On Monday, Morgan Stanley’s equity strategist Hans Redeker made an ominous observation: highlighting the decline of easy monetary policy and the rapid shrinkage of central bank liquidity…
… Redeker noted that the recent spike in bond volatility has been mostly a side-effect of the receding monetary tide.
Why the focus on bond volatility, i.e., the MOVE Index? For one reason: while rising FX and equity volatility can remain isolated events, rising bond market volatility tends to steer other volatility indices too, Redeker said. Hence, rising bond volatility makes a difference when volatility for risky assets diverged on the back of liquidity concentration in the US.
This led him to conclude that “in many aspects, the current constellation reminds us of what happened in autumn 1987”, which we recalled as follows:
The Fed was hiking rates, deploying a hawkish tone. Chair Greenspan had just taken office, providing hawkish rhetoric, and the global economy seemed to trail the better US performance supported by the second Reagan tax package kicking in in 1986. The consensus assumed the rest of the world (RoW) – notably Europe – was running wider output gaps and hence was surprised when the Bundesbank withdrew liquidity in September 1987. In this sense, we would not dismiss hawkish remarks from ECB’s Knot, who said that ECB rate hikes could come earlier than markets are expecting.
Just two days later, and the Dow over 1,400 points lower, it appears Redeker was on to something.
But not everyone agrees. As Bloomberg’s latest macro commentator John Authers, who recently joined from the FT, writes in a note tonight, whereas there is a growing chorus that the market may be coming up against it own Black Monday moment – and historically half of the biggest market crashes in the US have taken place in October which is statistically significant…
… Authers believes that despite the growing concerns, it’s not really quite as dire as what Morgan Stanley suggests.
He explains why in the note below.
The Hunt for Another Red October
It is not such a crazy idea. The elements of a narrative that finds a parallel between the alarming sell-off in equities over the last few days and the epic disaster that was the Black Monday crash of October 19, 1987, do exist.
Then, like now, stocks had been rising despite a menacing rise in bond yields. Then, like now, there is a new and untested chairman at the Federal Reserve (for Alan Greenspan then, read Jerome Powell now); and then like now, the U.S. economy had just enjoyed a big tax cut at the end of the previous year, after much drama involving Congress and the Republican president.
So it should be no surprise that references to Black Monday, when U.S. stocks fell more than 20 percent, are proliferating ahead of its 31st anniversary. Earlier this week, Hans Redeker’s team at Morgan Stanley produced a note suggesting that the greatest risk from the parallel was the implication that European monetary policy would also now have to tighten, as happened in 1987. Similar arguments might apply to Japan, where the Bank of Japan has been aggressively expanding its balance sheet ever since the Fed desisted from doing so.
Scott Minerd, the widely quoted chief investment officer at Guggenheim Partners, also drew the parallel, saying “Rising rates and declining stocks echo shades of October 1987.” Plenty on social media have been making similar comparisons.
Any comparison to Black Monday is bound to set alarm bells ringing. And in any case, almost all of history’s most famous market crashes happened in October.
However, even with the S&P 500 down more than 5 percent in four days, the comparison is overdone. Equities were overblown entering this sell-off, but looked nothing like as frothy as they did in 1987:
Further, the international context is starkly different. In 1987, the party in the developed world outside the U.S., covered by the MSCI EAFE index, was just as intense as it was on Wall Street. The EAFE had gained 42 percent by October 14 that year, before it joined the subsequent sell-off to the full. This time around, the U.S. has stood alone; the EAFE is currently down 7.7 percent for the year, and has been moving gently lower for most of the year. The FTSE’s All-Word stock index, including all developed and emerging markets, entered this month up only 2 percent for the year. The ground for a dramatic short-term correction, therefore, is far less fertile than it was in the second week of October 1987
If we turn to the move in bond yields, widely taken as a reason for the pressure on stocks, we can see that the rise this year is indeed roughly comparable with the rise that was experienced in 1987. There is a true tightening of financial conditions, and this can only be expected to have an effect on the stock market
The problem with this, however, is that the bond market starts from a much lower and more accommodative level, and with cheap money available in the rest of the world. This move feels tight for traders who have grown accustomed to rates of virtually zero, but in absolute terms the rise in 10-year bond yields was far greater in 1987. At this point, the 10-year Treasury yield has gained some 70 basis points for the year; by the same point in 1987, it had risen by some 300 basis points
This is already another Red October for the stock market, and there are indeed a few similarities with 1987. But on this occasion the historical comparison is unduly alarming. There are good reasons to fear that stock markets could fall a lot further from here, but there is no particular reason to think that we are primed for a massive financial accident on the scale of what happened in October 19, 1987
Is Authers right? There are less than three weeks left in the month of October (and four until the midterm elections). We’ll know the answer in less than a month.