Financial markets have just suffered their worst week since February. The catalyst would appear to be a cocktail of rising bond yields precipitated by either concerns over a potential rate rise from the Fed or more general concerns that, no matter what central banks do, they are running out of ammunition and are powerless to prevent some pain being inflicted on markets. When we add into the mix that, post Brexit, investors went on a mad dash shopping spree buying anything that promised a yield, and a collapse in volatility that allows leveraged investors to load up even more, and we really do have a powerful mix that could easily make for a long lasting peak in prices.

We have considered negative bond yields as well as the negative interest rate policy (NIRP) of central banks as utterly insane and an accident waiting to happen. This environment, as covered quite widely now in the media, is extremely challenging for many important parts of the financial industry. It is not leading to any demonstrable increase in economic activity (no matter what claims central bankers make), is leading to an increase in debt (corporate in particular) and a mis-allocation of capital on a grand scale.

This deranged policy was always going to end badly, either because central bankers would finally see sense and reverse course, or because markets would begin to lose faith. It appears to us that the mixed messages from central bankers in recent weeks is finally causing investors to question the efficacy of chasing such low/negative yields. In our view, the selling witnessed in the last few days has inflicted enough damage to most longer dated bonds that we now have very good sell/bearish signals in place. For the time being, we are going to trade with a bearish bias in developed market bonds, and we have to wonder whether European and Japanese yields have in fact made generational lows in recent weeks.

Chart 1 below shows the recent price action in the current active futures contract for the 10 year German bund. We have highlighted the compressed trading post Brexit. What is interesting is that on the eve of the ECB meeting last week, price made a new all time high, and the subsequent losses have wiped out two months’ worth of trading. This price action screams failed break out and subsequent failure. Our bearish thesis will be enhanced by more losses next week if they occur.

Chart 1 – The active future for 10 year German Bund

We noted above the massive chase for yield in recent weeks as volatility collapsed and some investors added leverage. What this meant in simple terms is that all mainstream assets rose together. The risk therefore is that falling bond prices and rising volatility lead to falling prices for equities, corporate bonds of all flavours and perhaps most emerging market assets. The key to this forecast in the next couple of weeks is rising volatility.

There is a very large pool of capital that is managed with volatility as a key input. Simply put, when volatility is low/falling, these investors can add more risk to their portfolios. When volatility is rising, these investors have to reduce risk by selling. So, when the price of everything is going up and volatility is falling, this is the best of all worlds. However, after such a period when these guys have become fully invested/leveraged, and if price begins to decline alongside rising volatility, they have to sell.

So the risk was always that falling bond prices could trigger selling in other assets, triggering a rise in volatility thereby triggering more selling and so on. We think it is this dynamic at work at the end of last week, and if it continues next week, losses could mount quite quickly.

Having outperformed for so long, and having been the last country to make new post crisis highs in recent weeks, the US equity market may finally be cracking. In chart 2 below, we show how Friday’s loss of just over 2% wiped out two months’ worth of trading. If we are right about the current environment, then we expect Friday to be the initial acceleration in a period of losses most of which are still to be seen.

Chart 2 – The US equity market

To say that emerging market assets have been flavour of the month recently is an understatement. The broad emerging market equity index has rallied by 30% from the post Brexit low. In chart 3 below, we illustrate how this rally has so far stalled at a significant resistance level. We believe that a period of rising yields/volatility, especially after such a strong rally, will be very bearish for EM assets generally. We have got short some EM currencies in the RMG FX Strategy UCITS fund – see below for details.

Chart 3 – Emerging Markets Equity ETF

For all those who have ever been on a long journey will children constantly asking ”are we there yet?” you will understand what we are about to say. For probably about two years, central banks have taken us on a journey that was ever more likely to end in tears for investors. At many times during the last couple of years, we have asked ourselves “are we there yet?”. Are we at the point when investors simply give up on believing that central banks can force investors to chase ever rising prices regardless of valuation extremes and lack of growth in the real economy.

We will dissect the current central banking situation in a separate note, but we do now think “we are there”. Having strayed into negative territory, bond yields in Europe and Japan are back at the zero level, and probably headed higher still. It would appear that the reach for yield (in these bond markets at least) is over. If this party ends with a bang of rising volatility and falling prices spreading to other mainstream assets, we may well have just seen a very important high in many markets. At the very least, last week’s price action should be seen as a warning signal that all is not well in this central bank inspired dash for yield.

We have moved to a very defensive position in the portfolios we manage. We have made changes in the RMG FX Strategy UCITS fund (See details HERE). We went short South African Rand, Malaysian Ringgit and Hungarian Forint as well as short AUD as another high beta FX.

In the Real Return Fund, we also sold some Nasdaq and bought a Vix call spread.

So long as price remains below the highs seen last week, we will work on the assumption that markets are headed lower. We will be watching volatility closely to judge whether our immediately bearish thesis remains valid or not.
Stewart Richardson
Chief Investment Officer