After a very smooth run higher for stocks since the beginning of the year, volatility has returned to the financial markets. It can be traced back to two events.
The first was when the Bank of Japan announced its bold new program of monetary easing, in which it committed to doubling the monetary base in two years. This caused a sharp rise in Japanese government bond yields, from 0.3% to 1.0%, and with it quite a bit of volatility.
The second event that drove volatility was when Fed Chairman Ben Bernanke first started talking about tapering the Fed’s monetary policy at his May 22 Congressional testimony, and then following his post-FOMC press conference on June 19. (Tapering refers to a decrease in the rate at which the Fed has been buying assets every month, as part of its open-ended QE.) The June FOMC meeting minutes show that half of the members were in favor of tapering, suggesting that the notion of reducing monetary accommodation is gaining momentum at the Fed.
Since May 22, coincidentally the very day that the S&P 500® Index made a new all-time high of 1,687, the index has corrected 6% to a low of 1,560 on June 23. During that same period, the yield on the 10-year Treasury rose about 100 basis points (bps)—to a high of 2.7%—and spreads on yield product such as corporate bonds widened sharply. For instance, the spread on domestic high-yield bonds widened from a low of 437 bps on May 8 to a high of 551 bps on June 25. Again, with these sharp moves in a matter of a few weeks, volatility has returned after being dormant for months.
The resulting rise in volatility, falling stock prices, rising yields, and widening credit spreads are things that the Fed would probably rather not see happen—or at least not with such speed. After all, with rising Treasury yields comes a spike in mortgage rates, which could undermine the housing recovery. In fact, the rate on 30-year mortgages has shot up to 4.75% in recent weeks.
Indeed, it appears that the Fed may have been taken aback by the market’s swift response, because last week Chairman Bernanke appeared to backtrack on the taper talk, saying in a speech that monetary easing was likely to continue for some time. Since that speech, the financial markets have stabilized and volatility has been reduced. As of July 15, the S&P 500 is back to its May highs.
Is higher volatility here to stay?
To answer this question, we need to look at the bond market and explore the amazing growth in bond fund assets over the past four years—especially the growth in so-called spread product such as investment-grade corporate and high-yield bonds. Over that time span, the Fed’s bold QE program has pushed investors out the risk curve, away from cash and Treasuries and into higher-yielding (but riskier) spread product. The reach for yield has even extended into the stock market, with the higher-yielding sectors like utilities and REITs.
According to the fund flow data provider EPFR Global, these types of bond funds and exchange-traded funds have taken in some $700 billion in cumulative net inflows since late 2007. But in recent weeks, these same funds have suffered redemptions totaling more than $50 billion. So it is clear that we are starting to see at least some unwinding taking place.
“Great Unwind” for bonds?
Are these recent redemptions a mere bump in the road, a small correction, or the start of what might be called the “Great Unwind,” in preparation for a normalization of interest rates and spreads? By the Great Unwind, I mean a meaningful reversal of the tsunami of inflows that these funds have enjoyed since 2009.
If the recent outflows are merely a blip on the radar screen, then this may soon all be forgotten. But if it’s something more, then volatility could be here to stay. Why? Because primary dealer inventories have gotten so low since the peak in the leverage cycle back in 2007 that any serious amount of redemptions in these funds may not be able to be absorbed by the dealer community.
Dealer inventories in investment-grade and high-yield corporate debt peaked in 2007 at $286 billion. That year was of course the peak of the leverage cycle, when subprime CDOs (collateralized debt obligations) seemed like a sure thing. As of the New York Fed’s latest data, inventories are now a mere $48 billion. Without sizable dealer inventories, there may not be an adequate ability for the market to transfer risk from one group of holders to another without doing serious damage to price. Indeed, that is what we have already seen occur in recent weeks, with the above-mentioned widening in spreads and rise in yields.
Another question is: How would any such disorderly liquidation—should it happen—affect stocks? Will those investors whose bond portfolios are now turning red go up the risk curve and turn to stocks, thereby causing the long-awaited Great Rotation? Or will they go down the risk curve (as investors tend to do when they suffer losses) and hide in cash? Time will tell.
- Fidelity® Global Strategies Fund (FDYSX), co-managed by Jurrien Timmer.
- See if your investment mix is in line with your long-term goals with Portfolio Review.
- Research stock, bond, and commodity mutual funds.
- Research stock, bond, and commodity ETFs.
- Let Fidelity professionals manage your investments with Portfolio Advisory Services (PAS).1