DID THE TAIL WAG THE DOG?

That would appear to be the case of yesterday’s market tantrum. A retracement was long overdue, and markets have had a lot to think about over the last month or so. But the trigger for the previous day’s decline would appear to be the algo traders.

You see, it appears as though many of the programmes had programmed in a 3% level for 30-year bonds as a trigger when investors would switch from equity to bonds. So, when the selling became pronounced, around 2.90% and higher, the machine trading ramped up in a frenzy of selling. The numbers being produced and the movements point towards machines as the culprit.

So, we know machines started the orgy of selling.  The Vix had a bad day and much of that also had to do with the plummeting equity market and a need to hedge various ETNs and ETFs linked to the Vix. One ETN in particular (issued by Credit Suisse) lost 84% of value and in all probability will be wound up shortly. The hedging required some $37 bio of futures contracts. A massive requirement and most likely the reason why the Vix gapped the way it did.

Once again though, the movements were exaggerated by machines and there is a lesson here. When machine learning was first being used by HSBC, they would use the machines in periods of low volatility because traders would become bored and put on bad trades. When volatility jumped the machines would be turned off and the people would trade. Nothing has changed. The algorithms are the same just a little more complex.

Key data points are inputted, and key correlation numbers are inputted so that when a certain thing happens the programme either buys or sells according to what the input is. There is a problem. If everyone has a similar data point, then the trigger becomes exaggerated as all the programmes are reacting to a certain number and accordingly will sell or buy according to that data point. That way a choke point is initiated, and everything then gets messy. For the regulators and banks that use machine learning, there is a message.

Similarly, machines are now being outsourced to do credit work. All that says is that one day there will be an ugly mess. Due diligence and research is paramount to understanding credit and equities. A machine cannot sniff out a deception, but a person can. There is a subtle difference and machines can only do so much.

Enough of the previous day. What happened today. Well, after the hurdy gurdy of yesterday, today was relatively quiet. The Dow recovered most of yesterday’s losses, bonds were slightly weaker, and the Vix fell to 30. Initially, the Dow fell some 2.1% but then soared, to recover some of the previous day’s losses. The Dow is up about 2.3%, and the S&P 500 is up 1.75%.

What is more important today though is that many banks are revising their bond forecasts higher. Many banks are now looking for the U.S. 10 -year to end the year around 2.90% which is not that far from where we are currently.  Bond investors have to contemplate how investors will react to possible increases in inflation and, in the U.S. case, a significant increase in issuance and a widening deficit.

For the moment, many banks are giving the GOP +3% growth. However if growth falls, and it most likely will as rates increase, then there is a structural problem. The U.S. will have a widening deficit with inflation increasing especially if the U.S. ends up in a trade war with its Asian, and European allies and China itself. However, some of the biggest movements are expected in Europe with UBS predicting the 10-year bund to move to 1%.

Meanwhile on the bonds, we saw a little retracement. Yields backed up a couple of basis points and European bonds rallied on the day, but that rally was most likely correlated with weak equities at the time. The inverse relationship had not broken down.

Recap. 

Equities: The S&P 500 rose 1.74%. The Dow rose 2.33%. The Stoxx 600 fell 2.4%.

Currencies: The pound fell 0.05%, the euro rose 0.2%, the Bloomberg Dollar Spot Index was fell 0.1%.

Bonds: The ten-year hit 2.79%. The 2-year closed at 2.10%. The ten-year bund closed at 0.64% and the UK gilt closed at 1.52% and the OAT closed at 0.96%. The U.S. curve closed 2/10 at 68.3bp, 2/30 at 95.3 bp and the 10/30, closed at 26.8 bp. The U.S. 5-year closed at 2.53.

Commodities: Gold fell 1% and WTI fell 1.1 %. Copper fell 1.3%.

Bitcoin is trading around $7,500 after slipping below $6,100. The cryptocurrency is likely to come under more selling pressure as regulators globally start to focus on the currency.

Aussie Market Today.

Equities will have a respite today and no doubt will stage a sympathetic rally. I expect equities to recover most of yesterday’s losses. Credit should perform on the back of an improved equity market.

Bonds will be a bit soft on the day but won’t deviate too far from current levels until more information is digested. After a good day yesterday expect a little bit of a bounce.

The Aussie looks set to be weak on the day.