Well, Friday was a rough day for risk. Apparently, the Brits held some kind of referendum on EU membership and from what I'm hearing, some folks voted to "leave" the clubhouse. Did anyone else hear about this "historic" plebiscite ahead of time? Because I had no idea until ES collapsed and cable imploded late Thursday evening.
All sarcasm aside, it wasn't hard to see this coming. Everyone knew it was going to be close all week and if you've ever taken a freshman level prob and stats course, you likely knew that the "edge" the "remain" camp supposedly held on the heels of MP Jo Cox's murder was probably within the sampling error. But that didn't stop everyone from convincing themselves that "remain" was a done deal.
CNBC's Kelly Evans probably wishes the vote had gone the other way, because everyone's favorite mainstream financial news network dragged the "Closing Bell" co-host back into the studio late Friday night where she was forced to quarterback an ad hoc Brexit special in conjunction with Michelle Caruso-Cabrera, who was apparently standing by in London in case things took a turn for the worst.
What's funny is, I too assumed "remain" would prevail, but I penned a piece prior to the vote entitled "There's Nowhere To Hide" anyway, because I figured hell, if the drawdown doesn't come from Brexit, it will come from some other geopolitical black swan, any number of which are circling and waiting to land over the next six to 12 months. Best to help people prepare, right?
Well, now that we all made it through the vote alive (as far as I know, no investment bankers took a black swan dive off their penthouse balconies on Friday), I wanted to revisit the whole "nowhere to hide" thing, because the risk-off frenzy certainly produced some winners -- notably, US Treasuries:
Safe haven bid, no surprises there.
But I wanted to take a closer look at high quality govies as a hedge during equity (NYSEARCA:SPY) drawdowns. I mentioned this on Friday, but I think it's key that investors understand the risk they're taking in supposedly "riskless" asset classes.
Here's what Goldman had to say this week on the subject:
Bonds have also become a source of risk in case of 'rate shock.' Bonds have also become a driver of market fragility and we think there is potential for higher rate volatility.
Exhibit 21 shows the number of days over the prior 12 months with return moves (positive or negative) of 3 standard deviations for bonds, using rolling 1-year standard deviations. At the end of 2015 bonds had more 3-standard deviation days than during the GFC. And the skew of large moves from bonds has shifted more negative with negative 3-standard deviation days outweighing positive ones at the end of the year with central bank disappointments.
During the S&P 500 drawdowns in August 2015 and at the beginning of 2016, bonds provided a less effective hedge with monthly returns of a standard 60/40 portfolio dipping to -5%, much larger drawdowns than during the euro-area crisis and the global 'growth scare' in October 2014. In addition bonds are increasingly a source of risk as both the 'taper tantrum' and 'bund tantrum' showed.
This recent decline in the effectiveness of bonds as a hedge for equities can possibly be explained by three factors: (i) stretched (expensive) bond valuations; (ii) lower coupon (carry) income providing a reduced buffer from sudden sell-offs in yields; and (iii) the low level of bond yields, making them susceptible to a 'taper tantrum' or 'bund tantrum' type of shock, thereby reducing their attractiveness.
Let's look back at two examples of bond "shocks." First, here's a look at US 10s (NASDAQ:BLUE), German 10s (teal), bunds (bright pink), and UST futures (light pink) with the 2013 "taper tantrum" and the 2015 bund VaR shock highlighted.
Admittedly, there's a lot going on there, but I've color coded the arrows so you can more easily discern the moves. Red denotes rising US yields, yellow is USTs selling off in tandem, white are rising German yields, and pink are bunds selling off in tandem.
