Did you see yesterday’s stock market volatility? Crazy, huh? Listening to pundits try to explain it, was like watching Abbott and Costello meet Sherlock Holmes. There were a few sentient voices, such as Barron’s Amey Stone and CNBC’s Steve Liesman, but beyond that, there was much grasping at straws.
The equity markets and high yield bond prices were surging, yesterday, after stronger than expected ADP job data. The reflation trade was back. Market participants looked forward to a surging U.S. economy being pulled along by pro-growth fiscal policies and a patient Fed. Then the clock struck 2, 2:00 PM EDT, that is.
It was at 2:00 PM Eastern Daylight Time that the Fed released the minutes of the March FOMC meeting. The minutes contained two details which shook the markets. One was that the Fed could begin to shrink its balance sheet, later in 2017, rather than in 2018 (as many market participants assumed), by halting reinvestment of portfolio proceeds at once, rather than gradually, as market participants believed. Secondly, the minutes indicated that some FOMC members saw equity prices as “quite high”. Following the release of the Fed minutes, equity prices and junk debt prices plunged.
I found this somewhat humorous. After all, that the Fed planned on shrinking its balance sheet, at some point, was no secret. That equity prices are somewhat frothy is not a state secret either. I would add that many market participants have been very critical of the Fed, as its forecasts and outlook have proved largely incorrect. Yet markets, mainly risk asset markets, reacted sharply to the FOMC meeting minutes. Why would markets react the way they did? The answer is: Algorithms.
Many trading algorithms are programmed to read the headlines on news wires and trade on them. When the Fed released hawkish meeting minutes, which contained a reference to overvalued equities, algorithms pressed the cyber sell button. This was again evidenced when Speaker of the House, Paul Ryan, commented that tax reform could take longer to pass and may not be as encompassing as originally planned. Once again, risk asset markets took a leg down.
Investors and some advisors have fallen in love with algorithmic trading and investing strategies. The idea behind algorithms is that they take emotion out of the equation. They are supposed to stay the course and not be meaningfully impacted by market noise and headlines. Yet it is headlines to which many algorithms react. For ages, financial advisors and financial firms have sought to educate investors to look beyond the noise and short-term volatility. Today, some investors, of their own accord or through their advisors, are investing in a way which exposes them greatly to the very noise and headlines they have been told to look beyond.
Another thing that troubles me is: It seems that many investment and trading models are structured using algorithms which react similarly to headlines and data. This can create crowded trades. Since most algorithms react to what while giving little consideration to why, the algos could act imprudently should there be a shift in paradigms and correlations. As of now, humans are better at seeing the why. Algorithms cannot react to changes in paradigms and correlations until their quant masters tell them too. As intelligent as they are most quants are mathematicians. They are brilliant at crunching data and tracking past trends. However, they may not be adept at understanding why investors, such as pensions, insurance companies, central banks, etc. react to Fed policy, trade policy or tax policy.
To be fair, human economists can be just as guilty of not seeing changes within an economy. For decades, economic orthodoxy was, when interest rates were lowered, consumers would be incentivized to borrow and spend, and disincentivized to save. However, as the population aged and an increasing number of consumers relied on income to fund their lives, lowering interest rates incentivized an increasing number of consumer to save more as it required larger savings to generate needed income. The bond market and its participants, which have been called wrong by some economists, investment strategists and media pundits, saw the demographic changes years ago. Thus, in spite of record shorting, long-term UST yields have been decidedly range-bound.
Speaking of the bond market; it’s response to both the FOMC and Speaker of the House Ryan’s comments, was muted. When the FOMC minutes were released and it became apparent that the Fed desires to begin shrinking the balance sheet, later in 2017, the 10-year UST note yield drifted higher, from 2.36% to 2.38%. This modest rise was believed to be due to a knee-jerk reaction to the prospect of having greater supply of long-dated Treasuries on the market. However, the 10-year UST note yield was soon back at 2.36% and then 2.35%. After Mr. Ryan’s comments, the 10-year UST note yield fell to as low as 2.32%, before ending the day at 2.33%. Why the drop in long-dated UST yields?
For one, the prospect of a long drawn-out process for tax reform resulting in only moderate cuts and reforms is somewhat less inflationary than what the Trump administration originally proposed. Secondly and, perhaps, more importantly, the shrinking of the Fed’s balance sheet can be seen as removing accommodation from the U.S. economy. I have published this idea/opinion on many occasions. This morning, CNBC’s Steve Liesman confirmed that some bond market participants with whom he spoke viewed the shrinking of the Fed’s balance sheet as tightening and anti-inflationary. Mr. Liesman also reminded viewers that the Fed’s balance sheet is focused on the 6-year area of the yield curve and hypothesized that is where much of any long-term yield increase could occur, when the Fed begins shrinking its balance sheet.
I would also remind readers, again, that there is a severe shortage of U.S. Treasuries, in the fixed income market. This has resulted in otherwise fairly conservative investors moving farther out on the risk spectrum than they otherwise might (or should) and is causing foreign insurance companies and banks to purchase U.S. municipal bonds to earn relatively safe returns, even though they do not benefit from the tax free status of many municipal bonds.
In my opinion, when the Fed shrinks, the modelers will probably reduce their holdings of U.S. Treasuries, anticipating rising yields due to greater supply of USTs. They will probably move capital farther out on the risk curve as their models tell them that high-risk assets tend to do well when the Fed is tightening. However, this strategy misses facts such as the tremendous appetite for U.S. Treasuries and that, because the Fed had kept rates so low for so long, and that the economic cycle is old, the junk debt story appears to be played out.
My base case is that, after a knee-jerk selloff in long-dated Treasuries, demand comes rushing back in, holding down or driving down long-dated UST yields. In the junk debt market, I expect a short-lived rally followed by selling into that rally for the purpose of moving in on the risk spectrum. This will probably happen following the December 2017 FOMC meeting. Why December? I believe the Fed wants to give the economy as much time to gather steam, after what feels like a weak first-quarter and to see what form fiscal policy takes. However, like her predecessor Ben Bernanke, I believe Fed Chair Yellen would like to get the next phase of monetary policy renormalization underway before her term ends at the end of January 2018.
About Thomas Byrne
Thomas Byrne brings nearly 30 years of financial services experience to Wealth Strategies & Management LLC. He served as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.