This morning's piece is relatively short. Considering the avalanche of weekend opinions offered on blogs, on Twitter, and in papers, I can’t imagine being able to add anything new or useful to the debate over whether the S&P 500
(INDEXSP:.INX) is in the process of kissing goodbye the underbelly of two trendlines and the 50-day moving average, or whether it is about to start another long strong run.
For every technician there is a different interpretation of the charts, and for every fundamental and macro maven there are differing views on the health of the job market, the impact of rising interest rates, the reasons for rising interest rates, the coming earnings reports, guidance, China, Egypt, Portugal, the German elections, the taper… you get my drift. So rather than make up my own story, let me offer you some food for thought via the following charts.
The first one shows the volatility of the key world currencies.
As you can see, the Japanese yen started the volatility party at the beginning of the year, was quickly followed by the Swiss franc and the euro, and by mid April all currencies began a second sharp leg higher.
The second chart shows the volatility of gold.
In mid-March gold began its ongoing collapse, and its volatility naturally spiked.
The third, and by far most worrisome chart shows the MOVE Index, which is a blended-tenor volatility index for Treasury bonds. Think of it as the VIX
(INDEXCBOE:VIX) of bonds. On Friday it hit the highest level in two and half years...
...and the percentage move it has seen in the last three months is the largest since the beginning of the MOVE Index, back in 1988, with the bulk of the spike starting in the middle of May.
Do you see a pattern here? It started with currencies at the beginning of the year, spilled into gold in mid-March, caught up to Treasuries in mid-May. Can anyone categorically exclude that these rolling volatility spikes will infect equities and the VIX at some point?
Consider the following as well: I think it’s fair to say that Treasuries are not owned with an expectation for high volatility, and moves as violent as what we have seen of late compound the pain of the size of the move. In other words, high volatility in asset classes that are not supposed to be volatile can be just as harmful as the size of the move itself, and create a negative feedback loop. In addition, high bond volatility puts a damper on the critically important issuance of corporate bonds, and makes M&A and LBO (leveraged buyout) transactions much more complicated.
We also know that Treasuries are the quintessential form of collateral for all kinds of leveraged assets (beginning of course with equities), and that at the peak of the gold bull market, gold was also being pledged as collateral for equities and other assets. With both these classes getting slaughtered, can we be sure we won’t see liquidation (voluntary or forced) in the collateralized assets? Is there a rising risk of a volatility-induced spiral across most or all markets?
These are not rhetorical questions. I perceive them to be very important questions, but I honestly do not have clear answers. While high volatility is generally synonymous with fear and lower prices, volatility is not per se directional. Volatility is often defined as the inverse of liquidity, and a lack of liquidity is often a sign of uncertainty around the future price of an asset. This future price might end up being lower, but it could also be higher.
In my humble opinion today’s uncertain markets are very much a fair representation not only of very uncertain circumstances, but of the very uncertain potential outcomes of these uncertain circumstances. Dovetailing back to one of my favorite essays (a must-read), markets are in the grasp of ever-growing "Fingers of Instability
." They may be able to extricate themselves successfully with few if any ripples, or they may be on the brink of an avalanche. Either way, price risk seems high.
Position in SPX, long term bonds.
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