Back to Basics

Last week I tumbled down the rabbit hole of quantitative finance, so this week I thought that I would take stock on some of the main themes. In addition, I am going on holiday soon, which means that you will have to survive without my mishaps for a couple of weeks. The continued woes of the greenback are probably the main story for markets at the moment. It is driven by a number of factors as far as I can see. Firstly, economic data in the U.S—in particular core inflation—have remained underwhelming, which have forced markets to roll back on their expectations for Fed rate hikes. September, which was a done deal only a few months ago, has now become a long shot. Secondly, just as the Fed's hiking cycle potentially has hit a snag, other central banks have stirred.

Has this time been different?

One of the main tenets at this space has been to cut away the extremes in your [equity] investing strategy. There are those who see market tops and imminent crashes everywhere, and then there are those who believe debt-financed share buybacks and dividend payments can continue to propel the market higher forever. They are both wrong, but the persistence of these two narratives and their interaction has been a key story in this cycle. It is my firm belief that the oscillations between these two positions have created a huge middle ground, which allows investors to make money. In the peanut gallery we talk about "sector rotation," but it's more than that. It's also about different themes which cut across traditional equity sectors and allow for price movements of key industries—even country indices— in opposite directions. I suspect most market geeks would be able to agree on this over a pint in the pub. But can we quantify it?

A World of Suboptimal Choices

It's never easy when bonds and stocks decline at the same time, but despite the much-publicised death of the "risk parity" strategy, I don't think the past few weeks' price action qualifies as decisive evidence. After all, the S&P 500 is down a mere 0.6% from its peak in the beginning of June, while US 10-year futures are off only 1.5%. In writing this, though, I remember that many punters in this business use leverage. This acts as an accelerant not only for the volatility of their PnLs, but also for the speed with which a meme can take hold in the peanut gallery. I sympathise with the plight of bond traders in Europe where the dislocation in yields has been particularly nasty. When yields are near zero, or even negative, the relationship between small changes in yield and prices can be brutal. This is even acuter in Japan, where the BOJ might soon have to actually defend that 0% target on the 10-year yield, to avoid an accident in the domestic asset management industry. In the U.S., the 10-year yields has been altogether less dramatic, but big enough to raise questions about whether we have made a switch from a flattener to a steepener.

A confusing end to Q2

The second quarter finished with a tricky question for markets. Did last week’s price action signal a significant change in tune or was it just insignificant noise in an unchanged trend of lower global long-term interest rates? One the one hand, it’s tempting for me to run a victory lap.  Here I was musing about a steeper U.S. yield curve and outperformance in financials and energy. On that background the most recent price action has been a slam-dunk. On the other hand, I also said that I thought yields would fall over the summer, and that the reflation trade wouldn’t re-rear its head until Q3. So perhaps I shouldn’t raise my arms in celebration just yet.