The past month has seen a flurry of dramatic correlation shifts and changes across key US and global assets - traditionally an indication that a major market transition is upon us - with the most notable move being the sudden positive correlation spike between the USD and US Treasury yields, as rate differentials mysteriously recoupled after a year of forcing FX strategists to goalseek tortured explanations why surging US yields failed to push the dollar higher.
All that changed recently, but what is most interesting and what has gotten relatively little discussion, is what was the catalyst that unleashed this positive correlation between the USD and rates, one which as JPM said over the weekend, "could be as disruptive to global markets as the reversal of the correlation between stocks and bonds in February."
For the answer, look to Beijing, because it was here that something unexpectedly snapped mid-way through April. For those who may have forgotten what it was, here is a reminder from Bank of America:
April 17th Chinese surprised with an easing of monetary policy; this was the trigger for US dollar strength
And not only dollar strength, but bond weakness too: because it was almost as if a switch was flipped in the middle of the ongoing escalating Trade War with Trump, when Beijing suddenly decided to send a message, how easy it is to not only send the dollar soaring, but also unleash havoc among US risk assets and dump 10Y TSYs.
In any event, China's dovish capitulation, prompted a global echo and in the past 2 weeks, hawkish central banks including the BoE, BoC, Riksbank, and even the ECB, all turned dovish; this left the Fed (and the central bank of Argentina, of course, which hiked rates by 12.75% in just 5 days although we can ignore that for now) as the long hawk, a clear US dollar positive, and more importantly, EM FX negative, something we will touch on momentarily.
Meanwhile, as the dollars surged, so did Treasury yields, and just over a week after the start of Chinese easing, US 10Y Yields spiked, briefly rising above 3.00%, a level which it turns out, is now considered the "magic number" on Wall Street, above which risk assets start to crumble.
Here, once again, is Bank of America, which reminds us that in the latest Fund Manager Survey, respondents said that 3.5% is the level they will shift from equities to bonds. So, as BofA's Michael Hartnett notes, "it should not be a surprise if reallocation starts before yields get to 3.5%. Indeed, as we breached 3% the following asset classes all suggested that the 3-3.5% range would become “painful” if not accompanied by much stronger economic data."
Case in point, banks, homebuilding stocks, US dollar, EM, yield curve all suggested 3% on the 10-year Treasury yield was the magic number.
- Lower US bank stocks: rise in rates was shifting from a “good” rise to a “bad” rise (financials underperformed utilities by 1250bps since mid-March)
- Lower US homebuilding stocks: a good lead indicator of interest rates, homebuilding stocks are saying the Fed is making a “policy mistake”
But the biggest "tell" that any increase in the dollar - and the 10Y yield above 3.00% - would be a market destabilizing event, came from the Emerging Markets, where "exhibit A" was the following amazing chart showing an unmistakable correlation between the outperformance of the Dollar, and the underperformance of Emerging Market Debt.
Here, as Hartnett again chimes in, the higher US rates finally caused higher US dollar (courtesy of the PBOC), at which point "EM started to crack."
But while many have pointed at the collapse in the Turkish Lira, the Argentine Peso, and, more recently, the Indonesia Rupiah, as cracks in the EM narrative, the truth is that many of these are idiosyncratic stories.
So how can one decide if the Emerging Market turmoil is about to sweep across the entire sector, and result in DM contagion? According to Bank of America the answer is simple:
"EM FX never lies and a plunge in Brazilian real toward 4 versus US dollar is likely to cause deleveraging and contagion across credit portfolios."
In other words, the best indicator of imminent emerging market turmoil is shown in the chart below: if and when the BRL starts sliding, and approaces 4, it may be a good time to panic.
And just in case that was not enough, Hartnett also has a secondary "fail safe" EM-stress indicator:
Tremors in the periphery: 3% + rally in US$ has caused EM tremors (ARS, INR) at a time of peak EM debt/equity inflows ($371bn)…EMB <107.50 contagious
This means that once EMB, the JPM Emerging Market Bond ETF, drops to 107.50 - the level it hit right after the Trump election - it will be time to get out of Emerging Dodge.