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Contagion Risk Highest Since 2012 As Fed Raises Rates And “Unwinds” $4.4 Trillion Balance Sheet

This is a syndicated repost courtesy of Snakehole Lounge- Online Course Notes for Financial Markets. To view original, click here. Reposted with permission.

Deutsche Bank AG strategist Binky Chadha (a disturbing name since my Basset Hound’s name was  Binky) thinks that Contagion Risk (correlation among asset classes) is bad news.

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(Bloomberg) The concerted selloff that landed on stocks and bonds this week may be a taste of what’s to come for financial markets.

That’s the warning in new research from Deutsche Bank AG strategist Binky Chadha, which found everything from equities to bonds, oil and currencies are moving in unison to a degree rarely seen during this market cycle.

The tight relationships reflect a theme that traders are increasingly embracing: accelerating growth in the global economy. But there’s a related danger: that pain in one asset will spread quickly to another. Consider Tuesday, when a rise in Treasury yields sent stocks reeling while oil and the dollar also fell. Investors had nowhere to hide.

The coordinated retreat eased Wednesday, but Chadha says the risk remains elevated. A measure that tracks the average three-month correlation between the S&P 500, 10-year Treasury yields, the euro and oil has risen to 90 percent, a level reached only twice before, according to Deutsche Bank data that goes back to 2004.

 “A pullback in one for idiosyncratic reasons would likely spill over to the others,” Chadha wrote in a Wednesday note.

Momentum is accelerating in so-called reflation trade, where risky assets such as stocks and commodities rally and havens like the U.S. dollar and sovereign bonds lose favor. The S&P 500 just finished January up 5.6 percent in the best start to a year since 1997, while oil surged past $65 a barrel, hovering near a three-year high. Meanwhile, Treasuries posted their worst return in more than a year and the dollar fell in 10 out of the past 13 months against a basket of currencies.

As investors all chase the same trade, consensus is building that almost everything is stretched by historic standards. Net long positions in oil have more than tripled since June, driven by a falling dollar and a pickup in global demand. Fund exposure is now about 2.8 standard deviation above average.

Other assets are also showing similarly extreme readings:

  • Long euro is about 1.7 standard deviation above history while short yen is 1.4 standard deviation away
  • In U.S. equities, mutual fund exposure rose to a six-year high while short interst in stocks and ETFs fell to the lowest level since 2007
  • Bearish bets in rates are back at all-time extremes, reached since the 2016 presidential election

So extended is the positioning that an unwind could occur even without a fundamental catalyst triggering a domino effect, says Chadha. To him, the dollar has “potentially the widest fundamental impact” across assets as its deprecation over the past year has helped support oil and equity prices while contributing to weak inflation that kept yields low.

But fixed income may represent the biggest risk as valuations are “completely out of line with growth” and reflect weak inflation, he said. Yields on 10-year Treasuries should be 80 basis points higher based on the current level of manufacturing ISM.

A faster-than-expected pickup in inflation is “likely to be interpreted as a sign of the economy overheating and the Fed embarking on hiking until it ends the cycle, resulting in broad based risk aversion,” Chadha wrote.

To add to Binky’s analysis, part of the “Contagion” story is that The Fed, that kept interest rates near zero since 2008 but is finally raising rates again. Did The Fed CAUSE Contagion (of course it did) … and now it is unwinding the contagion.


Binky the Basset Hound (RIP).


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