By Steve Sosnick, Chief Strategist
We seem to have fallen into a new pattern recently: IF (bond yields higher) -> THEN (buy stocks).
That is a vast oversimplification of algorithmic trading, but you should get the idea. Traders love patterns and there are highly-paid teams of mathematicians who search for both patterns and “leads”. Leads are moves in other assets that can presage moves in stock prices. There are also hordes of traders who utilize momentum or trend-following strategies. Over the past few weeks, these two forces have ingrained that new pattern into the market.
Those of us who follow market movements should be familiar with the idea of a risk-off/risk-on paradigm. There are days when traders and investors seek safe havens and days when they seek higher returns. On “risk-off” days, we typically see money move out of equities and into items like government bonds and currencies like the dollar and Swiss francs. “Risk-on” days bring the opposite effect as money moves from bonds to stocks. (Remember that bond yields move inversely to prices) There is a definite logic to that type of thinking – it is the push/pull between fear and greed in a nutshell.
We saw the “risk-off” mentality in full force last month when Russia invaded Ukraine. We saw parabolic moves higher in affected commodities like oil, wheat and nickel alongside falling equity prices and bond yields. Eventually, traders became somewhat inured to the moves. The affected commodities pulled back from their highs — not all the way, but to levels that the market deemed manageable – and bond yields began to rise alongside oversold stocks. The latter pattern could certainly be considered part of a “risk-on” mentality, certainly among stock traders. Just as it was profitable to look to lower yields as a trigger to lower stock prices, it has become profitable to look to higher yields as a trigger for higher stock prices.
From an algorithmic and trend-following standpoint, the relationship makes perfect sense. From a fundamental viewpoint, frankly it doesn’t. Bear in mind that algorithms and trends don’t necessarily care about why a tradeable pattern or lead is in place, just that it can be the trigger for a profitable strategy. That creates a self-fulfilling prophecy. If enough money is devoted to following a strategy it is likely to work. In this case, if enough people (and remember that “the machines” are programmed by people) find a pattern that works consistently, it will keep working. A positive feedback loop can develop.
But here’s the problem. Patterns change, especially if they are challenged by fundamentals. Risk-off/risk-on is indeed rooted in fundamentals. But I will assert that rising bond yields are now part of a very different type of risk aversion. Bonds are falling because fixed-income investors are nervous about inflation, a faster pace of Federal Reserve rate hikes, and the likelihood that the Fed will need to shrink its balance sheet. None of these are beneficial to stock prices.
In theory, rising rates should be taken as a negative by equity investors. Indeed, if they persist that could very well be the case, especially if the Fed actually takes steps to reduce its balance sheet. (Even though they have stopped buying bonds, the balance sheet has been steadily growing nonetheless).
Over time, fundamentals usually prevail. The feedback loop can certainly prevail over the short- or intermediate-term. Yet it has been my experience that the market’s mood will change, sometimes unpredictably. I can recall times when the key “lead” has been the yen, oil, gold, and pretty much every globally tradeable item. Then the market’s attention moves onto something else. The “risk-on/risk-off” paradigm has been in place for a few weeks, even if it has unknowingly morphed into “risk-off/risk-off”. Traders might as well enjoy it for as long as it lasts.
This post first appeared on March 24th 2022 on the Traders’ Insight Blog.
PHOTO CREDIT: https://www.shutterstock.com/g/photocreo
Via SHUTTERSTOCK
DISCLOSURE
Investing involves risk, including the possible loss of principal. Diversification does not ensure a profit nor guarantee against a loss.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information is not intended to be individual or personalized investment or tax advice and should not be used for trading purposes. Please consult a financial advisor or tax professional for more information regarding your investment and/or tax situation.
