Two days before the February 5 volmageddon, and before everyone became an overnight expert on inverse VIX ETFs, CTAs an risk parity funds, we showed two charts which we then said presaged a turning point for markets and vol-targeting funds, and hinted at an imminent risk-parity tantrum.
The first showed the unmistakable correlation shift between 10Y yields and the S&P, which we said is “considerably worrisome for investors.”
Meanwhile, we also showed that the bond-equity correlation, which has been predominantly negative since the Lehman crisis – had started creeping up towards positive territory. Specifically, we said that “the 90-day correlation between stock (SPY) and bond (TLT) markets has surged ominously in the last few weeks.”
The unexpected correlation inversion, in addition to blowing up the cottage industry of inverse VIX ETFs, led to fireworks among risk-parity funds which suffered substantial losses if only briefly. Shortly afterward the correlation normalized and stocks resumed their levitation higher while bonds meandered playfully in the mid-2% range.
Then, two months later, the brief “rates shock” in late April when the 10-year Treasury yield crossed 3% – which we now know was the result of Russia dumping half of its Treasury holdings – and briefly sent equities lower, led to another brief positive correlation phase between stocks and bonds.
And while this shock was just as brief as that in February, risk-parity funds, which tends to be long both stocks and bonds, were once again hammered, however like two months earlier, they promptly recovered. After all the “market’s most important correlation” remained positive for just a few days.
To be sure the persistence of the negative correlation between these two asset classes is what permitted risk-parity funds to flourish. However, recent correlation swings are starting to question whether this “regime paradigm” will persist. Over the weekend, One River CIO Eric Peters said the following:
“Guys who thrived in 2008 had the DNA of fighters, they were willing to lean into the wind,” said the CIO. They were skeptical of Moody’s, AAA ratings, the Fed, carry, complexity, they made a lot of money. “Now it’s the guys with risk parity DNA who have cleaned up, prospered.” There’s never been a quick dip they haven’t bought. “That’s why the market over-weights any new information that reminds it of the risk-parity paradigm.” People see what they want to see, hear what they want to hear. “Even though that paradigm is so clearly changing.”
But what are the external stresses that lead to the dreaded “positive correlation”? This is the question that Goldman’s James Weldon set offs to answer in a note released today, in which the analyst writes that Goldman’s framework argues that the bond-equity correlation rises and falls depending on what types of economic shocks markets are digesting.
Some types of shocks (such as changes in consumer demand) tend to drive bond and equity returns in opposite directions, and are therefore “negative correlation” shocks. Other shocks (e.g., monetary policy surprises) tend to drive bonds and equities in the same direction, and are therefore “positive correlation” shocks.
Goldman then provides a basic taxonomy of economic shocks. The third column summarizing the implied correlations is the most important, as it groups shocks into either “positive correlation” or “negative correlation” shocks. The implied sign of the stock-bond correlation is indicated in the third column.
It is worth noting that this correlation doesn’t depend on whether an economic shock is positive or negative. For example, a hawkish Fed surprise would likely send equities down and rates higher, while a dovish surprise would do the
opposite, but in either case, equity and bond returns move in the same direction, and hence imply a positive correlation. Note also that shocks are not mutually exclusive. For example, the passage of fiscal stimulus might also be accompanied by an improvement in market risk sentiment, in which case correlations would obviously reflect both shocks (among others).
To illustrate this framework, Goldman’s next chart interprets stock-bond correlations over the past year according to the relative importance of various economic shocks, or “economic regimes” (correlations are calculated on 5-day returns over a 20-day rolling window).
This plot is annotated with Goldman’s recollection of the “economic shocks” that were dominant within each economic regime, described as follows:
- Hope of fiscal stimulus fades (bond-equity correlation from 1. +0.8 to –0.7). The prospects for fiscal stimulus in the form of a US tax package appeared to fade during the summer of 2017. The tax basket our US equity colleagues used to track the market pricing of tax reform dropped 3% during this period, and the 10-year Treasury yield reached 2.05% in September. Shocks: Demand.
- Strong US data leads to hawkish repricing of the Fed (–0.7 to +0.6). Our US MAP index of economic surprises moved sharply higher in October 2017. This stronger US data and the prospect of fiscal stimulus in an economy at full employment led markets to begin pricing more Fed tightening. The 2-year Treasury began its steady sell-off that would last until May 2018. Shocks: Monetary Policy.
