Wall Street whiplashes school traders on fragile modern markets

Greed has overcome fear on Wall Street – and the market disaster that has rocked the world in recent weeks may prove to be just a blip on the long-term price chart.

Yet Summer’s ways will also go down as a particularly extreme example of a trend that has shaped modern finance over the years: increasingly frequent shocks with little warning.

As quickly as volatility erupted, it quieted down, with the S&P 500 posting its biggest weekly gain since November, junk bonds posting a one-week gain and Treasury yields stabilizing. In one particularly vivid example, the VIX index, Wall Street’s “fear gauge,” just broke two records: the fastest spike of 25 points or more and the fastest rebound from a spike, according to UBS Group AG.

This reversal is a nightmare for anyone trying to intelligently combine contracts with the movement of the markets. Was the trigger for August’s confusion technical in nature, or something more sinister, like the Federal Reserve’s policy failure and fears of an impending AI bust? Whatever your view, feverish markets periodically move from euphoria to despair — and back again just as quickly — amid an interconnected herd of leveraged traders.

Indeed, the increasing frequency of fast-reversing price pulls has been an expanding wing of financial research since at least 2019, when strategists at Bank of America Corporation used the term “fragility” to describe events that have become five times more common. . last century. These include the China devaluation scare of 2015, the Volmageddon trauma of 2018 and the Covid crash.

“We’ll point to the extreme market swings over the past two weeks as the latest example of how markets have naturally become more fragile over the past 15 years,” said Nitin Saxena, head of US equity derivatives research at BofA. “The speed with which the shock dissipated only adds to our certainty, as fast-mean reversions are hallmarks of fragility shocks due to their technical nature. A more fundamental shock will have more staying power.”

Past blowups have included crowded trading and dicey liquidity, both of which were in evidence in 2024, when a handful of artificial-intelligence-fueled super stocks dominated index returns and left a large chunk of the equity universe. The fragility became apparent when swift unwinding in popular positions, including yen carry trades, quickly spread across borders and turned into market-wide disruptions.

That such anomalous assets are caught up in the mess adds to Saxena’s view that the nature of markets has something of its own to contribute. Bitcoin, the Swiss franc, investment-grade credit, copper, Japan’s Nikkei 225 all took lumps, he notes, “how widespread fragility there is in markets and how markets can become dysfunctional in times of stress due to extreme supply/demand imbalances. “

A number of systematic funds sharply reduced their exposure to stocks last week and quants exited market-chasing trades. By some estimates, three-quarters of global carry trade was closed as of last Wednesday, with only corporate clients and hedge funds rushing back days later.

“We had a unique set of circumstances where the combination of position, cost of risk, level of volatility and liquidity of the market was arranged in a way where you challenged things that worked all year round,” chief Ashish Shah said. Investment Officer of Public Investments at Goldman Sachs Asset Management. “And you’ve really stripped down the status quo around those themes.”

This week followed the biggest rally of 2024 with stocks, bonds, credit rising, according to data tracking popular ETFs compiled by Bloomberg. The S&P 500 posted its best weekly gain for the year of 3.9%, snapping a four-week losing streak. The world’s largest Treasury exchange-traded fund rose nearly 1% as investment-grade and junk bonds scored equal gains. Gold topped $2,500 for the first time. The VIX fell below 15 after rising above 65 at the height of the maelstrom.

A raft of recent data prompted traders to recalibrate their Fed bets after signs of inflation. The producer price index, for example, rose less than forecast earlier in the week. Swap traders are still pricing in about a percentage point of Fed easing in 2024, while the market prepares for the first reduction in September. Attention turns to the Jackson Hole Symposium for any clues on how Chair Jerome Powell views the economy.

“We’ve only been focused on the Fed and rates and inflation and now it’s about earnings and economic slowdown and volatility,” Caterina Simonetti, senior vice president at Morgan Stanley Wealth Management, said on Bloomberg TV. “It can be very confusing for investors who sometimes have short-term memories.”

While warnings of economic weakness persisted in the bond market, all 11 major equity sectors staged a concerted rally this week. With the Fed poised to cut interest rates in a still-expanding economy, investors are back to worrying about missing a rally in a risky corner — and unwinding the hedges they bought just weeks ago.

As sentiment potentially returns to the bullish levels ahead, there is a greater chance of another disruptive market event. Framed this way, one group of investors – particularly those offering portfolio insurance known as tail-risk hedging – argue that markets are more fragile. Thanks to investor herding, questionable liquidity — and the rise of volatility-sensitive investors who buy and sell on technical rather than economic.

“We’re in this area of ​​consistently making new highs, just as we’ve been around other market tops,” said Josh Kutin, head of North American asset allocation at Columbia Threadneedle Investments. “It makes for a more fragile market. It creates an environment where people are more easily intimidated.”