U.S. equities were hit with their worst selloff in several months on Friday as long-term government bonds around the world are being hit hard. The catalyst? Indications that the Bank of Japan, worried about the negative impact of ultra-low long-term yields on pension liabilities and bank earnings, could conduct a “reverse Operation Twist” to sell long-term bonds and buy short-term bonds.
The problem is that with long-term interest rates already so low, and because of the inherent duration leverage that results, this will create bigtime losses for long-term bonds. Already, Japanese 40-year bonds have suffered a near 20% decline in price in recent weeks.
This volatility ends a long three-month quiet period in the market and further raises the stakes for the Federal Reserve policy meeting later this month.
In the end, the Dow Jones Industrial Average lost 2.1% as it closes back in on the 18,000 level, the S&P 500 Index lost 2.5%, the Nasdaq Composite lost 2.5% and the Russell 2000 finished lower by 3.1%.
Treasury bonds as represented by the iShares 20+ Year Treasury Bond (NASDAQ:TLT) lost 1.6% to close at levels not seen since June and pushing the 10-year bond yield to 1.67%. The dollar was stronger, gold lost 0.5% and crude oil fell 3.7%, pulling back from Thursday’s big gains.
The chatter on oil is that this week’s big inventory draw — the largest in 17 years — could reverse next week as production cuts related to Hurricane Hermine bounce back as storm-disrupted tanker traffic docks and unloads.
Focus also remains on the prospect of an OPEC production freeze agreement at a meeting in Algiers later this month. Concerns linger that Iran, which wants to aggressive lift output now that economic sanctions have been lifted, continues to request higher production levels.
This despite Reuters reports today that Iranian output has stumbled over the last three months after reaching just 3.6 million barrels per day in August vs. a previously stated target near four million barrels and headlines Thursday that Tehran wanted to set a target as high as 4.2 million barrels.
Financial stocks were the leaders, if you could call it that, limiting their decline to 1.9% ostensibly on hopes higher long-term interest rates will boost profitability via net interest margins. Yield-sensitive utilities and telecoms led the decliners, down 3.8% and 3.4%. There was some good news, however, with teen apparel retailer Zumiez Inc. (NASDAQ:ZUMZ) up 4.7% on better-than-expected second-quarter results.
The move in long-term government bonds started on Thursday after the European Central Bank left policy on hold (amid rumors of a possible move to start purchasing equities) and said it didn’t consider lengthening or expanding its bond purchase program. This was more hawkish than expected.
The bond market pressure was precipitated by ongoing hawkish chatter from Federal Reserve officials despite a clear slowdown in U.S. economic data, pushing up the odds of a September rate hike to 24% from 18% previously. Dallas Fed President Robert Kaplan today said the case for rate hikes has strengthened in the last several months, although he added there was no urgency to do so.
And finally, the Bank of Japan capped it all off with indications it could cut short-term interest rates deeper into negative territory on September 21 in combination with an effort to lift long-term rates to ease the pressure on retirement accounts and savers.
The problem is that puts Wall Street professionals under extreme stress by undermining the benefit of “risk parity” diversification strategies since both “risk free” long-term government bonds and equities are dropping in unison. With some $13 trillion in global bonds trading with negative interest rates, the bond price sensitivity to any increase in interest rates is very high — a concept known as “duration.”
Back in June, Goldman Sachs warned that a sharp 1% rise in interest rates in the United States alone would result in mark-to-market losses of $2.4 trillion.
Adding to the pressure on the bond market has been a big increase in fresh bond issuances. According to RBC’s Charlie McElligott, U.S. investment-grade issuances at $52 billion through Thursday with another $50 billion scheduled for next week. This comes amid a potential $100 billion issuance of Treasury bills.
The takeaway is that it won’t take much of a lift in long-term bond yields (because of duration) to unleash a wave of selling pressure in bonds that will spread to equities.
Offsetting this is still remote possibility the Fed would action hike rates this month with markets nervous and the U.S. presidential election on the horizon. Moreover, September options expiration is next week as well, a time when Wall Street tends to lean against volatility to ensure the maximum number of options expire out of the money.
For now, I continue to recommend betting on higher interest rate via the ProShares UltraShort Treasury Bond (NYSEARCA:TBT), which is up 6.3% this month for Edge subscribers, and higher volatility via positions like the options spread on General Electric Company (NYSE:GE) that is up 28% for Edge Pro subscribers.
For long positions, I believe next week will feature a relief rebound that will present the last best exit opportunity ahead of what is likely to be a very rocky end of the year.
Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters. A two-week and four-week free trial offer has been extended to InvestorPlace readers.
