Friday Sell-Off Bigger For Quants Bigger Disaster Than Brexit

Last Friday’s bond driven sell-off was a bigger event for quant flows than Brexit according to Bank of America.

Since Brexit, financial markets around the world have enjoyed a period of extended stability. Even though markets were rocked following the June 24 vote, central bank rhetoric in the weeks following calmed nerves, sent bond yields plunging and pushed investors into equities in the hunt for yield. Through Thursday, September 8, the S&P 500 recorded its longest stretch in history of trading within a range of 1.77%. The data goes back to 1928. However, on Friday the lull was broken as the S&P 500 fell 2.45% and similar losses could be seen today.

The losses of Friday and possibly Monday are the biggest markets have seen since Brexit but this time around the sell-off is spreading to other areas of the market, which benefited from the June declines. Indeed, this sell-off has extended to Treasuries and European government bonds, causing a greater jump in multi-asset portfolio volatility.

Sell-off will drive more equity selling 

Quant funds have become a huge force in capital markets since the financial crisis. While these funds can achieve steady risk-adjusted returns during times of market stability, during periods of volatility they add to the selling pressure exacerbating risks. Unfortunately, the calmness that has fallen over equity markets since Brexit has only increased the risk that quant funds would add to the turbulence when the eventual self-came. Ahead of Brexit the three-month the correlation between the S&P500 and 10-Year US Treasury bond prices set its year-to-date low at -0.66. As a result, risk parity-style portfolios likely fared well through Brexit as sharp moves lower in global equities were diversified by the strong performance in bonds. However, since hitting this low as investors have pushed money into both equities and bonds the correlation of daily moves between the two benchmarks increased to -0.08 over the past three months on average. Over the last month alone, the correlation has turned positive to 0.27. Increasing correlation implies less diversification for risk-parity style portfolios and, could be a precursor to higher volatility if/when the current bull market finally dies.