US equities barely budged for a second day, reflecting a consensus view that the weak world economy won’t get much weaker. I’ve been calling this a coupon-clippers market, in which corporate debt should do reasonably well while equities flounder. That’s becoming the consensus view.
Fears of a significant downturn in Chinese growth have disappeared, as China’s monetary and fiscal stimulus proves effective. The consensus view now expects some improvement in China. Goldman Sachs chief economist Jan Hatzius wrote to clients on February 17:
“[I am] seeing tentative signs of a turnaround in Chinese growth […] the recent set of indicators looks more encouraging than the relentlessly negative news of prior months. Moreover, policy has shifted to a more expansionary stance, consistent with the rebound in the latest money and credit figures, and trade negotiations with the US seem to have taken a more positive turn, at least for the time being.”
The most important market signal Wednesday came not from stocks but from Treasury bonds, which sold off at the start of the New York session. Later in the morning oil moved up and the inflation component of bond yields followed, but the rise in yields clearly was led by TIPS.
Treasury Inflation-Protected Securities, or TIPS, usually respond to one of two factors. The first is the expected path of short-term interest rates as set by the Federal Reserve. The second is perception of risk. TIPS are a form of insurance against extreme economic changes. If the dollar collapses and inflation rises, TIPS pay out because they are indexed to inflation on the upside. In the case of deflation, they pay out like an ordinary Treasury bond.
During the past several months, TIPS yields have fallen as the Federal Reserve signaled easier monetary policy. As the price of one-year-forward federal funds futures rose (that is, the expected federal funds rate fell), TIPS yields fell during the past four months. But the TIPS yield also fell as the price of gold rose. Gold functions as an end-of-the-world hedge in more or less the same way as TIPS. When investors pay more for extreme-outcome hedges in the gold market, they also pay more for TIPS, and the TIPS yield falls.
That’s what happened in New York’s morning session. Gold fell and TIPs yields rose, as investors lightened up on risk hedges.
The shrinking price of hedges against extreme outcomes is also evident in the market for equity volatility. The implied volatility of options on the S&P 500 is reflected in the VIX Index, traded on the Chicago futures exchange. Chicago also trades a futures contract on VIX – an option on an option, priced according to the volatility of S&P 500 volatility. This is dubbed “VVIX.” If you really want to hedge against a violent market move, you buy options on the options.
Usually, the price of VVIX (options on S&P 500 options) trades in line with the underlying VIX volatility index. But starting at the beginning of 2019, VVIX fell much faster than VIX. That means simply that investors are less concerned about extreme outcomes and will pay less for the really high-octane hedges on the S&P 500.
Last year’s slide in equity markets followed on fears of Fed tightening and trade war. Both have receded. The economy is weak, but the risk of extreme outcomes has shrunk.