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Cash Trumps Volatility

10 November 2016 by Eoin Walsh

Now that the dust is beginning to settle on the unexpected victory of Donald Trump in the US presidential election, investors are beginning to take stock of the market reaction and the new landscape they face.

To recap on the volatility yesterday, much of which took place in the early hours as the electoral colleges began to announce their results, the Dow Jones equity futures dropped by almost 1,000 points from 18,400 at 1am to within a whisker of 17,400 by 5am, before ending the day at 18,500 – exposing traders to a classic whipsaw move of over 5%. The US treasury markets were equally skittish, with the 10yr yields rallying to a low of 1.72% at 5am, from 1.85% at the open, and finally ending last night at over 2%! In the longer dated, 30yr UST, you would have made over 1.5pts initially, before finally losing 5 points – a loss of almost 5.5% for a classic risk-off position. Even the Mexican Peso staged somewhat of a recovery, finishing the day down 7.5%, after an initial fall of 11.6%.

In the corporate bond markets we witnessed a more subdued version of this volatility, with bonds initially opening lower but quickly regaining ground on strong buying interest, with most sectors finishing unchanged, to slightly higher for the day.

So what do we make sense of this?

To some extent maybe we shouldn’t be too surprised – this was an event that was happening on a specific date, just like the Brexit vote and therefore, investors could, and should have, been prepared. The Brexit experience is also important as it gave investors an insight into what might happen; a sharp sell-off, creating some great value bonds as the baby is thrown out with the bathwater, followed by a strong recovery.

In addition to the Brexit knowledge, technicals are extremely supportive, with central banks here in the UK, in the Eurozone and also in the US, despite a rate rise being on the cards, continuing to anchor yields at historically low levels, making yield a very scarce commodity, and if you own it, you are going to be very reluctant to sell it.

Finally, and maybe most importantly, cash balances were also at elevated levels, a good indicator that investors were well prepared and hoping to profit from any sell-off by being able to put money to work cheaply. As a result, the fall in equities was sharp, but short-lived, while in corporate bonds, where trading takes place over-the-counter, traders very quickly pulled any cheaper offers, while short sellers scrambled to cover their positions.

Ultimately, bargains were difficult to come by, everyone wants to buy cheap bonds and this time investors were alive to the possibility, but willing buyers and very few sellers doesn’t equal a sell-off.

Obviously it’s still early days, President-elect Trump will have very different policies to his predecessor. If he lives up to his campaign promises, with increased fiscal spending looking likely, it should drive inflation higher; this was probably one of the culprits behind the move wider in the long end of the treasury curve. How the Federal Reserve reacts, and importantly the FOMC in December, is also an unknown. Expectations of a rate rise fell from 85% to 50% initially, but are currently back at 82%.

We have said previously that if you own yield in this environment, you should probably hang on to it. Our view hasn’t changed. Yieldy bonds will generate volatility from time to time, but income remains a scarce commodity and if the reaction yesterday is anything to go by, it remains in high demand and very sought after.

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