The sharp drop in longer-term U.S. Treasury yields, seen in recent sessions and again Thursday, has sparked risk aversion in other asset classes, with the dollar tumbling versus most majors, and commodity and stock prices falling.
Traders saw financial markets as being driven largely by the moves in fixed income, especially the persistent demand for U.S. Treasuries, seen even with yields nearly back at the lowest levels seen since Oct 30, 2013, when 10-year yields bottomed around 2.473%.
That U.S. yields could not press higher on upbeat data sets in prior sessions, and today did not firm on weekly jobless claims and CPI, suggested something is at work, but what? traders asked.
“Yields are driving the boat,” one trader said. The thinking is, “What do they (in fixed income) know that we don’t know?” he said.
In terms of overall bond demand, it was a perfect storm with UK bond yields moving lower in the wake of the Bank of England’s release of its Quarterly Inflation Report Wednesday, which did not move UK rate hike expectations forward as expected, and euro zone yields moving lower on disappointing Q1 euro zone GDP data as well as European Central Bank easing expectations.
The negative spillover from fixed income was evident in stocks, commodities and FX, traders said.
Credit Suisse strategists observed U.S. Treasuries continued to “react perversely to economic data, with yields breaking lower out of their range despite a significant upward surprise in PPI inflation.”
There was a similar lack of reaction to Thursday’s release of CPI and weekly jobless claims.
“Typically, this type of behavior signals a market in some advanced stage of distress,” they said in a research note.
In currencies, “the highest rolling correlations with U.S. yields over the last three months have been (in descending order) USDJPY, USDCHF, USDNOK and USDEUR,” they reminded.
In emerging markets, Credit Suisse maintained that the yield move argued in favor of further gains in high yield currencies.
The recent emergence of official resistance to currency strength, i.e. FX intervention and jawboning, “suggests an extension of carry strategies will need to be more selective,” they said.
On the day, traders reported that some accounts were covering euro shorts versus emerging markets and other higher yielders, such as Aussie and kiwi.
The dollar came under pressure as 10-year yields dipped below 2.50% for the first time since late October.
Dollar-yen and dollar-Swiss were especially weighed Thursday, with yen and Swiss in demand as safe-havens. Dollar-yen held at Y101.48 and dollar-Swiss at Chf0.8899, on the low side of their respective ranges of Y101.32 to Y102.12 and Chf0.8883 to Chf0.8960.
In stocks, the S&P 500 was down 1.05% at 1,869. While down from the new life-time high of 1,902.17, seen May 13, the index remained above last week’s low of 1,859.79.
In commodities, gold and oil sold off despite an overall weaker dollar.
Spot gold held at $1294.50 and NYMEX June light sweet crude at $101.54 per barrel, down from earlier highs at $1307.26 and $102.26.
The BOA Merrill Lynch monthly fund managers survey, taken May 1-8 and released Tuesday, offered insight in terms of how much more pain may be in store for bond market bears.
The survey found that a net 55% of portfolio managers were underweight bonds in May, unchanged from April and compared to a net 53% underweight in March and a net 62% underweight in January.
As a reminder, 10-year Treasury yields topped out around 3.0% in early January before ending the month near 2.6675%.
Last September, when the market was thinking that the Federal Reserve might announce a tapering of asset purchases, asset allocation to bonds was a net 68% underweight, the lowest level since April 2006.
As a point of comparison, in March 2009, when the S&P 500 bottomed at 666.79 (March 6, 2009), the BOAML March 2009 survey showed that net 26% of those polled were overweight bonds.
In terms of risk aversion however, highly-watched indicators suggested only a modicum of unease.
The CBOE’s volatility index or VIX stood at 13.41 Thursday afternoon, in the middle of a 12.72 to 13.77 range.
Only Monday, the VIX posted a low of 11.88, and was nearly back at the 2014 low of 11.81, seen January 15.
The VIX topped out at 17.85 April ahead of the Easter holidays and at 18.22 in March, ahead of the Crimean Referendum, but remained in sub-20, risk friendly territory.
The index posted a 2014 high of 21.48 on February 3, at the peak of concerns about Fed tapering and rising U.S. yields.
As another barometer of risk, the Cleveland Federal Reserve’s Financial Stress Indicator, which is released daily at 3:00 pm ET with a one-day lag, showed no sign of risk aversion, with the CFSI in Grade 2 or a “normal stress period.”
The latest CFSI, as per Wednesday, May 13, showed the index at -0.449365311, i.e. within Grade 2 or “normal stress,” which requires a CFSI level greater than -0.733 and less than 0.544.
For much of Q1, the CFSI had a daily reading less than -0.733, which is Grade 1, or a “low stress period.”
In early January, the CFSI posted readings that were -2.0 and below, record low levels. The record low reading was -2.098186497, seen Jan. 9, which was the lowest amount of stress in the market ever in the history of the survey, tracked since Sept. 25, 1991.
Current readings are a bit more risk friendly than the “normal stress” levels of -0.336073907, seen Oct. 8, 2013 at the height of jitters about the government shutdown and debt ceiling.
The CFSI assesses 16 variables in six major types of financial markets (credit, equity, foreign exchange, funding, real estate and securitizations). The more positive the number, the greater the risk aversion and vice versa.
The Cleveland Fed has stressed that the values noted are not percentages, but rather “z-scores” or standard deviations. The various grade thresholds (Grades 1-4, from low stress to significant stress) are dynamic and do recalibrate, although they move very slowly.