Worse Than Covid

They Must Save Bonds

I fear we’re getting to the point where investors have gotten accustomed to quick turnarounds from periods of market volatility. The reverse yen carry trade from last August is a good example. The VIX only really saw one day with a major spike and within a couple days the VIX was back in the 20s. Even after the S&P 500 fell by 9% in that situation, it was back to near all-time highs within a month. When the index fell by 10% in the second half of 2023, it recovered everything, again, within about a month.

This current market over the past several days is easily the longest extended run of much-above average volatility we’ve seen since the COVID pandemic. And I think it’s very important to point out the difference between volatility and recovery. During both the financial crisis and the tech bubble, the markets experienced wild swings in both directions. The downside volatility is what ultimately controlled the market in both situations, but there have always been big up days in the course of a broader market correction. Is it dip buyers? Is it investors reacting to any sense of improving sentiment? Could be. In many cases, however, it’s just an attempt at price discovery. The VIX continuing to hover in the high-30s to low-40s is the real tell. The VIX typically comes down during sharp up days and the fact that it’s remaining elevated throughout suggests that this current cycle isn’t over.

There are a lot of attempts at interpreting the direction of prices here. Outside of the broad trend that defensives are outperforming and growth/tech are lagging on the equity side, there’s the issue of Treasuries and gold. After briefly touching below 4%, the 10-year yield is back up to 4.25%, square in the middle of the range it’s been in for the past two years. If this was a stronger flight to safety trade, you might expect to see yields much lower. This could be a reaction to the inflationary effects of the trade war. Perhaps yields can only fall so far in a flight to safety if higher inflation could threaten to push yields higher as they did in 2022. While the Fed has been preaching patience up to this point, it’s looking more like Powell might opt to cut rates further and quicker than he did just a month ago. That could put more pressure to push rates lower, but there are a lot of moving parts.

I see some people wondering why gold prices are falling in light of what’s happened in the past week. I think the idea of people selling whatever they need to (winners getting sold off first) in order to cover margin calls is a real thing. We may see more of this if volatility remains elevated and the major indices test new lows. There’s also the possibility that investors are bypassing Treasuries altogether and going straight into cash. The overall takeaway is that I don’t think this period of volatility is over. The trade war is still only escalating at this point and there’s a sense that the White House isn’t particularly interested in cutting deals at this point, just “winning”. As of right now, there’s really no firm development on the trade front that would warrant a bullish turn outside of the notion that investors are hopeful that something will improve.

Japan was one of the countries to get upended in this escalating trade war. The Nikkei plunged roughly 20% from peak to valley over the past couple weeks and bank stocks did even worse. That might put the Bank of Japan on bailout watch. They’re in a really tough spot given how the central bank’s tilt was toward QT and lifting interest rates in order to fight a 4% inflation rate. Now, with conditions collapsing all around it, the BoJ might need to push rate hikes off the table altogether and re-consider hitting the brakes on QT. Growth is already sluggish and the trade war could steer the economy back towards recession. There’s not much room to lower rates and the BoJ already owns 50% of Japanese government bonds. It’s getting to be an ugly situation with no good solutions.