Volatility Picking Up, Yields Inverting As Equities Near Highs

As the world crumbles around the U.S., within the New York stock market, prices have seemed immune to events outside America. The U.K. Parliament is pushing Brexit towards a crisis by failing to agree on an exit deal. European leaders just accorded the U.K. three more months (pushing back the March 29 deadline for the U.K. to leave Europe), but it remains to be seen if this time will be sufficient to come up with a deal and avoid the “hard Brexit”. Putting Italy and other political worries aside, the European economy is taking a dire turn for the worse. Germany’s 10-year government bond yields slipped into negative territory on Friday for the first time since October 2016. The PMI survey revealed that Germany’s manufacturing sector contracted for the third consecutive month in March, with output growth nearing a six-year low. Meanwhile China exports continue to collapse (-20.7% y/y in February), industrial production (+5.3% in February) is increasing at the slowest pace since 2002, and auto sales are contracting sharply (-13.8% in February). Yet in this context, U.S. equities hit new 2019 highs and the major indexes were only a couple percent below the all-time records of 2018 before Friday’s panic selling.

Meanwhile, all quiet on the Western front this week regarding the trade war with China. U.S. Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin both plan to travel to Beijing next week for another round of negotiations with Chinese. Look for more headline-driven equity swings next week as official comment on the progress of negotiations.

The macroeconomic news this week was highlighted by the FOMC meeting on Wednesday. The Fed decided to hold interest rates steady and indicated that no more hikes will be coming this year, a sharply dovish turn from policy projections just three months earlier. Recall that the Fed members had estimated in December that two rate hikes would be appropriate in 2019 after four increases in 2018. In light of Friday’s sell-off, maybe some market participants are finally seeing that the end of rate hikes due to weakening economic conditions is not a good thing for risk assets.

Elsewhere, U.S. macro data this week did not show any more signs of economic deterioration.

  • The Philadelphia Fed business activity index rebounded in March to a seasonally adjusted reading of 13.7 from – 4.1 in the prior month. The gain reverses most of the steep 21.1-point plunge in February.


  • The leading economic index increased +0.2% in February, the first uptick since September. Even if the index is pointing to a slightly improved economy, however, it’s not signaling a big turnaround. Despite the latest results, LEI’s growth rate has slowed over the past six months, suggesting that while the economy will continue to expand in the near-term, its pace of growth could decelerate by year end.
  • Existing-home sales ran at a 5.51 million seasonally-adjusted annual rate in February, an increase of 11.8% for the month.


  • On the negative side of the data, U.S. factory orders rose a scant +0.1% in January (vs +0.4% expected), another sign pointing to slower economic growth in the first quarter. Orders for durable goods, or products meant to least at least three years, rose +0.3%. But orders for cheaper products not meant to last a long time, known as nondurable goods, sank -0.5% in January.

Market Update

The S&P 500 hit 2860 on Thursday (not far the all-time record around 2930) before pulling back Friday. Even before the equity wipe-out Friday, we saw the VIX trending higher all-week after touching a low the prior week at 12.5. The VIX soared to a high of 17.5 this Friday.

The S&P 500 broke above the November highs this past week, triggering lots of short-covering. Undoubtedly, the majority of investors saw the break-out and placed more chips on the bet of seeing the index return to alltime highs. We know that the market does whatever it takes to prove the majority wrong. Perhaps Friday’s pull-back will be the dip not to buy in this 2019 rally.


We have been most bearish on the Russell 2000, as small caps carry the highest valuations and will be most sensitive the economic slowdown unfolding. We re-shorted the Russell 2000 this week via the TZA. The trade moved quickly into the money and we’ll hold on to this one for a potential long ride down.


The Nasdaq-100, driven by Apple, came the closest of the major indexes to re-taking record highs this past week. Risk-on is still being defined by loading up on Tech stocks, whatever the price. When the market finally turns down, we’ll know it by the forced selling in Tech names.


The bond market may prove to be the best performing asset class in March. The U.S. Treasury Long Bond (TLT) held stable throughout the crazy risk-on rally in 2019. This week we got a big jump in Treasurys off the still-elevated level following the December risk-off episode.


Even more flagrant than the VIX trending up, the bond market is flashing its biggest recession sign since before the Financial Crisis. The spread between 3-month and 10-year Treasury notes has fallen below 10 basis points for the first time since 2007. The two maturities inverted Friday morning, a near-perfect sign that a recession is coming. An inverted yield curve does not mean a recession is imminent but that one is likely over the next year or so.

Below is the on-the-run U.S. Treasury curve after Friday. A picture is worth a thousand words.



While equities have been signaling risk-on, the bond market has been sending warnings. The bond market has historically been correct when diverging from the equity market. Friday’s plunge in equities may be a wakeup call. We have been heeding the warning of the bond market in our portfolios and have continued to remain in cash.

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