If Safe Assets are Getting Clobbered, Risk Assets Don’t Stand a Chance

By:

Chief Strategist at Interactive Brokers

By now I assume you’ve seen, if not experienced the carnage in the markets today.  I won’t belabor the specifics too much, with 2-3% drops in major US indices and double-digit percentage declines in cryptocurrencies leading the headlines.  Yet in my opinion, this chart offers the best explanation for the selloff that there is:

Two-Year US Treasury Note Yields, One Month Range, 30 Minute Bars

Two-Year US Treasury Note Yields, One Month Range, 30 Minute Bars

Source: Bloomberg

It is quite astounding to see how dramatically perceptions have changed about short term rates since the CPI number was released on Friday morning.  A 40 basis point rise in 2-year note rates in less than two trading sessions is quite frankly staggering.  Bear in mind that this comes after a significant rise in this rate throughout 2022, as shown below:

Two-Year US Treasury Note Yields, Year-to-Date

Two-Year US Treasury Note Yields, Year-to-Date

Source: Bloomberg

If a relatively low-risk asset like 2-year notes is getting clobbered, what chance do risky assets have?  I wish that was a rhetorical question, but it is important to remember that risk-free rates are utilized in nearly every asset pricing model.  If you think of current stock prices as the present value of a company’s future cash flows – which I do – then those future values are diminished.   Investors are being forced to reevaluate their holdings.  That is a difficult process under any circumstances, and incredibly so when a drastic reevaluation must occur in a very short period of time.  The recent selloff in stocks is a direct result of investors reassessing the prospects for companies’ flows in the face of rising rates, inflation, diminishing consumer confidence, and investors’ diminished tolerance for risk.

If equities are getting tossed because of diminished risk tolerance, what hope do cryptocurrencies have?  Looking at the price movement in cryptos large and small today and over the weekend, it is clear that many crypto holders decided to de-risk in a hurry.  More ominously, the Celsius network froze all withdrawals and transfers, while Binance froze bitcoin withdrawals.  Actions like this have all the characteristics of a run on the bank – except that these are not banks, but rather unregulated, decentralized financial institutions that act an awful lot like banks anyway.  There is no FDIC or SIPC for crypto institutions.  Those arose after bank runs and failures during the Great Depression.  For all the futurism that underlies cryptocurrencies and decentralized finance, human behavior is rooted in millennia of psychological biases.  The banking system eventually developed a regulatory framework and safety nets to protect its customers – we’ll see if the crypto industry comes around to that idea.

If we’re looking for silver linings, well, there aren’t many.  One of course is that stocks are on sale, and there are some that are getting unfairly punished.  Those aren’t easy to find of course, especially when the best way to do that is to use the type of modeling that is under pressure right now.  But we’ve recently asserted that we all must think like value investors now.   That means that we can look to buy dips – not reflexively, of course – but when stocks with solid earnings and cash flows appear to be trading at or below fair value. 

Another silver lining is that we have, at least for now, a day when declining stocks outnumber advancing stocks by more than 10:1.  That ratio is often used as a signal for capitulation.   I would feel better about calling for capitulation if VIX were rising even more sharply than it is today.  It is around 33 as I write this, which is high, but not panicky.  We have stated numerous times that VIX levels in the mid-30’s with only modest inversion of the VIX futures curve is not sufficient for us to declare that we have seen a lasting market bottom.   While I stand by that assertion, it is quite possible that we might see a trading bounce if the current wave of selling abates – and until or unless we see short-term Treasury rates stabilize.

In the meantime, please stay nimble and watch your risk tolerance.  We have an FOMC meeting on Wednesday and a quarterly expiration on Friday.  Either of those can roil markets, and coming together in an already rocky environment can keep things volatile.  We’ll be talking more about both of these this week.  Stay tuned and stay safe.

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