In Jan 2001, “the Fed announced a surprise cut that sent the Nasdaq up 14% in a single day, which remains the index’s largest move since its creation in 1971. .. Folllowing that day, the Nasdaq would fall 57% before hitting bottom..” @WSJheard
The Merrill Option Volatility Estimate, or Move, aims to track the implied volatility of US Treasuries over the coming month, based on prices in their derivatives markets. It is the bond market equivalent of the Cboe’s Vix volatility index, considered the stock market’s fear gauge.
Back on March 20 of this year, I posted the $MOVE Index Bond Volatility chart on Twitter and wrote “Brace for Impact!”.
On 3/27 I wrote: “Treasury Volatility caused the 10-year yields to crash which further inverted the yield curve.” because ”Those who got caught selling volatility had to hedge by effectively going long Treasuries.” Basically, I judged from this $MOVE chart, we weren’t done!
Fast forward to today, MOVE has risen almost 100% from from 42.53 on 20 March to over 80.
Inversion and The R-Word
Most don’t expect that if Fed cuts the 10-year yields go UP not down – as market prices in “better economy” – steepening the yield curve. And … Here’s a friendly reminder of what can happen AFTER the Fed cuts: Recession. And judging from the ‘over-tightening’ implied (see chart below) compared to prior cycles, that may be why the bond market is aggressively leading the anticipated rate cut AND why both Gold and USD are interpreting it as recessionary.
This dramatic fall in yields doesn’t look done – either from the above Treasury Volatility MOVE chart (breaking up) or the bond market intonating 10-year rates are going lower to 2.0% this summer. It wouldn’t surprise me to see 1.75% by end of year.
The last time the U.S. 10-year government bond yield was at 2.25%, keep in mind, the Fed Funds rate was 1.25% in Q3 of 2017. And this is the disconnect – between what the market judges to be the appropriate interest rate and what the Fed judges to be the appropriate level – that is really helping to cause the dreaded yield curve inversion.
Fed Cuts Offer Diminishing Returns
Fed will likely cut and soon. If the Fed doesn’t ease policy dramatically, the chances of USD approaching escape velocity are great. And that is exactly what the Long DXY crowd is betting on. And since higher USD will help suppress yields, bonds will continue their ascent as well. Think of it: Long Bonds and Long Dollar. Neither is bullish equities!
So why are equities not falling?
Since the Jan 26th 2018 peak in the MSCI world index:
China Large Caps…..-25.15%
Where is the outlier? Yes, the US is the best performer. We have the higher-yielding rates and strongest currency which has directly facilitated these results. But now with the Trade War/s, we are putting this performance to the test. Since yields have diverged strongly from the USD, traders must accept that deteriorating fundamentals have led yields lower even if in the short-term, these same falling yields have supported sentiment-driven equities. This is not sustainable.
Traders may be sadly disappointed once they realize that even when the Fed cuts – whether June, July or September – this will only embolden Trump to ratchet up his trade war and tariffs. I’m not sure which dangerous childhood game to compare it to: the Cinnamon Challenge, Chubby Bunny or straight on Sack Tapping! But I am amazed the Fed wants to play.
For the market, Fed cuts can be negated by Trade Tariffs, supply chain disruptions, revenue/profit contraction, reduced Capex spending, unemployment. The immediate affects from Trade Wars – both in the economy and in the psyche – will be felt faster than the easing affect of rate cuts in the system. And for these reasons, the climb higher in asset prices will be that much harder. As global, domestic and earnings growth slows, consumers will start to get squeezed – slowly at first and then all at once.