- Post-tax reform “risk on” (+0.6 to –0.8). Markets began to price the impending tax package, which improved market risk sentiment. Following the continuation of the “risk on” rally into January 2018, the S&P returned nearly 9% in just two months. Shocks: Demand, Risk On.
- VIX spike sparks technical sell-off in equities (–0.8 to +0.6). The implosion of the VIX ETPs on February 5 led to a sharp spike in the VIX. The US equity market experienced a 10% technical correction while bonds were roughly unchanged. While the shock was subsequently considered to be mostly technical, contemporaneous market commentary initially focused on rising wages and Fed fears. Shocks: Monetary policy.
- DM growth disappoints (+0.6 to –0.6). DM growth data disappointed in the first quarter of the year, with our US, Euro Area, and Japan MAP indices all falling significantly. Risk appetite was also struggling to find its footing in the aftermath of the VIX spike. Shocks: Global Growth.
- “Rates shock” sends 10-year above 3% (–0.6 to +0.4). The 10-year Treasury yield rose 20bps in one week and crossed the psychologically-important 3% level sending the equity market lower. The Dollar rallied roughly 2%, starting the ongoing Dollar rally. Shocks: Monetary policy.
- EM weakness and trade concerns (+0.3 to –0.8). The recent negative correlation between bonds and equities began with the relief rally in risk appetite following the Italian political turmoil, but has extended likely due to concerns over EM vulnerability and a reescalation of trade tensions. Shocks: Trade, Global Growth.
Based on recent market risks, traders are mostly concerned about shocks that emerge out of monetary policy changes and material repricings of the global economy, of these, only three have led to a positive correlation swing (2, 4 and 6).
Here, as Goldman elaborates, in late-cycle economies, oil supply and monetary policy shocks are historically among the most active drivers of “positive correlation” shocks between bonds and equities. Will these be enough to outweigh the rise in “negative correlation” shocks, namely elevated recession fears and risk on-risk off shocks?
That is the question. Goldman’s answer is that the bank remains “doubtful”:
While we have clearly entered a phase of the global commodity cycle where supply constraints have begun to bind (most notably in oil), these supply effects are already well-reflected in oil prices, hence reducing the scope for surprise.
Goldman also adds that it sees limited scope for the market to focus on further monetary policy shocks. With 2-year yields having risen to 2.56% from just 1.27% in September, the market is now pricing a policy path roughly in line with the expectations of Goldman’s own economics team. In other words, “the heavy lifting has been done”, and if anythign the market now appears to expect just 2-3 more rate hikes before the Fed’s ends its tightening process (unless it risks pushing the economy into a recession).
Notably, Goldman believes that this explains why the bond-equity correlation has been so negative in recent weeks; not only have we seen increasing market focus on trade and global growth concerns, we’ve also seen diminished market focus on monetary policy.
The threat, however, remains, and it is possible that between one or more inflation surprises in the future, yields will spike even as the Fed is forced to push rates higher, resulting in the dreaded positive correlation that is a function of both stocks and bonds dropping.
The other question is what happens to the correlation should 3 or more economic shocks hit at the same time, and whether the positive correlation mode will emerge as the dominant one.
This is where the current market conundrum is most acute: for now the “trade/tariff concern” shock has led to lower stocks and higher bonds; but what happens if this is coupled with a inflationary shock and/or a surprise announcement by the Fed which is now clearly aligned with its “financial stability” mandate.
For traders, this is the only question that matters: as we have seen time and again, as long as Risk Parity funds remain viable dip buyers, any sharp equity selloffs will be promptly bought. However, if during the next stock market crash, a confluence of shocks also leads to the liquidation of bonds and a spike in correlation, that is the worst case scenario.
When and under what conditions that could happen is anyone’s guess. However, we do know that during his January webcast, DoubleLine’s Jeff Gundlach made an interesting prediction: he said that in the next recession, which he expects will strike in the next 2 years, “we won’t see a bid for safety out of stocks and into bonds.” In other words “we won’t see a bond market rally.” It is then that the central-banks’ bull market of the past decade will finally end.