Smoldering markets...
We replicate a previous chart (subject of both a BloombergView and Barron's article) showing extreme daily moves in the U.S. stock market.
This time though, we focus on U.S. bonds and show that something
disquieting is afoot. As we approach this month's well anticipated
Federal Open Market Committee meeting, market participants are
interested in knowing what acceleration there might be going into year
end, in extreme bond volatility.
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We see some kinship with the stock market chart linked above. Namely
that during the global financial crisis, there was a dramatic uptick in
market gyrations (both up and down). At a high-level, this is where
the commonalities disappear. The two charts are otherwise probabilistically different (>90%
significance on a few nonparametric model fits) than one another. By
way of reference, seeing greater than a 0.5% daily move in the bond
markets (in either direction, and as proxied by the Vanguard total bond
market index), or seeing greater than a 2.0% daily move in the stock
market accounts for ~8% of all trading days (over 9 years or more than 2200 trading days) in each of their respective markets. Or roughly a 4%-5% tail risk - since for stocks and surprisingly not for bonds
there is actually a slight wider tail on the losing end of the
distribution versus the gaining end. Notice in the chart above, a more
balanced split between years where there are more extreme down-days
versus years where there are more extreme up-days?
Now we show the extreme moves for both assets, jointly, in the chart below. Grey for stocks, and pink for bonds. One can appreciate that in a respectable recent bulk of the 9-year history, 2010 on through 2014, the probability relationship (between extreme risk for bonds and for stocks) entirely dissolves!
We essentially have some false starts, where there is a risk surge
in one asset class but not the other (e.g., 2013). But we know that
when a catastrophe in the markets occur, as we saw on Black Monday, we only need one asset class in distress (not multiple). And when things move fast, it could be difficult to stay ahead of the loss measures. Bonds too, which at that time moved only a fraction in magnitude relative to equities are hardly a diverse shelter from the storm. Note that there were no extreme moves in bonds overall during all of July and August 2015, and only 2 extreme moves in all of 2012 (both to the downside) despite the major Greece debt downgrades inspiring global markets' havoc!
But now as we end 2015 we still notice that things are different.
Both stocks and bonds have seen a pick-up in their frequency of
extremely volatile days (in both directions). There is no certainty
that things are not destabilizing in both markets, jointly. Advanced
algorithms can detect a probabilistic cluster that includes the rise in
risk during 2007 as a similar year (along with a couple other years).
And we know what happened in the year following 2007.
Clearly this pattern of looking at higher risk in both major asset classes (bonds and stocks), leading to momentum in at least one asset class, isn't a sure thing. Nothing is, but there is a high probability relationship that tilts the odds in favor of soon having a bout of extreme risk (correlation of 0.5). The analogy is as if you notice an ember smoldering in a combustible forest you might be only somewhat cautious, perhaps even rationalizing it away. But if then you notice a second ember smoking up...
Copyright © Salil Mehta, Statistical Ideas
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