As you can see from this Bloomberg article, the problem now is that
bond yields move in the same direction as stocks – which means that volatility
in stocks will be extreme once the momentum turns because investors will need
to sell stocks to compensate for losses in bonds, just as the bond losses
become pronounced! Ouch! The same thesis was in an FT opinion appeared just
yesterday - link is
Here are the first two
paragraphs:
Covid-19
has brought us to a historic turning point in financial markets. A fundamental
investment strategy that has protected institutional and retail investors alike
for decades — balancing equity risk by holding high-quality government bonds —
has finally run its course. When the Fed lowered short-term rates to zero in
response to the pandemic, the last shoe dropped. The implications of this
change are huge. For one thing, millions of retail investors have been left
largely defenceless, lacking a tried and tested means of diversifying the
inevitable risk of holding equities. Similarly, the sophisticated and extremely
successful hedge fund strategy known as Risk Parity faces an existential
challenge: without meaningfully positive government bond yields, it has been
thrust into a harsh environment in which it is unlikely to prosper.
In a nutshell, the argument is that low bond yields have
pushed investors into stocks. But if yields rise, overvalued stocks will be
sold just as investors experience capital losses in the bond market!! Of
course, the junk-bond market is in a far worse situation than the overall Treasury
market with “covenant-lite” and leveraged debt obligations verging on the
simply catastrophic in a crisis! Conversely, as investors rush out of stocks for the "safety" of bonds, yields simply collapse even further! As the French say, sauve qui peut!
The U.S. Fed Has Stamped
All Over Volatility
For the Fed, dampening down
volatility in the financial markets has been key to bringing things back under
control. The battle isn’t quite over yet.
By
As the Fed can’t buy stocks, it had to manage this market
rescue act by controlling the volatility of bond prices and by flooding the
money markets. This gave investors enough of a feeling of security to start
buying shares again, rather than sticking to haven assets.
By
pumping in excess dollars and increasing so-called swap lines for foreign
central banks — letting them deliver U.S. dollar funding to their
country’s banks in a time of extreme market stress — Powell was also able
to calm the sharp movements in currencies, which might otherwise have started
an emerging markets crisis as investors fled to the greenback.
The biggest lesson from the last two crises is that the
plumbing of the money markets is vital to stopping panic. This time, banks were
charging a huge premium to lend longer than overnight and that was causing a
breakdown in confidence across all asset classes, as well as that stampede
into dollars. Even stable major currencies such as the U.K. pound were
affected.
The Fed has increased its
balance sheet by 70% to more than $7 trillion to fix these
problems, so it might be time to rein back on
some of the stimulus as the trade-weighted value of the dollar is turning lower
at last, and the first phase of the pandemic eases in the West.
Yet
Powell can’t relax his guard entirely. While equity volatility has
fallen, it is still higher than at any other time since 2011. With
Treasury bond yields rising sharply again last week, the Fed’s job isn’t
over.
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