Old Correlations Die Hard: Stocks and Bonds Tandem Sell-Off

Say it ain't so!

Most younger industry professionals (myself included) have only participated in the markets during the regime of risk on/risk off. You know, when stocks go up, bonds go down (and stocks never go down). However, I try my best to learn as much market history as possible as it is the best teacher for navigating the financial markets.

In the midst of this "bloodbath" of S&P falling ~2% in the last few sessions, we've seen stocks fall - What?!

Even more shockingly, we've also seen bonds sell off at the same time - How?!

Well, I recall long ago when watching Paul Tudor Jones' Trader documentary where he actually used rising bond prices and decreasing yield as a potential clue to rising equity prices (something I have alluded to in the past).

Clearly, I was obligated to look at the correlation further. Cue commandeered chart from PIMCO:

We are in a negative correlation regime today. However, the key word here is "regime". This is not a permanent state and should be treated accordingly. We should focus on potential causes for this relationship to revert. These periods last for prolonged periods of time, and thus the quants are too focused on "recent" (the last decade) of data to care.

Then you have this guy from the Illinois state pension fund.

Industry “experts” suggested we keep these investments to diversify our holdings and reduce overall risk. Yet we already owned bonds for that purpose.

Unfortunately, even for some market veterans, the warnings from history are not always heeded.

I took a look at a different time frame based on daily and weekly returns data.

Daily return correlation

Weekly return correlation 

In the last few weeks, we have seen a small bump up in correlation and general trend higher for the last year.

I know I've written extensively about inflation here and here. Disregarding fears of being branded that guy who's an inflation bug; here goes nothing.

Inflation once again is the key here. It will be the source of the next drawdown - a drawdown for both equities, fixed income, and high yield.

1) contrary to popular CNBC pundits' beliefs, stocks are not a good inflation hedge in the case of high inflation. Here is an excerpt from the newest edition of Intelligent Investor by Ben Graham with commentary by Jason Zweig.

While mild inflation allows companies to pass the increased costs of their own raw materials on to customers, high inflation wreaks havoc—forcing customers to slash their purchases and depressing activity throughout the economy.

 A negative 10% nominal return on stocks can easily materialize even in a 3% inflation environment. 

Furthermore, a rise in inflation expectations will undoubtedly lead to a rise in nominal yields purely from the calculation of the nominal yield from real yield + inflation expectation.


2) Structural reasons for a combined sell off also lies with the emergence of risk parity based investing. I've written about this in the past as well, as a form of a potential catalyst for increasing equity market volatility and an equity market drawdown. 

The drawdown controls for these funds do indeed work to sell off all assets across the board when volatility rises, building in structural reasons why markets can sell off in a cascading fashion. 

However, I want to note one major strategy change in my analysis: the asset class that will be affected is fixed income in TIPS or in the credit market.

Since treasury volatility is a fraction compared to that of an equity index, risk parity funds must lever up its exposure to achieve the equal diversification of risk. As this has occurred, we've also experienced a tremendous bull market in bonds, killing off any hints of volatility.  Which means that bond positions are even more levered than they otherwise would be in a higher volatility environment.

The negative correlation between stocks and bonds and their coinciding bull markets have fueled both the hedging and outperformance of risk parity. 

In my previous experience at my previous firm, the inflation bucket for risk parity holds not commodities due to its high/frequent roll costs but instead inflation-linked fixed income products - the product that I was in charge of trading. You can extrapolate the chart below to be true for inflation-linked bonds as well.

Historical real returns of nominal bonds:

Due to the OTC nature of TIPS (lack of centralized limit order book), the product lacks liquidity. We had already experienced severe problems trading switches and during drawdowns for French and UK linkers, and similar but slightly milder issues rolling and trading large programs in TIPS.

Credit is another bucket of risk parity. They also trade OTC. although historically boasting a higher volatility, the performance in credit since 2008 has also meant relatively sizable positions in credit must be built into the credit buckets of these portfolios as well. It is well documented how illiquid this asset class can become during times of economic or financial market stress.

During a cross-firms sell-off of risk parity, it would be easy for dealers to sniff out these large programs in TIPS and credit being moved at the same time. As a result, I suspected, they would simply shift mid-price far from the inter-dealer mids to take advantage, thus raising volatility further  - potentially enough to compound additional drawdowns in a reflexive cycle.

Recent risk parity sell-offs:

In conclusion:

To be clear, I know the short bonds trade is a crowded consensus trade at this point in time; in fact, we could be close to reversal to shake out some late arrivals to the party. Also, calling the top in equities has been a strenuous and fruitless exercise. This post is not a specific short-term market call regarding those assets.

What I am trying to address is that this negative correlation labeled as risk on-risk off is cyclical, and the shift in cycles can potentially last a decade(s). I believe the inflation will be at the crux of the change and the beginning of the next correlation cycle. People like the Illinois pension guy, as well as other investors are clearly relying on this current correlation regime to hold.

These long everything investor of 2018 should tread carefully. The road you're on won't always suit the car you're driving.

Happy NFP Friday!