People at r/wsb liked my explanation and found it helpful, I figured I'd share the knowledge and whore up the karma over here. This is not a perfect explanation and I typed it all at like 2am last night so there may be minor errors.
TL;DR:
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The market is beholden to central banks due to years of QE
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The Stock/Bond return correlation is important to watch
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Diversification between stocks and bonds only works when this correlation is negative.
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If bonds selloff too quickly, the return correlation can flip positive..
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When this happens equities selloff along side bonds.
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Friday's jobs report showed higher than expected signs of inflation.
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If inflation spikes, the Fed will tighten monetary policy faster than previously expected.
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In anticipation of such a move, the market fell.
Now the entire “Goldilocks” environment that we have in the current economic climate hinges upon central banks (namely the US Federal Reserve) normalizing policy slowly and carefully. Why? [Because central banks have injected nearly $20 trillion dollars into global financial markets since 2009 and such a rising tide has lifted all boats. What happens when global QE is done and we start to see QT? We don't know because its never occurred on this scale before. Also worth mentioning is that the Fed will be the first to pull out later this year. (You can read more about that here:.
But don't just take my word for it, here's an exerpt from a BofAML note:
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"In 2017, multi-asset portfolios continued to benefit from equity/bond diversification. Low equity/bond correlation alongside record low cross-asset volatility is driving the vol of equity/bond risk parity portfolios to its lowest levels since the 1960s. Other multi-asset portfolios holding a mixture of equities and bonds have likely also seen extremely low volatility recently. However, a disorderly rise in yields that accompanies an equity market pullback (i.e., 2013 Taper Tantrum) could be a surprise for many investors who have become conditioned to the recent environment in which bonds and equities diversify one another.
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"The correlation of rate-sensitive assets to US rates is at record highs as investors fail to care about outside risks, leaving markets increasingly dependent on US policy. Coupled with rates vol near lifetime-lows - on few expectations for policy disruption - this has helped suppress global cross-asset vol. However, with the Fed appearing to soldier-on towards policy normalization, persistently low rates vol may be at risk. This in turn creates risks for a market slaved to rates."
The Fed began tightening 2 years ago but very slowly. As long as inflation remains subdued then they can’t yank away the punch bowl too quickly. But,on Friday morning we had a jobs report that had very positive average hourly earnings gains leading to worries about a marked uptick in wage pressures. Wage pressures are one of the key areas that we have not seen inflation in years. If inflation spikes unexpectedly and the Fed is caught with its pants down behind the curve, they will be forced to tighten monetary policy at a faster pace. This is a negative for risk assets.
The other piece of the puzzle is the bond market.
Stocks and bonds tend to move inversely to one another as the former is riskier than the later. If you're a diversified investor with both stocks and bonds, you're doing that because if one market suffers the other ought to soften the blow to your portfolio. In a general sense think of bonds as safe investments and stocks as risky. There is a lot more to it but thats the general idea. When investors are bullish on the future and "risk-on" is alive, you would expect to see flows out of bonds and into stocks. (Like we did immediately post-2016 election).
So starting with this chart from goldman, (which is almost a year old but serves to illustrate my point), you can see how stocks and bonds tend to behave relative to one another over time.
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The top left quadrant shows how a diversified 60% equities/40% bonds portfolio has performed over the long term. This is showing us in the dark blue spikes above the 0-line that such a portfolio has performed very well, better than the long term average (which is the horizontal light blue line).
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Next look at the bottom right quadrant, which shows us the equity/bond return correlation shaded in dark blue. Now as you can see, aside from a few short instances, the correlation between equity and bond returns has been negative since 2000. This means that since 2000 bonds have almost always rallied when equities have sold off..Thus, diversified investors have been sheltered from losses as their bond holdings were intended to do.
However when that return correlation flips positive, as it has many times in history, the two asset classes may sell off together and such a diversified portfolio may not help staunch the bleeding.
Now as bond prices and yields more inversely, most people will reference the US 10-yr Treasury bond yield as a benchmark or a thermometer of sorts. Rising bond yields can be a good thing, as it means investors are selling bonds and (hopefully) moving into equities or riskier investments. BUT, there a point at which a bond market selloff moves too quickly, yields spike faster than expected, and investors interpret that as a panic signal.
So last week we saw bonds sell off dramatically, causing yields to spike above the comfort levels of many investors. This combined with the jobs report:
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WSJ: "The Labor Department reported Friday that average hourly earnings for private-sector workers rose 2.9% in January from a year earlier, their largest year-over-year increase since June 2009, when the last recession ended."
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And heres the jobs report itself.
(and likely the political theater of today) spooked the market.
Will it continue? Your guess is as good as mine but I think that "BTFD" will be muted next week due to the fervor of last week's volatility spike inverting the VIX curve.
Submitted February 04, 2018 at 05:50PM by Bulletproof_Haas http://ift.tt/2s61qAn
