By Michael McKenna
We were on the Copenhagen Metro, swinging around into Kongens Nytorv station at speed and I really should have been holding the handrail. Instead, however, I was holding my smartphone, on whose screen was displayed today's SHCOMP chart
As the train jerked around the bend, I stumbled a little, bumping into the passenger behind me and quickly apologising. His reply, after looking toward my screen?
"Where are we at?".
So where are we at? Well, Shanghai is down another 7.65%, the Nikkei is down 3.96% (after opening flat and holding on to that level for 18 whole minutes), and the market consensus on a September rate hike from the US Federal Reserve is down at 26%.
As Saxo trader Tareck Horchani told us from Singapore this morning, "it's going to take more than one day for this market to recover".
On the other hand, however, we are seeing a few signs of normalcy as well. Saxo Bank FX Options trader Kresten Bechmann, for instance, tells us that volatilities have sold off significantly from yesterday's dizzying heights. In London, trader James Doxford said earlier this morning that European bourses were ready to open higher and as of press time they were doing exactly that, with the FTSE and the DAX pushing towards 2% and 3% gains respectively.
It is important to remember, after all the hair-tearing and rending of garments in the financial press, that market corrections are normal
. Equity market corrections, in fact, are desirable
, and as the New Yorker's John Cassidy pointed out yesterday evening, "there was a surfeit of proximate causes
" for yesterday's equities rout.
This is doubtlessly the narrative pushing indices higher this morning, this sort of "there, there, it's not so bad"-style method of getting over a traumatic Monday. It was just a correction. It was just a shadow, a cat, a weather balloon.
But what if it wasn't?
Gold, bonds, powder
"The reaction we saw in bond markets yesterday was not normal," says Saxo Bank head of fixed income trading Simon Fasdal. "Ordinarily, we see bonds working as an 'airbag' in the event of an equities crash, but this didn't happen yesterday."
What happened instead was that the equities selloff – and the consequent outbreak of risk-off sentiment – was not, in fact, met with normal panic buying of low-risk assets. In fact, says Saxo Bank commodities head Ole Hansen, not even gold could pull the buy orders from stock-spooked investors. There was a breakdown of correlation yesterday, and a few hours where nobody seemed to want to buy anything.
A correction is ultimately an immune response, and thus a sign of life. This appears to be something different.
"Negative correlation such as that which exists between bunds and other high-rated bonds
and equities is vital for balanced portfolios and pension funds", says Fasdal, adding that "when this turns positive, and all asset classes sell off, the resulting risk figures give fund managers a huge problem".
Essentially, says Fasdal, yesterday's rout was the result of a breakdown in this widely used "hedge"; when fund managers realised that the normal bond/equity correlation had flipped, their only recourse was to draw down risk by dumping risky assets... i.e., stocks.
"When you add that to the fact that many huge funds use the 'risk parity' trading strategy – a strategy that automatic sells assets as volatility kicks in and if correlation gets to high, this has a self-sustaining and probably and intensifying effect".
If this was indeed a primary factor behind yesterday's panic, then we could soon see rebounds in riskier assets, says Fasdal. So watch those indices...
The commodities complex
While yesterday's correction in equities may have been sustained by risk parity, intensified by sentiment and fanned by headline panic, underlying macro factors involving China, commodities and US economic growth/policy normalisation were its true mother's milk... and these don't appear to be going anywhere.
"We might see a rebound above $40/barrel in WTI crude" says Hansen, "but tomorrow sees the release of the US inventory report and the forecasts are for a gain... the structural glut remains in place".
As noted earlier, gold failed to run when the risk-off starting pistol was fired
and Hansen says the answer here lies with the other metals: yesterday's panic saw copper breach the psychologically important $5,000/tonne level and both platinum and silver (which have significant industrial uses and are thus tied to demand/slowdown fears) were sharply down as well.
The result, then, was a metals complex that, aided by an unwinding of the recent record short position total in gold, would not allow the yellow metal to assume its role as a safe-haven.
It don't mean a thing (if it ain't got that swing)
The oversized JPY activity, of course, relates to the strange and anomalous behaviour seen in gold and bonds yesterday, and it was this activity, rather than the headline stock crashes, that was the most interesting thing about Black Monday
"You saw risk figures giving fund managers huge problems," said Fasdal.
"You want to get out of this or that asset," said Hansen, "but where can you go except for cash?".
"Except for cash" is one of the more frightening sentences in the investing world. You picture it there, bundled into a jar perhaps, or stuffed behind a mattress. In the dark. With a shotgun pointed at the door...