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All change for the markets, or maybe not

7 February 2018 by Eoin Walsh

Following Monday’s volatility in the rates market and the subsequent “meltdown” in US equities, which saw the Dow Jones falling by more than 1,500 points intraday; yesterday had a more orderly feel to markets, and ultimately the 3 major indices in the US, the Dow Jones, S&P 500 and Nasdaq, are all still in positive territory for the year to date.

There are a number of points we think are worth highlighting following these moves. The sell-off undoubtedly started in the rates markets, resembling a mini-version of the 2013 taper tantrum. Of course, treasury yields have been moving north since the end of last year due to increasing inflation fears, with the 10yr UST yield selling off from 2.4% to reach 2.7% by the end of January. These fears gained traction towards the end of last week with a strong ISM Manufacturing number and Prices Paid numbers being reported on the 1st of February, followed the next day by wage numbers that were also ahead of consensus. While these data points don’t by themselves confirm that higher inflation is imminent, the mere hint of inflation was always likely to drive a negative reaction in long dated treasuries. When on Monday the ISM Non-Manufacturing index reported its highest level in over 10 years, the spike higher in yields intensified, culminating in an intraday high of 2.88 being recorded on the 10yr UST; its highest level in 4 years.

With correlations having broken down, the equity markets in the US (followed by global indices) sold off aggressively, as traders feared that higher rates would negatively impact economic growth. The capitulation towards the end of trading on Monday, which saw the Dow Jones lose over 800 points in a matter of minutes, has been attributed in some quarters to algorithmic trading strategies (Algos) and commodity trading advisers (CTAs); however, whether these contributed to this sell-off or not, they do appear to have helped to restore market correlations, which had broken down for a number of days – with both traditional risk-off and risk-on assets all weakening significantly. With the equities crashing, these automated strategies aggressively purchased long dated treasuries, causing an aggressive rally back in USTs, with the 10yr hitting 2.65% during Asian trading hours.

As mentioned, this had all the hallmarks of a mini taper tantrum, although it remains to be seen whether a period of calm now ensues – correlations remained broken for a significant period of time during Bernanke’s version in 2013. However, it does feel that the upward pressure on treasury yields is here to stay, with inflation numbers likely to be stronger in Q1 2018 than they were last year, although the move higher from there could be more orderly. However, orderly or not, there is a growing consensus that long dated rates are simply not compelling and that owning the short end, particularly if you can lock-in reasonable yields, is a much safer option at this stage.

Away from equity markets, the fixed income universe was reasonably stable by comparison, except from long end rates obviously. Credit spreads undoubtedly moved higher; the US HY index added 28bps since month-end, to move back to an asset swap spread of 232, while euro and £ HY both added 20bps to go to 234 and 338 respectively. Traders were certainly expecting a difficult day yesterday, but although there were cheaper offers available at the start of trading, part of the move was certainly down to a widening of the Bid/Offer spread, and by the close of trading yesterday, many assets were unchanged on the previous day’s close.

So ultimately what have we learned? We still don’t like long dated rates (or those assets highly correlated to longer rates) as a portfolio strategy here at TwentyFour, and we anticipate that 2018 will not be as smooth as 2017.  The orderly trading in credit markets and emergence of buyers as cheaper offers appeared, also suggest that the technical factor of cash on the side-lines, that was so supportive in 2017, continues unabated.

However, markets are undoubtedly more jittery.  No pressure then Mr Powell, when you deliver your first speech as Fed Chairperson later this month!

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