BAC Bank of America Corporation

By Gregory Zuckerman, Julia-Ambra Verlaine and Paul J. Davies 

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the U.S. print edition of The Wall Street Journal (March 13, 2020).

Treasury prices extended their declines Thursday while U.S. stock indexes suffered their worst losses since 1987 -- an unusual dual downturn that raised concerns that the Wall Street rout is entering a painful new stage: The forced unwind of a number of popular trading strategies, some of which involve leverage, or borrowed money.

The Dow industrials dropped 2,352 points, or 10%, bringing their decline to 27% in the month since the last record high. The yield on the 10-year Treasury note, which hit a record low Monday at 0.501%, rose to 0.842%. Bond yields rise when prices fall.

Sharp stock declines aren't unusual, particularly at a time of economic stress following a long bull market. But the sight of bond and stock prices declining sharply together unnerved some traders, suggesting further selling could follow in response to margin calls, risk limits at banks and investment firms, and other factors. Also surprising investors: Gold, a traditional haven, dropped 3%, marking its third straight decline.

"There was nowhere to hide today with stocks, bonds and gold all hit hard," said Jonathan Krinsky of Baycrest Partners LLC.

The latest carnage came even after the Federal Reserve said it would inject more than $1.5 trillion into Wall Street on Thursday and Friday to prevent ominous trading conditions from creating a sharper economic contraction.

Investors view the Fed intervention as providing relief to banks facing demands for cash, as economic shocks force companies to tap credit lines and draw down revolving loans.

The Fed's action marks an effort to interrupt what some analysts and investors view as a dangerous negative-feedback loop, in which market declines beget further declines, even absent changes in financial and economic fundamentals.

But the Fed announcement only paused the selling, adding to concerns in the market involving two long-running trades: The "basis trade," which seeks to exploit pricing gaps between Treasury securities and futures, and "risk parity funds," which try to score strong performance with moderate risk using futures contracts that can boost the returns of low-risk assets.

On Thursday morning, Bank of America warned clients that the unwind of several leveraged trading strategies risked creating "a cascading effect whereby U.S. Treasury yields rise sharply and force liquidations from other similar investors."

Thanks to the disruption of short-term funding, securities dealers could be left with $300 billion of 30-year Treasurys on their books whose ultimate sale would cause U.S. Treasury yields to rise sharply, potentially forcing further unwinds and worsening conditions throughout financial markets, analysts at Bank of America and JPMorgan say.

The risk parity strategy is intended to adapt to market conditions and be a one-stop shop for investor assets. Firms including Bridgewater Associates LP and AQR Capital Management LLC are the leading investors in the strategy. Bridgewater founder Raymond Dalio says he helped invent the risk-parity category nearly two decades ago and in the past has told clients he has the majority of his net worth invested in the strategy.

A spokesman for Bridgewater wouldn't comment.

Risk-parity investors, who manage about $175 billion, according to industry estimates, usually buy futures tied to the performance of bonds, stocks and commodities. They use risk metrics to determine the proper allocations to various markets, shifting assets to maintain an equal distribution of risk. The goal of these funds: Somewhat higher returns with the same amount of risk of other investment classes.

The key to the trade is assessing the volatility of each asset class. If stocks are determined to be three times as volatile as Treasury bonds, an investor would put three times as much in bonds as in stocks, for example. As stock volatility increases, as it has lately, a risk-parity portfolio manager would sell some stocks -- something that has been happening in recent weeks -- adding pressure on the overall stock market, risk-parity traders say.

And if bonds or other safer asset classes also come under pressure and become more volatile, as has also been happening this week, they'd sell those as well, incurring losses along the way.

Risk-parity specialists say the bond losses haven't been enough to cause true pain, and that the broader concerns about the strategy are unfounded.

"Risk parity is not big enough, doesn't trade enough, and doesn't trade quickly enough to ever be noticeable in the movements of stock or bond markets," says Michael Mendelson, a principal at AQR.

The AQR Multi-Asset fund is down 6.63% this year through Wednesday, and was down 2% Thursday, topping the overall market. The S&P 500 is down 27% in 2020.

In the view of many in the markets, the underlying key factors are the scarce liquidity in many markets, which is causing prices to move sharply, and the prevalence of technical trading driven by trends in a few key gauges including certain prices and measures of volatility.

One such gauge is the value-at-risk framework, used at many banks and investment firms to judge the likely losses they would face in any single day under certain stated conditions. Some analysts say that when volatility is high, this value at risk, or VaR as it is known, increases -- prompting firms to sell riskier assets in a bid to reduce the risk of their position.

Nikolaos Panigirtzoglou, global markets strategist at JPMorgan Chase & Co., said that much of the widespread selling of all kinds of assets in recent days has been driven by risk management rather than any fundamental view on the economy or securities prices.

"With the lack of liquidity in markets, one thing is feeding the other," he said.

The main measure of stock market volatility is the Cboe Volatility Index, or VIX, which on Thursday approached levels last seen in 2008. A high reading on the VIX can cause some investors to breach their risk limits and become forced sellers, Mr. Panigirtzoglou said.

Investors also said the market was losing faith in political leaders in some countries to tackle the coronavirus, or in policy makers' ability to support markets and the economy with rate cuts or other stimulus.

"It's become that kind of liquidation where you see people sell what they can and move to cash," said David Riley, chief investment strategist at BlueBay Asset Management.

(END) Dow Jones Newswires

March 13, 2020 02:47 ET (06:47 GMT)

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