’s economic performance nor its anemic money supply growth can possibly account for the recent bubble-like advance. The rally has reportedly mainly been driven by retail traders opening a record number of margin trading accounts and going into debt up to their eyeballs. We conclude that Chinese shares are held by the proverbial “weak hands”, hence the recent setback has the potential to become quite harrowing.
Perhaps there is nothing to worry about yet, but we believe anyone long so-called “risk assets” should ask himself the Dirty Harry question right now, just in case.
The Dirty Harry question
Usually markets don’t fall out of bed without giving people a little time to consider the situation. However, this is precisely what just happened in assorted bond markets, so one should never say never. Still, in stock markets initial downturns are usually followed by some sort of rebound that fails at or below the previous highs. Moreover, the US stock market displayed some short term resilience yesterday, as the index that is usually leading at turns of late, the Russell 2000, closed in positive territory near the day’s highs. As always, it will be an important signal if this fails to produce a short term low, as it would be out of character.
The most important point to keep in mind when unusual market moves are suddenly invading the radar en masse and disturbing the previous tranquility is the fact that an unusual convergence of market correlations is usually a sign of stress. This is to say, they are signaling that someone, somewhere is losing a lot of money and is trying to raise liquidity quickly.
There is no telling when this sudden need to raise liquidity will be over or how big the players involved are. But hedge funds always try to avoid large short term drawdowns as their investors are held to dislike volatility. Many of these funds are therefore trigger-happy when trend changes seem to be in the works. Highly leveraged traders meanwhile can easily be forced to sell, and will do so indiscriminately when the need arises. Given that we know for a fact that countless traders are leveraged like never before (the recent record high in margin debt is likely a microcosm of system-wide leverage), recent market behavior is at the very least a short to medium term warning sign.
Charts by: StockCharts, SentimenTrader, BigCharts, St. Louis Federal Reserve Research