A respite from the cesspit

So bonds took a respite from the cesspit yesterday, though the follow though from the strong open was less than impressive.   Still, the best thing for bruised equity longs was a decline in volatility, which Macro Man will confess came a bit earlier than he anticipated (though stocks still sold off on an index level in both the US and Europe.)

How anomalous has this bond market sell-off been thus far?  While it has certainly achieved a goodly amount of attention (and had a knock-on affect on other markets), that seems to be largely a function of the strength of the prior trend and of the apparent contradiction with recent data weakness in the United States.  If we look at a rolling six month information ratio of a US aggregate investment grade index, we see that it is still quite good (1.66), though naturally it is quite a bit lower than the recent peak.  That peak (4.3 in early July) represented the best run for US fixed income in nearly 5 years- just what you'd expect after the onset of the first Fed tightening in a decade, right?

Interestingly, in the post-crisis period this rolling IR has turned negative roughly every two years.   If one believes that the pattern should hold (though really, there's no reason to), that would imply that bonds stabilize fairly soon and only dive properly during the first half of next year.  On the other hand, if you take the view that with an unemployment rate below 5 and inflation slowly crawling its way back to target bonds should put in negative returns over a six month horizon, clearly that would require further weakness.  Given the strength of the peak in recent performance, Macro Man would incline towards the latter view.

What does it mean for stocks?   Well, it's hard to see it as a positive.  If we look at rolling correlations between fixed income and equity returns, we see that they have recently turned positive.  Macro Man has touched on this before, but it is really curious to see how the correlation regime between the two asset classes changed early in the previous decade.  Historically, bond and stock returns have been positively correlated, but for much of the past 12-15 years they have been negatively correlated- the apotheosis of the dreadful risk on/risk off framework.

Given the degree to which accommodative policy conditions have driven expected equity returns since the crisis, it certainly seems reasonable for the longer-term positive correlation to assert itself.   Given the global nature of capital flows, it has perhaps required the belief in other central banks to waver (and for the persistent asset bid from petrodollars to dry up) for this to materialize.

All this being said, while it's tempting to construct a scenario of a return to 1990's style correlations (while dreaming of 90's style volatility and nominal rate levels, etc), the proof of the pudding will be in the eating.  Macro Man wrote the other day that he doesn't think that this is "the big one", so the inclination will be to book profits on further weakness, not to give the market a good kicking (i.e., the "old skool" macro way of trading.)

Still, it's been a nice respite from the cesspit of ultra low vol, and if Macro Man's wrong and it kicks off properly, so much the better- that's a proper trader's environment!