Aesop’s fable of The Boy Who Cried Wolf is an ancient Greek story dating back to 620 BC. The tale involves a lonely shepherd boy who was looking for excitement. The boy concocted a plan to generate excitement by running down the hill and crying out “wolf, wolf.” Upon hearing the boy’s cries the local villagers ran to his rescue only to find out there was no wolf. The boy was so pleased with his first attempt that he replicated the trick with the same outcome. On the third attempt he cried out “wolf, wolf,” still louder than before, but this time the villagers, who had been fooled twice before, did not respond.
The wolf made a meal of the boy’s flock when no one came to the rescue. The repeated false alarms had conditioned the villagers to ignore Peter’s cries even when there really was a wolf. Looking at the markets over the last two weeks, the Federal Open Market Committee’s attempt to end its quantitative easing has resulted in a similar set of behaviors from investors. Last week both equities and high-yield bonds plunged, due in part to the pending end of QE3, only to rebound this week as investors’ demand for risk pushed asset prices higher.
The FOMC’s response last week effectively showed that they were crying wolf in regard to their stimulus reduction. The discussion around when they would begin raising rates was quickly replaced with an orchestrated dovish response that introduced the possibility of a fourth round of quantitative easing. Investors, like the villagers, did what they have been conditioned to do, ignoring the risk and buying the dips. The last few days have seen stocks explode, with most global markets 3% to 4% higher on the week, and 10% to 13% higher vs. last week’s lows. Volatility remained elevated this week as the VIX closed at 16.25 on Friday, but well off last week’s highs at 31, which was the highest reading since December 2011.
On the economic front, the global PMI data was generally better than anticipated. The Chinese (50.4 vs. 50.2 expected) and European (51.5 vs. 51.2 expected) reports both beat consensus, while the U.S. release (56.2 vs. 57 expected) missed estimates. Investors focused on the positive aspects of these releases, which were generally viewed as pointing toward slow steady growth. Moving on to employment, the U.S. Initial Jobless claims report rebounded by 17,000 to 283,000 for the week ending Oct. 18 (the payroll survey period). Most economists viewed this report as having statistical issues tied to the seasonal adjustments surrounding the Columbus Day holiday, so the increase was largely ignored by investors. Lastly, the FHFA House Price Index came in at 0.5%, beating the 0.3% survey, indicating that housing remains on steady footing.
On the regulatory front, the European banks will find out the results of the Asset Quality Review tests (AQR stress tests), with the results made public on Sunday. Based on a draft of the final report, it appears that 25 of the banks will fail the test. Analysts are estimating that another 40 banks will "barely" pass the test. This means that roughly 40% of the Eurozone banks will need some form of remediation. On a positive note it appears that all of the major banks will pass the exam.
The asset-based securities purchase program will do little to resolve these issues so it is likely that the European Central Bank will implement a new program specifically targeting problem banks.
Global sovereign rates finished the week mixed. The peripheral sovereigns that were under so much pressure last week closed trading on Friday with yields that had dropped, in the case of Greece, by as much as 67 basis points. Conversely, the tier one sovereigns that had benefited from last week’s flight to quality finished trading this week with yields rising by 5 to 10 basis points. Fixed-income investors that had shed risk last week quickly repurchased that risk this week as equities rallied and credit spreads tightened. Investment-grade spreads finished the week 5 to 10 basis points tighter while high-yield spreads finished the week 70 basis points tighter vs. last week’s widest levels during the selloff.
In looking at the U.S. yield curve, the short end was the best performer as rates across the curve moved higher. The 2-year Treasury rate rose by 1.5 basis points as trading pushed levels to 0.39%; 12 basis points higher than last week’s low. Out the curve, the 10-year hit a high of 2.30%, before falling 4 basis points by mid-day Friday. With the 10-year now 40 basis points higher vs. last week’s low, we have seen longer-duration investors begin to deploy cash. Most of the demand across account types was focused on notes with durations of 10 years or shorter as risk-focused accounts sought a balance between yield and duration.
Last week I had noted that technically the 30-year was extremely oversold and likely to push higher, into the 3.05% to 3.10% range. Trading this week hit a high of 3.07% before pushing lower by 4 basis points in Friday’s close. In looking at the 30-year we have retraced 50% of the move from the Sept. 19 highs to the Oct. 15 lows. If the bulls are going to regain control of the market it should occur in this area (3.03% to 3.10%). Price volatility on the 30-year has dropped, which indicates that we are in a more "range"-like environment and are likely to see rates move both higher and lower within a range of 10 basis points off of Friday’s closing level of 3.03%.
The curve finished Friday with mixed results as the front of the curve steepened while the long end was largely unchanged. The spread between 2-year and 10-year Treasuries increased by 5.1 basis points and finished the week at 187 basis points. The current steepening should find resistance in the low 190s and the longer-term trend still suggests further flattening. I would frame the range on 2s/10s at 180/205.
As we finish trading this week “risk-on” was clearly the mindset for most investors. Any dislocations tied to last week were all but completely forgotten once the market felt that the FOMC had in fact cried “wolf” in regard to ending its stimulus.
This pattern of behavior is a global issue as almost every monetary authority responds with stimulus, or the promise of stimulus, at the earliest sign of market stress. It would be irrational for anyone, including the monetary authorities, to believe that programs designed to support asset prices would not have the opposite effect once they were removed. Peter conditioned the villagers to believe there was no genuine danger; with deep consequences. Investors are acting much like the villagers by mispricing risk and assuming that the next dose of stimulus will quell every drop in the market.
Sean Fallon, CFA, is Senior Vice President of Stephens Inc. He joined Stephens in July 2012 to head the Municipal Taxable efforts and to trade CMBS, Agency CMBS, and ABS. He has 19 years of experience managing and trading fixed income assets.
