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Why is everything dropping? 

market crash short

  • The 60/40 portfolio management theory has come under pressure as both stocks and bonds have been hammered in the wake of the U.S. Federal Reserve’s 50-basis-point rate hike and there appears to be no end in sight for swift market downturn.
  • As bond yields soar, investors are disincentivized to take risks by buying stocks, leading to a self-fulfilling negative feedback spiral that is seeing stocks and bonds plummet back to earth.

The typical 60/40 stock and bond portfolio was intended to be the “free lunch” of investing.

According to the 60/40 portfolio management theory, because bonds and stocks are supposed to move in opposite directions to each other (negatively correlated), a portfolio that contains both assets ought to be less volatile.

But that theory has come under pressure as both stocks and bonds have been hammered in the wake of the U.S. Federal Reserve’s 50-basis-point rate hike and there appears to be no end in sight for swift market downturn.

Last week, stocks and bonds rallied momentarily when the Fed promised no jumbo-sized rate hikes, before that brief window provided an opportunity for investors to exit.

Since then, stocks and bonds have been in virtual freefall as rate rises against the prospect of a recession are seeing investors turn to cash (the dollar is at its highest in two decades), while no corner of the market has been spared.

But is this rout overdone?

To understand how we got here, we first have to examine what circumstances have caused a self-fulfilling feedback loop that has led to the stock-bond portfolio death spiral.

For the longest time, excess liquidity meant that there were few “safe” places to put money to work and institutional investors with relatively conservative mandates had to find places to plug their assets, one of which was corporate bonds and sovereign debt.

This kept yields on haven assets such as U.S. Treasuries very low, as more money was chasing these bonds (yields fall as bond prices rise) which pushed their prices higher.

When the risk-free rate of return from Treasuries is so low, the other excess money has to find an outlet somewhere, and that place was in all manner of risk assets, from high-yield corporate debt to unprofitable tech stocks.

But, when the Fed calls an end to the party, for instance by throttling back bond purchases and raising interest rates, demand for U.S. Treasuries reverts to the mean and yields start to rise – in recent times benchmark U.S. 10-year Treasury yields have blasted past 3%.

Even though yields are well below the rate of inflation, which in the U.S. has been 8.5%, it provides less of an incentive for investors to start hunting for yields in all the riskier places, like the stock market.

Ordinarily, as more investors pour into Treasuries, this should theoretically bring yields back to earth, enticing yet other investors back into the stock market – but these are not ordinary times because the 400-pound gorilla that is the Fed, is also no longer buying Treasuries.

And to make matters worse, the Fed is also letting its balance sheet runoff, meaning that near-term Treasuries that are expired aren’t being replaced, increasing the supply of Treasuries in the market.

Recent changes to banking regulation has also meant that financial institutions, which could typically be counted on to soak up the excess government bonds, no longer have the capacity to act as buyers of last resort for Treasuries, because of stricter capital reserve requirements.

As bond yields soar, investors are disincentivized to take risks by buying stocks, leading to a self-fulfilling negative feedback spiral that is seeing stocks and bonds plummet back to earth.

And that, is why everything is dropping.

 

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