You Should've Listened to Deutsche Bank's Warning on Contagion

  • Everything from stocks to bonds and commodities falling
  • Volatility outburst spurs record VIX options trading

Dwyer: A Correction Feels Healthy Until You Get One

If the selloff feels like news, don’t blame Binky Chadha.

Yes, stocks are heading for their worst week in two years. Treasuries are sinking, with 10-year yields jumping to the highest level since 2014. And commodities from oil to gold have been roiled. But according to Deutsche Bank AG, signs of trouble have been plainly visible for a while.

Chadha, the firm’s strategist, sent out a warning earlier this week that investor positioning is stretched in almost every major asset. Even worse, markets are moving in unison to a degree rarely seen during this market cycle, in which pain in one asset is spreading quickly to another.

It came home to roost Friday. The Dow Jones Industrial Average plunged 600 points as a strong employment report of sent Treasury yields toward 3 percent. The S&P 500 ended an unprecedented streak of going without a 3 percent pullback and traders are scrambling to hedge against losses. As a result, options trading in the Cboe Volatility Index surged to a record.

At first glance, the timing of the rupture looks odd, with global growth picking up momentum and earnings estimates rising faster than ever. But anyone heeding Chadha’s call would have at least had a clue.

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.

The tight relationships reflect a theme that traders are increasingly embracing: accelerating growth in the global economy. 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. In U.S. equities, mutual fund exposure rose to a six-year high while short interest in stocks and ETFs fell to the lowest level since 2007. In other assets, fund exposure to oil is now about 2.8 standard deviation above average while long euro shows similarly extreme readings.

So extended is the positioning that an unwind could occur even without a fundamental catalyst triggering a domino effect, warned Chadha in his note. To him, fixed income may represent the biggest risk as valuations are “completely out of line with growth” and reflect weak inflation.

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 Wednesday.

That seemed to be what triggered Friday’s carnage in financial markets. Stocks and bonds extended their weekly losses as strong jobs data increased the likelihood the Federal Reserve will lift rates next month.The selling accelerated after Dallas Fed President Robert Kaplan suggested more than three hikes may be necessary this year.

    Before it's here, it's on the Bloomberg Terminal.
    LEARN MORE