This analyst perfectly explains why markets have suddenly gone haywire

Goldfinger. Source IMDB Metro-Goldwyn-Mayer Studios

After a prolonged period of tepid market moves, volatility has returned with a vengeance in recent days.

For three straight sessions risk assets have been on a roller coaster ride, tumbling, then surging, before tumbling yet again.

But why?

In an excellent research note released earlier today, Chris Weston, chief market strategist at IG Markets in Melbourne, outlines the three reasons why he believes market volatility has suddenly spiked.

We see plenty of research notes every day, but this is perhaps the best, and most concise, that we’ve seen so far.

Here’s Weston’s view:

Firstly, we have seen a further steepening of various yield curves, which in itself is not necessarily bearish if the cause is higher inflation and growth expectations. However, that is not the case and this move is being caused by the Bank of Japan looking to change the structure of its asset purchases, largely as a result of how poorly its asset purchase program has worked thus far. Throw in recent commentary (or should I say lack of) from the ECB that throws into question the sustainability of the ECB’s asset purchase program and you have a move higher in longer-term bonds, that no one is positioned for.

Secondly, some of the biggest systematic (rule based/computer driven – see point seven) funds have had to alter their portfolios, many which have been at extreme levels. This has caused massive shifts in their portfolio and in turn we have seen markets respond in kind. The rest of market participants have had to simply react and when volatility increases traders’ absolutely have to alter their strategy if they are to stay in the game. Pure and simple, if volatility increases and we see (price) range expansion one has to look at altering position sizing, while pushing out stop losses to account for greater leverage in the market.

Thirdly, throw in comments from the IEA [International Energy Agency] that have pushed crude price lower and we have a further move out of equities. The concerning situation is the genuine reasoning behind the risk aversion move is very complicated for many to fully understand. The issues causing a strong correlation between equity and fixed income selling is not the same as say the European debt crisis that everyone has an opinion on.

There we have it.

Bond yields are rising as investors question the belief that central bank stimulus will be ongoing, forced selling from some funds due to the spike in volatility and concerns about the outlook for the crude market.

On the second point, Weston suggests that some “systematic funds have been max short volatility and at their upper limits of long equities and short USD”.

“These are some of the biggest financial market players in the world. There is much talk on the floors that we seeing a huge position unwind,” he says.

Business Insiders’ Bob Bryan covered this in detail in late August.

Noticeably, there’s no mention of the US Fed and near-term expectations for rate hikes. Something many experienced investors would agree is not driving market movements right now. It’s a small contributing factor, not the reason.

Given the focus on sovereign bond yields, Weston believes that the open of the Japanese government bond (JGB) market later this morning will be crucial in determining how broader asset classes perform in Asia.

“All eyes should be on the open of Japanese bond futures at 09:45AEST, as the moves in developed market fixed income, which are largely behind the volatility, have stemmed from Japan and the potential changes in monetary policy,” he says.

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