Risk on, or risk off?

Mid-week market update: In view of this week’s market volatility, I thought that I would write my mid-week market update one day early. After the close on Monday, my Trifecta Market Spotting Model flashed a buy signal. As shown in the chart below, this model has been uncanny at spotting short-term market bottoms in the past.
 

 

Now the Trifecta model has flashed another buy signal as the market faces a possible meltdown from volatility related derivative liquidation. Is it time to take a deep breath and buy?

To be sure, it is hard to believe that a durable bottom has been made. As recently as Sunday, Helene Meisler tweeted the following anecdote of investor complacency.
 

 

Could complacency turn to fear that quickly for a washout bottom in just two days?

Echoes of 2015

The Trifecta buy signal is reminiscent of the events of August to September 2015. Stock prices cratered in August and created a Trifecta signal on August 25, 2015. It proceeded to rally and chop around for about a month before making a final bottom on September 29, 2015, which coincided with an Exacta (almost Trifecta) buy signal.
 

 

Still there are some key differences between the environment today and 2015. The rally leading up to the current selloff was marked by rising complacency, as measured by a steadily falling CBOE equity-only put/call ratio (CPCE). The 2015 selloff was preceded by a rising CPCE, indicating skepticism about the advance.
 

 

I interpret the current market environment as a bottoming process. Stock prices are likely to make a W-shaped bottom, perhaps with multiple Ws strung together, as it is difficult to believe that sentiment can be washed in such a short time. The stock market is likely to stage a short-term oversold rally over the next few days, but don’t be fooled by the bull trap. Sell the rips. Don’t buy them.

Tactically, the market is setting up for a bounce of unknown magnitude over the next few days. Subscribers received an email alert that my inner trader had covered his short positions and flipped long. However, he does not expect the duration of that trade to last significantly more than a week.

Opportunities in the bond market

The likely risk-off market tone over the next few weeks opens up a trading opportunity in the bond market. The chart below shows the stock/bond ratio (grey) and the 10-year Treasury note yield (green). The top panel shows the six-month rate of change of the stock/bond ratio. In the past, whenever the six-month ROC of the stock/bond ratio hit 20% and turned down, it has represented a good buying opportunity for the 10-year Treasury. The blue vertical lines marked instances when the 10-year yield has fallen (and bond prices rallied), while red lines marked instances when the 10-year yield rose (and bond prices fell).
 

 

The six-month stock/bond ratio’s rate of change flashed a buy signal recently. Does that mean investors should buy the bond market? How much risk does the recent backup in yields represent?

Consider the fundamentals. In a recent FT column, Gavyn Davies framed these risks as possible changes in the risk premium of going out in the yield curve. In other words, how much should investors get paid to extend the maturity of their fixed income holdings?

Since the overall bear market in US bonds started in mid 2016, the 10 year yield has risen by 130 basis points, from 1.5 per cent to 2.8 per cent. Most of this increase has been due to a rise in the nominal risk premium, and by far the majority of the increase in the nominal risk premium has come from the inflation component, with the real component rising only slightly.

What has happened, therefore, is that the tail risk of deflation that was being priced into bonds in early 2016 has gradually disappeared, and the inflation risk premium has returned to a fairly normal level around zero. All this has happened while the core inflation rate, and the expected path for future inflation, has barely increased at all. The recovery in real output growth (and commodity prices) seems to have reduced the market’s fear of future deflation, and that is what has driven the bear market in bonds.

Edward Harrison at Credit Writedowns decomposed yield risk as risk premium, Fed policy, and possible bond vigilante reaction over rising deficit spending:

The rise in interest rates so far is mostly about the term premium normalizing due to systemic risk receding after the endless succession of mini-crises has finally faded and global growth has returned. But, now that term premia have normalized, I don’t think we have to worry about a vicious bond bear market because of deficit spending. It’s inflation and the Fed’s response to perceived inflationary signs that will matter.

I believe the Fed will maintain its forward guidance unless the economy slows considerably. In fact, signs of inflation or wages rising more quickly or unemployment falling more quickly than the Fed has anticipated will accelerate the Fed’s timetable. There’s money to be made there in the short-term.

If the future health of the bond market is mainly in the hands of the Fed, here is what Fed watcher Tim Duy had to say about the likely direction of Fed policy:

Two central bankers spoke up during last Friday’s sell off. San Francisco Federal Reserve Bank President John Williams said that the economic forecast remains intact and hence the Fed should maintain the current plan of gradual rate hikes. He does not think the economy has “fundamentally shifted gear.” For what it is worth, it is my impression that Williams is slow to update his priors. His colleague Dallas Federal Reserve President Robert Kaplan also retains his base case of three rate hikes in 2018, but opened the door to more. My sense is that Kaplan is sensitive to the yield curve and will tend toward chasing the long end higher.

Also, if the economy is shifting gears, watch for St. Louis Federal Reserve President James Bullard to warn of an impending regime change in his model and with it a possible sharp upward adjustment of his dot in the Summary of Economic Projections.

Bottom Line: If as I suspect much of what we are seeing in the economy is a cyclical readjustment, then long term yields will likely reach more resistance soon while short term yields will continue to be pressured by Fed rate hikes this year and beyond. If the Fed turns hawkish here they will likely accelerate the inversion of the yield curve and the end of the expansion (this could be the ultimate impact of the tax cuts – a short run boost to a mature cycle that moves forward the recession). If a more secular realignment is underway, long (and short) rates have more room to rise. It is reasonable to be unable to differentiate between these two outcomes as this juncture.

In other words, Fed policy is likely to be relatively benign. Under those circumstances, the combination of a risk-off market atmosphere and a relatively friendly bond environment is supportive of higher bond prices and lower rates.

Disclosure: Long SPXL