Rules to cope with market panic
The coronavirus outbreak is costing hedge funds billions, as a massive dislocation across asset classes causes a breakdown in traditional relationships.
In the past 10 days, bonds, stocks and even gold — a hedge against the prospect of central banks’ helicopter money — are falling in tandem. Funds that rely on computer algorithms and historical global macro trends are hurting.
Take the risk parity trade, made popular by Bridgewater Associates LP. Such strategies bet on a near-perfect match between stock rallies and bond sell-offs — and it has worked out very well for the past decade. As of early March, the weekly correlation between the S&P 500 and 10-year Treasury bonds was minus 0.84, the lowest since early 2015, Goldman Sachs Group Inc. estimates. A score of minus 1 would mean there is perfect negative correlation — that is, when stocks rise, bonds would always fall.
But the coronavirus shook that landscape. The yield on 10-year Treasuries has doubled in recent days, from 0.54 per cent on March 9 to 1.14 per cent Thursday, even as the Federal Reserve slashed its benchmark rate to zero. We’re seeing the same thing in Japan. Stocks and bonds are falling, dragging the underlying thesis of the risk parity trade down with it.
To make matters worse, these trades tend to use leverage to amplify bond exposure, because stocks have historically been more volatile. Risk parity — as the name implies — seeks to equalize a portfolio’s risk exposure in both asset classes. And boy, whoever said bonds are stable hadn't seen anything like the coronavirus. Take a look at the ICE BoA MOVE Index — the bond-market equivalent to the Chicago Board Exchange Volatility Index, or VIX — which is at its most volatile since 2009. It turns out even U.S. government bonds aren’t that safe.
Or consider those statistical arbitrage funds that use computer algorithms to scour markets for tiny mispricings. These funds rely heavily on leverage to juice gains. But dollar funding is freezing up as banks hunker down for corporate clients and add to reserves to buffer against market volatility, margin calls and flash crashes. If a fund was only making, say, 10 basis points on illiquid trades, and its broker is now raising lending rates to pare back counterparty risk, it now faces the uncomfortable question of whether to liquidate its position.
And forget about relative value trades, which seek to find arbitrage opportunities in mispriced pairs of highly correlated assets. In the currency world, this has unraveled as investors rush to the haven of the U.S. dollar. A sharp weakening of the Australian dollar this month, for instance, might seem overdone, as it tends to follow the Chinese yuan, which has been eerily stable lately. But as Societe Generale SA's currency strategist Kit Juckes wrote, the current market makes a mockery of overthinking trade ideas.
Industry titans are getting caught wrong-footed. Bridgewater’s All Weather fund, which pioneered the risk parity trade, is down 12 per cent so far this year. Meanwhile, Izzy Englander’s Millennium Management has closed more than 10 of its “trading pods.” Millennium relies heavily on relative value trades.
And these are the pros, who have been through the Long-Term Capital Management bailout in 1998 and the Lehman Brothers Holdings Inc. bankruptcy a decade later. For those too young to remember such violent market dislocations, the bloodbath has probably been even worse. Considering the benchmark S&P Risk Parity Index already tumbled 16.5 per cent this year, Bridgewater’s All Weather fund isn’t even doing that badly.
Global markets managed to breathe a little Thursday as major central banks took out the big guns. The Federal Reserve revived a few emergency lending facilities put to sleep after the global financial crisis, and established currency swap lines with emerging markets such as Brazil and Mexico. But is it enough? We have all agreed central banks can’t stop the virus; at best, they can only blunt the blow to financial markets.
Ray Dalio, Bridgewater’s founder, famously said that cash is trash. Now, Dalio, who is revered in China, m has to get associates there to dispel rumors that his funds have “crashed.” As we’ve argued, the coronavirus is turning all of us — people and companies — into hoarders. All we want is cash. The hedge funds that borrowed piles of the stuff to buy everything around the world can't be feeling too comfortable about the weeks ahead.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.