On February 5th two bubbles burst: the first was the tulip bubble and the second was the bubble in complacency (low volatility). As fate would have it, yesterday was the 381st anniversary of the peak of the tulip bubble in the Dutch Republic.
No one knows, least of all us, if this is the start of something larger.
What a day it was. Stocks were down over 4%. The largest drop of that magnitude since August 2011. The Dow experienced its largest point decline in history. Volatility, as measured by the “VIX”, had the single largest percentage jump ever (+115%) and the volatility of volatility (“VVIX”) closed at the highest reading ever.
The real carnage was focused in funds that sell "volatility", which is to say they make money by effectively harvesting equity insurance premiums. This works until it doesn't. Some of these funds were leveraged 2x, which means a spike in the VIX of 50% in any given day will theoretically wipe them out. So they got wiped out. The fund pictured below lost over 80% yesterday (through after hours trading) and is going to formally unwind later this month.
Despite the spike in volatility, the carnage seemed relatively contained in a few asset classes. But that doesn't mean it wasn't a significant day.
Here are some things we have been watching leading up to today and some thoughts on the day.
Let’s go back to last week. Long-term bond yields (which move inversely to prices) appear to have broken out to the upside. Even though the absolute level doesn’t seem like a concern, a 35-year trend line breaking is worrysome. Also, we believe higher debt levels vs. prior cycles means rate rises will start to bite sooner.
Our view is that rates were the proximate cause for the decline. Higher rates are linked to the dramatic increase in Treasury issuance (supply) expected this year, wage growth and labor market data suggesting higher inflation will force the Fed to continue hiking and the Fed unwinding its balance sheet ("quantitative tightening").
But everything is linked, so pinning a decline on a specific trigger is impossible. Markets can go down simply because buying stops. That’s how markets function.
That said, we have been discussing the ramp in Treasury supply for months because so much of it is going to be concentrated in just two months – February and March. The U.S. Treasury expects to borrow $441 billion in the first quarter (of which it has already borrowed $40 billion). This is a massive amount of supply – nearly the total for all last year.
However, the supply cannot be issued until the debt ceiling is raised. The Treasury has stated it will extend the debt issuance suspension period into February to keep using extraordinary measures to stay below the debt ceiling. Congress needs to act to raise the debt limit with the Congressional Budget Office believing the debt ceiling needs to be raised by mid-March.
We believe this is an important development for markets. This increased supply pressures interest rates (lower prices) and serves to reduce liquidity in the market which, in turn, can negatively affect riskier assets such as stocks. The lack of issuance recently, may have been a contributing factor to the melt-up in equity prices in January.
The Fed’s gradual unwinding of its balance sheet also removes a price-agnostic buyer of Treasuries. For the first time in many years, markets must find a balance with not just less support from the Fed, but with the Fed heading in the other direction and draining liquidity.
Inflation expectations have also been driven higher by strong economic activity in the first quarter (Atlanta Fed GDPNow is up over 5%), rising commodity prices and signs that wage growth may finally be picking up. Both 2-year Treasuries and 10-year US Breakeven Inflation rates are now securely above 2% after rising persistently over the last three months.
We are paying special attention to how these factors come together in the context of a diversified portfolio. If inflation is driving bond prices down, and higher inflation is met with tightening by the Fed, we may be entering a regime change for stocks and bonds. We need to consider that if rates rise meaningfully, the tail-wind of lower rates that drove bond prices and equity prices higher likely ends, and with it, the negative relationship between stocks and bonds.
That negative relationship has persisted for most of the last 17 years, but looking back through history it is a dynamic number. A dynamic that is a function of the inflation and policy regime.
Our chart of the week, shown below, looks at rolling 3-year correlations between stocks and bonds alongside a shorter-term rolling 6-month correlation (daily prices). Correlations have recently spiked higher.
We think this is a really important topic to keep an eye on.
Some final thoughts on the action of the last few days. Thus far it has been about unwinding the most egregious expressions of "risk". In our minds, those were short volatility and digital assets or "cryptos".
Here is an updated "anatomy of a bubble chart" through yesterday. It is almost too perfect to take seriously. We wouldn't be surprised to see the space bounce from here, but you have to look at this and be in awe - very humble awe - of the predictability of human emotion.
Please let us know if we can help with anything.