Unwinding Trades Creates Market Turbulence

Over the last several quarters, we have made both a cyclical and structural case for being long fixed income. The cyclical case has been based on the view that inflation is returning to target, growth is slowing, and cracks are starting to appear in the labor market. The medium-term case revolves around the idea that U.S. real yields are quite attractive, both in absolute terms and particularly relative to U.S. equity valuations, where the equity risk premium is too low.

In the last few weeks, two shocks have been reverberating across markets concurrently. The first market shock has been a dramatic unwinding of some popular trades. One trade was a broad bet on Japan where investors generally were short the yen, long the Nikkei stock index, and short Japanese government bonds. Markets also have seen a violent unwinding of the long AI trade as many of the expected beneficiaries of AI have underperformed recently. Lastly, there clearly has been a short U.S. equity volatility trade unwinding, evidenced by the dramatic upswing in the CBOE Volatility Index, or VIX, in a short period of time.

These dramatic shifts are creating a flight-to-quality bid for bonds. However, these trades essentially represent overleveraged positions, and these excesses will eventually be cleaned up. So, while markets may overshoot further, we do not expect these extreme moves to last much longer.

The second shock, which could be more prolonged, is that markets are again pricing in higher odds of a deeper slowdown or even a recession. While the flight-to-quality dislocations should eventually run their course, this second trend is likely to be slower moving, with back-and-forth gyrations in markets as the macroeconomic data fluctuates between weaker and stronger readings.

In response to these two shocks, yields have dropped significantly. Until recently, the Federal Reserve (Fed) was priced for a modest easing cycle, which has been justified by the inflation story (see Exhibit 1). However, for yields to drop materially further or to support where front-end Treasury rates are today, the Fed likely would have to shift into a far more aggressive easing cycle. While possible, we would expect to see a more dramatic deterioration in the economic data than what has been reported so far. Hence, the abrupt change in rate cut expectations is overdone, in our view.

While we have seen a sizable repricing in the shorter-term cyclical story, the medium-term view, or the relative valuation story, has not changed much. Equity risk premiums have gone up slightly but equities are still generally expensive. Similarly, our views have shifted slightly on the margin as the cyclical case has played out. However, we have not yet dramatically rerated the odds of a recession. Absent a substantial deterioration in macro conditions or something else “breaking,” a recession is not our central case at this point.

In addition to watching how the leveraged positions play out across markets, we also will be monitoring credit spreads for a more meaningful widening, which might substantiate the need for more aggressive Fed intervention. Typically, VIX and credit spreads move roughly in tandem, but the recent spike in the volatility index has been far more extreme while credit spreads have remained well contained (see Exhibit 2). The employment picture may hold another other clue to what could come next. The labor market and jobless claims will be particularly important indicators, and we will be watching for early signs that companies are becoming more cautious on hiring.

Index Definitions:

The CBOE Volatility Index (VIX) is a financial benchmark, published by the Chicago Board Options Exchange, designed to provide a real-time market estimate of expected 30-day forward volatility of the S&P 500 Index. It is calculated by using the midpoint of current S&P 500 Index option bid/ask quotes.

The Credit Default Swap Index (CDX), formerly the Dow Jones CDX, is a benchmark financial instrument made up of credit default swaps (CDS) that have been issued by North American or emerging market companies.