In the days before radar and radio, ships could often not tell friend from foe on the high seas. So, it was common practice in the 18th century maritime world for the captain of a ship to order a “shot across the bow” to hail an unidentified ship. The protocol for the ship that was “fired upon” was to raise its “colors” or flag, which would identify its origin and often signaled its intent. If the colors belonged to an enemy, the captain of the first ship would likely order an attack–but the initial shot was essential for making an engagement legitimate.
In looking at the market this week, risk clearly fired a shot across the bow, demanding that investors show their colors. Many of the issues that were front and center this week were ones the markets had been dealing with for most of this year. However, the continuing weakness in Europe, specifically the weaker data from Germany, coupled with the uncertainty around U.S. monetary policy caused investors to shed risk. In the spirit of 18th century maritime law, investors raised their “colors,” and they were red as they shed risk and pushed prices lower.
Risk assets had one of their worst weeks of the year as global equities fell by 3 to 4 percent. Cumulatively, global stocks have lost $3.5 trillion in value since reaching record levels last month. Credit spreads finished the week wider as investment grade bonds widened by 2 basis points while high-yield spreads widened by 10 basis points. Volatility pushed up, breeching recent highs, as the VIX had a reading of 22. For perspective, this was the highest reading since December 2012 and clearly speaks to the magnitude of the move this week. As I have discussed for the last several months, risk and the rules of the market are changing, and this week saw one of the largest reactions around these variables.
One of the drivers behind this week's flight to quality was the ongoing concern around European growth. For much of the last two years Germany has been the economic engine of the region. However, this week a series of data points raised concerns that Germany could be sliding into a recession. Exports fell by 5.8% (expectations were a drop of 4.0%) and factory orders fell by 5.7% (expectations were a drop of 2.5%). The actual figures mark the largest drops in the data in 5 years. Investors are very worried that a German recession will not only exacerbate the economic malaise in Europe, but could also add to the deflationary pressures plaguing the region. The tepid response from European Central Bank President Mario Draghi regarding stimulus and the potential for additional measures did little to assuage investors’ concerns about growth, as investors quickly pushed both European equities and bond yields lower.
Global sovereign rates benefited from the flight to quality as most markets saw rates fall. The 10-year British Gilt was the best performer among the tier-one sovereigns as rates fell by 14 basis points. The 10-year German Bunds rallied by 2 basis points, hitting an all-time low of 0.86%. The spread between Bunds and Treasuries finished the week at 142 basis points as the spread narrowed by 11 basis points. As we had discussed, the relative attractiveness of U.S. rates compared to other sovereigns is clearly playing out. Over the last three weeks U.S. 10-year rates have fallen by 30 basis points while most other sovereigns have seen their 10-year rates drop by 20 basis points or less.
In looking at the U.S. yield curve, the belly was the best performer of the week. The 5-year Treasury rate fell by 16 basis points as trading pushed levels to 1.50% before pulling back to 1.57% on Friday. Out the curve, the 10-year hit a low of 2.27%, a level last seen in June, 2013. By mid-day on Friday 10-year rates had pushed back above 2.30% on profit taking. The long bond saw its rate drop by 8 basis points as accounts grabbed for duration going into the rally. The rally over the last 3 three weeks has dropped long rates to 16-month lows as most investors were caught on the wrong side of the rally.
Technically, the 30-year yield is beginning to look oversold and the tails on the candlestick charts (indicative of a push/pull between buyers and sellers) are getting bigger. These types of readings would ordinarily argue for profit taking, but in looking at the volatility of the move the levels are still increasing, indicating profit taking might not be finished yet. Most accounts appear to be duration-neutral against their benchmarks. In framing the market the current range looks to be 3.00% to 3.20%. Once the volatility dissipates we could see rates rise, which would allow the market to adjust to the recent rate move.
The curve finished Friday with mixed results in flattening/steeping. The spread between 2-year and 10-year Treasuries dropped by 2 basis points and finished the week at 186 basis points. The path of least resistance in this relationship still suggests we will see additional flattening. I would frame the range on 2s/10s at 180/205.
With the large move in the 5-year Treasury this week the 5-year/30-year Treasury relationship is the one to watch. Right now the relationship sits at 148 bps, 8 basis points wider on the week. This relationship could see a dramatic flattening over the next several months due to the volatility of the 5-year.
Most investors will be more than happy to see the end of this week. Selling was less orderly than previous sell-offs, but the activity was still controlled. The “buy the dip” investors who have been so cavalier in recent history were clearly less aggressive and more cautious.
The market has been leaving clues–subtle though some have been–to its changing nature and now the risk is out in the open. Much like a ship captain from days of yore, investors now know the facts and must decide on how to react.
