"Brutal Price Action" Looms
Stocks & Bonds Correlation
A "Flashing Warning Sign"
The correlation across asset-classes over the past few months - as global central banks ramp up QE to $200bn per month - is near record highs.
Massive central bank stimulus with below zero rates and quantitative easing has led to increasingly dysfunctional markets, with even the negative correlation between stocks and bonds breaking down. As we have noted previously, they are now largely moving in the same direction as markets have become more driven by central banks, leaving investors with no place to hide.
And short-term (intraday) bond-stock correlation has spiked near record highs...
Raising notable concerns over a risk-parity fund blow up. As BofA warns: "Latent risk remains worth monitoring, as (i) leverage is still near max levels across a variety of risk parity parametrizations, (ii) bond allocations are historically elevated, and (iii) markets continue to be sceptical of a 2016 Fed hike."
If BofA is correct, it would mean that a day which sees a -4% SPX drop and +1% bond rally (good diversification) would generate no selling pressure, "underscoring the critical role played by bond-equity correlation in governing the severity of risk parity unwinds." However, a troubling scenario is one where even a relatively benign 2% selloff of the S&P coupled with just a 1% selloff of the 10Y could result in up to 50% deleveraging,which in turn would accelerate further liquidations by other comparable funds, and lead to a self-fulfilling crash across asset classes.
Which incidentally sounds like precisely the scenario that could happen when the Fed tries to raise rates, and is also why asset classes continue to move without fear of any rate hike, as they now realize - very well - just how trapped the Fed truly is. That said, in short order, we will see if the Fed, for once, has the intestinal fortitude to actually raise rates in the face of the extreme volatility awaiting equities in the event they do... we doubt it.