Financial market volatility has returned with a vengeance.
Stocks are getting pummeled, commodities crunched, high-yielding currencies whacked and, as opposed to other period of acute volatility seen recently, government bonds are also getting smoked.
It’s been wham, bam, thank you ma’am, almost out of nowhere.
According to the Jefferies global equity strategy team of Sean Darby, Kenneth Chan and Irene Zhou, bold yields have driven the recent bout of market volatility.
Like a game of dominoes, or the fluttering of a butterflies wings in the Amazonian rain forest, government bond yields, after hitting record low after record low at will earlier this year, have suddenly started to reverse course.
First it was Japanese government bonds, then UK gilts, then German bunds and, reaching its crescendo last Friday, US treasuries.
After weeks of placid markets, the move to a chase for yield became a race to the exits, ending in a spectacular market rout.
Investors are now wondering what comes next.
Was it a one-off move, or the start of a longer lasting trend, sucking what were previous market gains into ever deeper losses?
While investors mull over what actually ignited the move in bond yields — be it smaller chance of additional central bank stimulus or the belief that governments will issue more longer-dated bonds, or others factors — Darby and his team believe that “certain segments of the equity market will be ‘no-go’ areas until yields have stabilised”.
It would surprise few that utilities, telecommunications and consumer staples — favoured destinations for yield-hungry investors — were particularly hard hit on Friday.
So what should stock investors expect in the period ahead? That answer, they say, will come down to movements in real US yields and the US dollar in the period ahead.
For some background, here’s a chart from Jefferies that looks at real US bond yields, simply derived by taking the nominal 10-year note yield and subtracting CPI on a year-on-year basis.
“Essentially equities have been tracking real yields on an absolute basis and have been trading relative to other indices based on FCF [free cash flow] yield,” they wrote on Monday.
“Provided US real rates don’t rise towards 2% and the dollar doesn’t strengthen, equities will probably only experience a ‘correction’.
From an asset allocation perspective, the Jefferies trio believe that investors should remain overweight emerging markets, yet admit that “weaker candidates should be cut”.
“We currently don’t recommended ‘reach for yield’ within the global asset allocation,” it says. “We continue to seek uncorrelated assets such as China A shares.”
As for the near-term outlook for US rates, Jefferies says that the Fed is unlikely to move next week.
Here’s a table that shows which markets Jefferies is bullish towards, and those it thinks look bearish.
For all the talk of a more hawkish US Federal Reserve being behind the spike in yields, market expectations for a US rate — be it in September or December – barely budged on Friday.
September is still seen as a one-in-three chance, December two-in-three.
Business Insider Emails & Alerts
Site highlights each day to your inbox.