Too much of a good thing is bad. That, in a nutshell, is an important insight that Hyman Minsky offered about the financial sector, but has broader application.
The low volatility that has been a characteristic of the capital markets for the past few years spurred financial innovation to profit from it. A broad range of financial instruments constructed to profit from continued low volatility, such as exchange-traded products and futures contracts. There was a broadly similar evolution in Europe, though there appears to have been greater restrictions (protections) for retail investors. Some vehicles also allowed investors enhanced leverage, which acts like a force multiplier.
The particular spark that ignited the dry tinder of market positioning may very well have been the jump in US hourly earnings reported with the January employment data on February 2. Even though some questions have been raised about possible distortions, if it was not this spark it would have been another. There was a stretch of around 400 days without a five percent correction in the S&P 500. The longer it took, the greater the positions betting that it would continue, the larger the shock, the greater the drama.
Stability leads to instability. The long stretch of low volatility led to the historic jump in volatility as if the music of the financial instruments created an echo chamber like a horror house.
It is not very pretty, and quite painful for many, but this is how the markets mature. In this sense, what has happened is much more like the 1987 stock market crash than the 2008-2009 brutal bear market. Then it was “portfolio insurance” that was said to have created that echo chamber. Going forward, this experience will likely shape debates about circuit breakers and appropriateness of products for individual investors.
The most important driver of the week ahead is whether the pre-weekend price action in the US stock market signals that we have emerged from this nail-biting echo chamber. The price action was encouraging. The market dropped to new lows before staging a strong recovery and close near the session highs which were recorded in late dealings. The S&P 500 approached the 200-day moving average, which has often provided support in this multi-year bull market after meeting the oft-used definition of a correction (-10% from peak).
If the equity markets stabilize, then it will be easier to make sense of what is happening to interest rates. The rise in hourly earnings ostensibly raised inflation risks and spurred the sell-off in bonds. Many observers are emphasizing the importance of the January CPI report due Wednesday. The base effect is strong, which means that the year-over-year pace of both the headline and core are likely to have eased.
Measures of inflation expectations are flawed for one reason or another. With that caveat in mind, using the market-based measures (like the five-year/five-year forward or the 10-year breakeven), it appears that real rates went up more than the inflation premium. An alternative narrative to the inflation-scare is the supply-scare.
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