Bloody Waters

Ok, so today was an important day symbolically - and not just because the Dow fell nearly 400 points. That’s a drop in the proverbial bucket compared to how far we’ve come since 2009.

There are several things you absolutely have to take note of. Let’s start with the dollar and vol:

The dollar is important because a soaring USD is one of the things that scares the Fed most. It precipitates emerging market outflows and irks the Chinese, neither of which is desirable in an unstable environment.

When it comes to volatility, you have to be careful here. Global QE has suppressed volatility but if it snaps back sharply, what you’ll get is forced selling from systematic vol targeting and trend following strats. They’ll have to rebalance, and there’s a lot of money at stake there. These charts outline the situation post-Brexit:

(Charts: BofAML)

Trust us, you do not want these things having to rebalance all at once if vol spikes.

Now let’s look at bond yields.

This is a recipe for disaster - and we’re not being hyperbolic. Here’s what Bloomberg’s Richard Breslow had to say earlier this morning:

“But whether it was the ECB waiting, Fed speakers pressing or, more likely, 30-year JGBs ‘backing up’ to 50bps, global bonds decided some caution was in order. And in the world of extraordinary monetary ‘largesse,’ bonds are the global investing bellwether. Everything else follows their lead.”

Precisely. And he means that both figuratively and literally. Consider this from RBC:

“The spook story for low-volatility equities for years has been a spillover of rate vol—see all of our various “tantrum” episodes.  Why?  Because of the painful grind higher in cross-asset correlations as the market has become more macro--thanks to both 1)  global central bank policy that is essential based around controlling one asset (USD) and tamping-down volatility through unprecedented asset-purchases…along with 2) the enormous growth of systematic strategies, especially those which target volatility and / or use leverage to “balance risk” across asset classes based on historical volatility.”

You get a rate shock, you get a sell-off. It’s just that simple. Then Ray Dalio will try to explain to you why it’s not Bridgewater’s fault.

But the most important narrative on Friday is the extent to which the Fed has apparently not lost all credibility. That’s a popular narrative when things are on the up and up, but when you get the worst selloff since June 24 all predicated upon Fedspeak, it makes you question how you can say they’ve lost credibility. It’s the same argument people made with OPEC in late 2014. That is, “the cartel is dead, look at prices.” Well, yeah. Who do you think orchestrated the price collapse? That’s not “dead” or a loss of “credibility,” things just didn’t move the way you wanted them to. They’re still in control.

Now everyone is focused on this Brainard speech on Monday. Here’s Bloomberg’s summary:

“Treasuries fell led by longest maturities, trailing more aggressive steepening moves by EGB and JGB curves that reflected shifting monetary policy outlooks. Yields were higher in late trading by 2bp-9bp, 10Y by ~7bp at 1.67%, above closing levels since June 23; U.K. and most euro-zone 10Y yields rose by 7bp-10bp. 5Y yield erased what remained of its drop in response to weak Aug. ISM non-manufacturing survey on Tuesday, aided by hawkish cast to comments by Fed’s Rosengren and Kaplan. Supply outlook was main domestic catalyst for selloff, as sales tied to next week’s IG calendar were said to be taking place and dealers prepared to underwrite 3Y and 10Y auctions on Monday, both at 1pm ET and concurrent with speeches by Fed’s Brainard (1:15pm) and Kashkari (1pm). 5s30s curve extended its rebound from YTD low close at 103.3bp on Aug. 31. It widened by more than 8bp on week, marking first time this year it has steepened by more than 5bp in a selloff, with all other instances being rallies led by 5Y sector.”

Treasuries:

  • 30-yr +9.1bp to 2.3946%

  • 10-yr +7.42bp to 1.6732%

  • 2-yr +1.22bp to 0.7821%

If they trot out Brainard to prepare markets for a hike, then they really will have lost all credibility. They’re supposed to be technocrats with a well-defined dual mandate. They should have never flinched in the face of last August’s Chinese devaluation. That set a dangerous precedent. Now they’re just testing the waters with different speakers everyday.

Well, let us be the first to tell the folks in the Eccles Building - the waters are red and the sharks smell blood.

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