This must be one of the longest 3 months for many fellow investors. It is not that often that we get to witness such spectacular movements from the markets. In just a short span of 16 trading days, S&P 500 went from a high of 3386 in February 2020 to a low of 2480 March 2020. To put it more bluntly, S&P 500 crash 26% and went into the bear territory. This wiped out what S&P 500 made in 2019, one of its best years, in just a little over 3 weeks. The speed is astounding.
It is not the first time I have seen this though. Back in 2008, the collapse of Lehman Brothers in 2008 saw S&P 500 tumbled more than 20% over 7 days. I was a junior analyst looking at quantitative hedge funds and strategies in the asset management industry then. And I still recalled a colleague telling me Citigroup was a no-brainer steal when it was trading at around 30 bucks shortly after. And about a month later, it plunged further and at one point in time, traded briefly below a dollar. Well, that was an exceptional period of tremendous stress in the market. FYI, I did not buy into Citigroup. Individual stock picking is not my cup of tea.
Then you have October 1987, Black Monday, which sees Dow Jones falling more than 20% in a single day. I am glad I was still a school kid then. While our current situation has yet to degenerate into another Great Financial Crisis (GFC), it does have a few anomalies going on warrant some attention. These tend to slip through the eyes of most people who are fixated on stocks and busy blaming the virus for their losses.
Bond Markets are behaving erratically
Some of you might have noticed. The US Treasuries are deviating from its usual behaviour. In extreme time of crisis, good quality safe haven assets such as sovereign bonds tend to rally as money flows in, particularly, US Treasuries. But in recent days, it came under heavy selling pressure despite extreme volatility and bearish sentiments in the stock markets. Here is a chart showing how TLT ETF (US 20-year Treasury Bonds) moved in tandem with the stock market when they should not be correlated.
People who don’t look at bonds might not even be aware and understand what this can mean for the broader market. Every asset class is intricately connected within the financial markets. A persistent and worsening dislocation in any major asset class spells trouble if the issue is not arrested. This is especially so when we are talking about bonds, the “Mother” of all asset classes. Because they are the bedrock of global liquidity or funding.
The 2008 GFC was a crisis of liquidity triggered by defaults across subprime mortgages which brought to surface a host of underlying issues plaguing the system: ultra loose lending, financial engineering that turned a pool of junk loans into products (CDOs, CLOs) with investment grade tranches masking the real risk to lots of investors, over reliance on rating agencies, failings in the mark to model approach, collaterals other than Treasuries turned “worthless”, off balance sheet accounting ……
As the fallout deepened, there were massive write downs. Lending froze. Creditors rushed for their money. And for those in distress, good luck unless you were too big to fail. Without means of financing upcoming obligations, businesses ran into cashflow issues and were forced to shut its doors. Lehman Brothers was one example.
So are we experiencing the same thing today? I don’t think so. At least not yet. Then what is driving the Treasury Bonds prices down?
Since the GFC, the rounds of global quantitative easing and low interest rates means credit has never been cheaper. With diminishing strategy specific profits (or alphas) and ultra-low volatility, funds and institutions are probably incentivised to take on leverage to amplify the returns as long as they maintain within their target volatility. And in times of exceptional uncertainties and volatility such as this period, many will start unwinding positions across their portfolio be it stocks, bonds, credit, commodities or real estate.
Profit Taking and Selling To Meet Obligations
Since the start of the year, Treasuries enjoyed a good run and an exponential one prior to its drop. And even after the dramatic tanking in the past week, it is still sitting on some decent profits year-to-date. So amidst this tough period, it is not inconceivable for players to take profits off the table to meet other obligations. A common thing that always happen during such episodes are fund redemptions. When fear gripped investors, many asked for their money back. This causes funds to unwind their positions and when the outflow is huge, this exacerbates the sell offs in the markets which in turn leads to more fear and more request for redemptions and further sell offs. It is a vicious cycle.
As of this writing, the first hedge fund casualty has emerged. Solus Alternative Asset Management, a billion-dollar distressed investing hedge fund, is shutting its flagship fund due to unprecedented withdrawal request.
Liquidity Issues Is Falling In The World Most Liquid Market – US Treasuries
The US$15 trillion Treasury markets seems to be rattled by the current volatility and is experiencing liquidity issues. Under calm markets, the less liquid and older issues of Treasuries (off-the-run) tend to trade at a slight discount to newer issues (on-the-run) with identical terms and maturities that are close to one another. Usually, traders capitalize on these pricing differences to make a profit by buying the former and shorting the other, thereby keeping such deviations to a minimal. But in more recent times, the pricing has diverged with the off-the-run issues (off-the-run treasuries are all Treasury bonds and notes issued before the most recently issued bond or note of a particular maturity) and yields have ramped up. That might in part be exacerbated by the unwinding of positions in these relative value trades and a lack of ready buyers for their off-the-run bonds.
Way Too Big To Fail
US Treasuries is the cornerstone in the funding market and the de-facto safe haven for a long time. It is equated as cash and regarded as the most credit-worthy collaterals in the market. Many huge players including banks, funds, pensions and other sovereign institutions hold a sizable amount of US Treasuries. So an illiquid market and sharply falling prices can have serious repercussions globally. This can drive up financing cost considerably and undermine central banks efforts to keep borrowing costs low. And precisely because of its size and implications, it is way too big to fail.
The US Federal Reserve have already stepped in at this point in time to provide liquidity to the Treasury Market. In fact, they have done so last year by purchasing short term T-Bills and injecting cash into the overnight lending markets when cracks appear in the short-term funding scene. And recently, they announced more measures for pumping liquidity including the purchase of $80 billion dollars in bonds across different maturities over the month. That might take some pressure off the lack of liquidity in the off the run Treasuries.
Why is this a Concern for Me?
Will this stem the tide of falling bond prices and restore calm to the Treasury markets? I have no answer. I don’t think even a fixed income expert would have one. What’s more, I am not one. My interest in this arose because I run a Risk Parity portfolio that holds a sizeable allocation to bonds at this point in time and was recently hit by the selloffs. But I am sure the world is not ready to let a thing of such magnitude fail yet. Better to deal with a stock centric crisis than another ugly financial crisis.
Having said that, the Risk Parity portfolio was still doing relatively better than the stock markets and spared much of the carnage. As of 12 March after the latest stock market bloodbath, the portfolio is down 3.5% year to date. In comparison, the S&P 500 was nursing a loss of 23%. If history is any indication, this will probably be just be one of the many crises to add to the list it has weathered.
- Masters of Science in Financial Engineering, NTU
- Masters (by research) in Engineering, NUS
- Bachelor of Electrical Engineering (1st Class) from NUS with Minor in Business, NUS
Eng Guan is a portfolio manager of a systematic hedge fund. He has extensive experience, having spent more than a decade in the asset management and banking industry working through various roles since 2006. These include performing investment due diligence on hedge funds, valuation control on derivative and structured products, proprietary trading and fund management.
Prior to all these, he started out his first career in the civil service in 2002. But it was also during this time that he developed a keen interest in the financial markets. This prompted him to make a mid-career switch and his decision vastly open up his horizon on the investment landscape. There was so much more beyond just picking stocks, reading analyst reports or financial statements. An engineer by academic background, he always had a strong passion and interest for models and systems. That naturally led him to pursue the systematic or data driven approach towards investing.