July 21, 2021 2:40 pm
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Q2’s Stock-Bond Correlation Regime Has Collapsed As VIX Curve Anticipates J-Hole Turbulence

Since the start of Q2 2021 bond prices and stock prices have, quite unusually, risen alongside each other as they each reinforced the narrative of a reflation trade that will lift all equity boats and sink all bond boats.

But, since the start of the week stocks and bond yields have re-engaged in their more ‘normal’ (yields down, stocks down) relationship…

q2s stock bond correlation regime has collapsed as vix curve anticipates j hole turbulence

Source: Bloomberg

Suddenly breaking the prevailing 2021 relationship regime and creating a negative 2-month rolling correlation between bond prices and equity prices (positive correlation between bond yields and equity prices)…

q2s stock bond correlation regime has collapsed as vix curve anticipates j hole turbulence 1

As Goldman notes, should that correlation persist (and the lower interest rates go, the more likely it is to, in our view), bonds may regain attractiveness as a diversifying asset, potentially reducing some demand for equity protection (even though for now thebid for downside tail risk, as we detailed earlier, is at panic highs).

But, perhaps what they are all really worrying about its the potential for a hawkish surprise at the late-August Jackson Hole conference.

That fear is clearly seen in the VIX term structure as it abruptly turns upward-sloping around the Fed’s Jackson Hole conference – reflecting concern about elevated volatility that week.

q2s stock bond correlation regime has collapsed as vix curve anticipates j hole turbulence 2

This elevated fear of turbulence around Jackson Hole is also evident in the significant demand for deep OTM VIX calls (in other words, investors are paying more than ever to protect against a March 2020-style event in stock markets).

50-strike VIX calls cost far more than they did with VIX futures at a comparable level – reflecting an extreme bid for tail risk protection

q2s stock bond correlation regime has collapsed as vix curve anticipates j hole turbulence 3

Implicitly the market is saying that 2020-2021 is representative of the range of possibilities in the next four weeks – which would mean that a 50+ VIX is far more likely (VIX>50 4.6% of the time in 2020-2021) than it is in normal times (VIX>50 0.7%/1.5%/1.0% of the time over the past 10/20/30 years).

Meanwhile, equity indices are rapidly ramping back towards record highs without a care in the world.

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