This week’s sell-off has been linked with and blamed on
interest rates, as investors became concerned about higher US
Strategists at Pavilion Global Markets and elsewhere
say this dominant narrative is incorrect.
As equity volatility spiked, rates markets stayed
Risk-parity funds, which invest in a combination of
stocks and bonds based on factors including volatility, may
have contributed to the sell-off as stock-market fear
increased, Pavilion said.
Rising interest rates are near the top of virtually every story
out there explaining why the
stock market fell this week.
But equity strategists at Pavilion Global Markets disagree.
They don’t discount the relationship between bonds and stocks,
specifically, how higher interest rates weakens the relative
valuation of stocks. The recent selloff gained speed on Friday,
jobs report showed that average hourly earnings rose
year-on-year at a pace not seen since 2008, in a sign that
inflation is picking up.
But in a note on Wednesday, they also laid out a few reasons why
this was not a rate-induced selloff. Their arguments line up with
other strategists’ who have pointed to the unwinding of
a popular short-volatility trade and computer-induced selling
as bigger drivers of the sell-off — especially as
the Dow lost more than 1,000 points in late-Monday trading.
If the sell-off were truly rate-driven, “we would have seen the
interest rate-sensitive sectors underperform broader equity
indices severely, which was not the case,” Pavilion wrote.
“Utilities and consumer staples actually outperformed during the
Both S&P 500 sectors, which can be hurt by higher interest
rates, were respectively the sixth and ninth worst performers
from last week Thursday through Tuesday. There are 11 sectors in
the S&P 500.
Inflation on its own was not the apparent concern, but how the
Federal Reserve may respond. The theory is that higher wages
would increase demand and prompt companies to protect margins by
raising prices, both of which are inflationary. But even on that
point, Joseph Lavorgna, chief economist of the Americas at
Natixis, cautions that higher wages don’t necessarily translate
to higher inflation.
“Fed Chair Powell would be wise to resist the temptation to
aggressively raise rates in the face of falling unemployment and
modestly higher wages,” he said in a note on Wednesday.
Lavorgna included this chart, which shows that core personal
consumption expenditures — the Fed’s preferred way to gauge
inflation — doesn’t always have a direct relationship with wages.
Equity volatility didn’t spread
Derivatives strategists at Bank of America Merrill Lynch echoed
this point. In a note on Tuesday, they highlighted that while the
Cboe’s volatility index, or VIX, saw its
biggest one-day spike ever, the rates market remained rather
calm. What this selloff was really about, they said, was exposing
the fragility of strategies that bet against volatility and are
at risk of being wiped out.
“While many suggest this
shock was driven
than expected policy normalization
(the right thing to be
in our view), rates have been
stable compared to past
bond-led shocks such as the taper tantrum,” said a team including
In fact, Treasuries rallied Monday in a
flight-to-quality (perhaps aided by CTA positioning), but the
fact this shock so far is very equity centric is positive,” they
added. “Key to understanding whether this is a short-term
technical equity sell-off,
the beginning of something bigger, lies in where rates vol goes
Pavilion additionally looked into the risk-parity strategy, which
distribute investments across asset classes based on their
They found that these funds increased their equity allocations
since 2016, helping them weather some of the volatility in fixed
income losses that were associated with inflation concerns. But
that made the strategy cyclical, in that these funds shed stocks
as volatility rose.
Pavilion said, “If there is a deleveraging of the risk
parity strategy in the wake of higher realized and implied
volatility assumptions, the increase in allocations to equities
has made equity markets more vulnerable to sudden selling by
these types of funds via a self-reinforcing mechanism.”