Here we go again. Or at least that’s what this market feels like relative to the credit crisis circa 2007-2009. Global equity markets continued to violently sell-off yesterday on concerns that the global economy is slowing down, and as investors got spooked after an unexpected uptick in U.S. jobless claims. When coupled with European fears and the probable passage of financial regulatory reform in short order, it is no surprise that this market, which was ripe for a correction, pulled back. In fact, by definition, the U.S. markets have officially entered correction territory with the Dow, Nasdaq, and S&P 500 pulling back 10.1 percent, 12.9 percent, and 11.9 percent respectively from their recent peaks.
While many are not surprised by the correction, I think some are taken back by how quickly and violently the pull-back has occurred. The fears of 2007-2009 are still very fresh and the theme among institutional investors has been to protect liquidity above all else. Specifically, many hedge funds that got burnt on margin calls and forced selling in 2008-2009 are preemptively taking risk off the table to protect liquidity. The de-risking trade is clearly on and has been magnified by the herd mentality. As we stated back in 2008-2009 when the system was on the precipice of collapsing, a falling market creates its own dynamic. Violent sells-offs trigger margin calls on leveraged accounts driving prices lower, which creates fear in the markets and so on and so on. To that end, the VIX, widely regarded as the “Fear Index” and a measure of future expected annual volatility in the S&P 500, closed at 45.79, up 193.9 percent since April 12. Clearly fear has crept back into the markets very quickly so one should expect volatile trading days ahead.
Concurrent with the de-risking trade, U.S treasuries are rallying unabated as the flight to quality trade is in full force. The curve remains steep with the 2-yr/10-yr spread at 247 basis points, but has flattened over recent weeks as longer-term yields have declined more than short-term yields. Below is a look at the term structure of rates and how precipitous the yield decline has been since the end of the first quarter.
|
Treasury Term
|
3/31/2010
|
5/21/2010
|
Basis point Change
|
|
3 month T-Bill
|
0.150%
|
0.152%
|
0.0020
|
|
6 month T-Bill
|
0.231%
|
0.203%
|
-0.0285
|
|
1 year UST
|
0.379%
|
0.305%
|
-0.0744
|
|
2 year UST
|
1.016%
|
0.699%
|
-0.3172
|
|
3 year UST
|
1.571%
|
1.139%
|
-0.4312
|
|
5 year UST
|
2.544%
|
1.949%
|
-0.5942
|
|
7 year UST
|
3.275%
|
2.612%
|
-0.6633
|
|
10 year UST
|
3.826%
|
3.176%
|
-0.6495
|
|
30 year UST
|
4.713%
|
4.052%
|
-0.6610
|
U.S. treasuries are still considered the risk-free asset and in times like these they catch a phenomenal bid. It seems unbelievable, but the 30-year treasury is in striking distance of dropping below a 4.00 percent yield. I continue to believe that yields are going to remain lower for a lot longer than many people think. First, demand driven (consumer) inflation is not on the horizon which enables the Fed to keep rates low for a long time. Second, global sovereign debt fears, geo-political issues, and issues that haven’t even occurred yet will precipitate the flight to quality trade.
Ultimately, I don’t believe this crisis will be a repeat of the last one. At some point I believe equities will catch a bid, although it doesn’t appear that will happen today as U.S equity futures are pointing to another weak opening, with the Dow futures below 10000. However, Germany is expected to grant final approval of the aid package to Greece, which could give the Euro a lift in the short-term, and the U.S. should pass a less severe, watered down version of the financial regulatory reform bill. If investors can take a deep breath, I think this will play out to be a short-term correction rather than the start of a new bear market, but I’ve been wrong many times.
On the fixed income front, remain nimble in times like these. Markets never move in a straight line forever, and treasuries will pull-back at some point. Take advantage of pull-backs to add collateral and use rallies to take gains and reposition. Corporate spreads continue to widen in the short-term and could widen further, but patiently and selectively adding short-term corporate is a strategy that worked extremely well in 2008-2009 and could work very well again.