The Janet Yellen Fed and the free money party has ended. But as with any great party, someone must clean up, and that clean up can be very messy. We got a glimpse over the last few weeks as to what that might look like as the stock market gyrated wildly. On February 5th, the Dow went into a free fall with the Dow plunging 1,600 points, easily the biggest one-day decline in history. While the market managed to recover part of its loses by the close it was still down -4.6%, the largest one-day loss since 2011.
I believe we are quickly entering a period of sustained higher two-way volatility. Volatility collapsed after 2008 as central banks manipulated interest rates to near zero in the US and $20 Trillion in negative rate bonds were bought worldwide. According to legendary bond trader Paul Tudor Jones, “That game is over! With inflation pressures building, we will look on this low-volatility period as a five standard deviation event that won’t be repeated.”
Tudor Jones believes that the confluence of three major events is about to crash the bond market and that could create real problems for an overstretched and overvalued stock market (source: interview with Allison Nathan, Goldman Sachs 3/2018). First, between now and the second quarter of 2019 we will see a huge flow of funds imbalance as demand is overwhelmed by supply. The Fed intends to stop buying bonds at the very time the US Treasury will issue more bonds to fund a growing budget deficit. Who is going to buy our bonds? Japan and China, the two largest holders of our debt, have been decreasing their holding of US bonds over the last quarter.
Second, we have passed a substantive tax cut and a spending bill which combined could create a budget deficit of 5% of GDP. Historically that is unprecedented in peacetime out side of a recession. Clearly, we are not in a recession. Quite the opposite, as the economy seems to be firing on all cylinders.
Finally, “bond valuations are at the highest level they have ever been by virtually any metric. They are overvalued and over owned” Tudor Jones believes these events together set the stage for rapidly increasing inflation and financial instability.
Jerome Powell, the new Fed Chief, will have his work cut out for him. Remember that in addition to factors mentioned above, corporate credit fueled by ultra-low rates is larger than ever relative to the economy and individuals currently have a record low personal savings rate. In other words, everyone is “all in”. The Fed is now faced with trying to undo its massively larger-than-it-should-have-been QE experiment. If you believe, as I do, that QE was responsible for the inflation of asset classes across the board, then shouldn’t we expect that “Quantitative Tightening” will have the opposite effect?
Now is the time to de-risk your portfolio. I continue to recommend that you stay long growth assets. It’s not over till it’s over and an inflationary cycle would be beneficial to securities, at least initially. But the risks are high, and hope is not a strategy. Diversifying into another asset class that is moving up and down in lock step with securities will not accomplish anything. I would recommend the addition of a diversified managed futures program. Since 1980, with one exception, when the S&P 500 has had a down year, the BarclayHedge CTA Index has had an up year (source:BarclayHedge 2018). That is risk diversification.
The content of this article is based upon the research and opinions of Tom Reavis.