The bond market is holding up a giant sign in capital letters warning of trouble ahead. Investors are on edge. The next big market scare might not be far away, but is hard to prepare for.
Monday’s panic highlighted some odd breaks from what normally counts as a haven asset: The China-driven selloff was different from the usual market freak-out, as the dollar didn’t prove immune to fear. Meanwhile, high-quality stocks with strong balance sheets were punished as the outlook worsened.
The normal pattern of safety has worked for the traditional trio of safety: the yen, Swiss franc and gold have all risen strongly, with gold up 17% just since the start of May. Government bonds also have done phenomenally well, with the 30-year U.S. Treasury and 40-year Japanese government bond matching gold in total return in dollars over the period, and Austria’s 100-year bond returning an extraordinary 47%.
But typically when investors flee for the hills, they think of the dollar as a place of safety behind only gold, the franc and the yen. Instead, the euro proved almost as safe as gold on Monday, and has risen almost every day since President Trump kicked off the latest fears with surprise new tariffs last week. Against significant developed currencies, the dollar managed to rise against only three on Monday, all closely linked either to China, as with the Australian and New Zealand dollars, or to the plummeting oil price, as with Norway’s krone.
So has the dollar lost its haven status? In one sense, clearly not. The greenback proved its worth against emerging-market currencies, rising against all of any note following China’s decision to let the yuan fall through seven to the dollar for the first time.
But against the euro, the dollar’s position is much less clear. Dollar bulls might argue that the euro benefited Monday only because traders were rushing to close out bets against Europe’s single currency amid the unexpected volatility. Negative interest rates in Europe made it attractive to borrow euros to buy higher-yielding dollars when markets were stable, but in chaotic markets these leveraged “carry trades” are shut down, which involves buying back euros and selling dollars.
There was heavy positioning against the euro in futures markets, suggesting a lot of leveraged bets needed to be shut down. In the short term that helps the euro, but once the leveraged traders are out, it offers no longer-term support.
Interest rates might help the euro if market conditions worsen, however. The Federal Reserve has scope to lower U.S. interest rates at least 2 percentage points if the economy gets into serious trouble. The European Central Bank can take its rates further into negative territory, but can’t go very far without hurting banks and encouraging hoarding of bank notes.
Anyone with memories of the last euro crisis will scoff at the idea that the currency could be a haven. It is true that serious economic troubles could again create doubts about the survival of the currency. But the ECB has shown its willingness to rip up its rules to hold the euro together, so things would have to get very, very bad before this becomes an issue.
In such situations of financial unrest, ordinary market relationships are upended anyway, so other havens also will become unreliable. Remember that gold lost one-quarter of its value after the collapse of Bear Stearns in 2008, just when holders really needed its security.
Within the stock market, one natural place to hide is quality stocks with little debt and solid earnings. Unfortunately, they were big losers on Monday, mainly because they are disproportionately exposed to technology, and tech was the worst-performing sector.
Tech weakness wasn’t only because of China-exposed tech stocks such as the chip makers and
none of which rely on China, all fell by more than the wider market.
In many ways this is odd. The big disruptive companies have shown their ability to grow independently of the strength of the economy in the past decade, have tons of cash and are loved by investors.
Again, their falls could be because investors were shocked out of leveraged positions, in this case in tech stocks bought because they had strong upward momentum.
Another possibility is investors were holding stocks in part because bond yields were so low, a theory dubbed TINA for “there is no alternative” to stocks. Reluctant buyers naturally avoided stocks that had been duds for years—cheap old-economy stocks—and went for high profit margins, growth and strong balance sheets for safety. When they fled stocks, they sold what they owned, and that dragged down both quality and tech.
As with the euro, bulls will hope such a reversal in positioning is purely temporary. As with the euro, though, the tech-stock underperformance could last a long time in a downturn purely because so many people shared the same views to start with.
My guess is that the dollar will still be king if things turn really nasty, while tech stocks will suffer from a loss of faith. But the trouble with choosing a haven is that we never really know how much leverage is supporting positions until it gets yanked away, and even the safest asset can do the opposite of what you expect when it is.
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