Let's zoom in on the bund shock:
Yields fell to 7 bps in April of last year before both Gross and Gundlach expressed their incredulity. Subsequently, yields spiked to 82 bps. Here's a larger version of the Citi chart inset:
So what exactly happened there and why should you care? Well, to answer the first question let's go first to JPMorgan with the very simple answer (emphasis mine):
The proliferation of VaR sensitive investors, such as hedge funds, mutual fund managers, risk parity funds, dealers and banks raise the sensitivity of bond markets to self- reinforcing volatility-induced selling. These investors set limits against potential losses in their trading operations by calculating Value-at-Risk metrics. Value-at-Risk (NYSE:VAR) is a statistical measure that investors use to quantify the expected loss, over a specified horizon and at a certain confidence level, in normal markets. Historical return distributions and historical market volatility measures are often used in VaR calculations given the difficulty in forecasting volatility. This in turn induces investors to raise the size of their trading positions in a low volatility environment, making them vulnerable to a subsequent volatility shock. When the volatility shock arrives, VaR sensitive investors cut their duration positions as the Value-at-Risk exceeded their limits and stop losses are triggered. This volatility induced position cutting becomes self-reinforcing until yields reach a level that induces the participation of VaR-insensitive investors, such as pension funds, insurance companies or households.
Ok. So essentially the same type of systematic strategies blamed for last August's brutal equity selloff (discussed here) can also precipitate violent swings in the assets investors use to hedge against stock market drawdowns. Here's a bit more from Citi:
We define a VaR-shock as a jump in the maximum loss that a market in aggregate can sustain over a period of time. As an approximation for the EGB market, we can use EGBI's market value and duration in addition to computing realized total return volatility.
If we combine EGBI's market value, duration and volatility into a measure of risk, we get a sense of the magnitude of the current move. The lower chart in Figure 2 shows how this approximate EGBI VaR-measure has more than doubled since the end of 2014 and is now higher than the peak of the EGB-crisis in 2011/2012 and the Lehman-crisis in 2008/2009. In terms of magnitude, we are talking about the risk of an instantaneous EGB-loss of around EUR 11mln/01 in the adverse scenario.
Why does this measure of risk matter at all? Because -- all else equal -- a higher level of market risk implies a lower risk appetite by investors as well as a reduced warehousing capacity for dealing desks (assuming risk limits).
Can you guess what happened to US yields and to your "hedge" assuming you were in iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) to protect against any downside in equities? You would have lost nearly 8% in just under 30 days and some 13% over two-and-a-half months.
Now you might fairly argue that had you been in TLT at the start of this year, you would have gained ~13% from the beginning of January through the February lows.
But remember, my point (and Goldman's point) isn't that bonds aren't negatively correlated with stocks (is that a double negative? Sorry). They pretty clearly are, perhaps more so now than ever:
(Chart: Goldman, my addition)
The point, rather, is to say that bonds are becoming less effective as a hedge (clearly demonstrated in the chart above) and less attractive as a hedge as central banks drive yields inexorably lower. Quite simply, it's not clear how much more assets like USTs, JGBs, and bunds can possibly rally.
Importantly, and as mentioned above, the presence of VaR sensitive investors can exacerbate already violent swings.
And don't think illiquid markets do anything to help the situation. Have a look, for instance, at bund market liquidity and depth going into last year's shock:
(Charts, Table: JPMorgan)
Here's what JPMorgan had to say at the time:
What is causing VaR shocks and why are they happening often? We argued before that one of the unintended consequences of QE is a higher frequency of volatility episodes or VaR shocks: investors who target a stable Value-at-Risk, which is the size of their positions times volatility, tend to take larger positions as volatility collapses. The same investors are forced to cut their positions when hit by a shock, triggering self-reinforcing volatility-induced selling. This, we note, is how QE increases the likelihood of VaR shocks.
One of the reasons for this deterioration [in market depth] is perhaps the almost secular contraction in the German repo market by 30% over the past five years. This contraction in German repo markets started five years ago as shown in Table 1 and continued up until the most recent data in 2014. It intensified during the euro debt crisis as flight to quality made investors unwilling to depart from their "precious" German collateral. The net withdrawal of Bund collateral as a result of ECB's QE and lower issuance by the German government makes it likely that the German repo market contraction will continue if not intensify this year hampering market trading liquidity further.
Let's leave it at that for now as the takeaway should be clear: are "riskless" government bonds a good hedge (i.e. negatively correlated) against equity drawdowns?
But they are becoming less effective and more worrisome, more prone to dramatic swings that could result in substantial losses that may or may not be compensated by a concurrent and commensurate rise in equity prices.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.