Perhaps it was just a coincidence that one month ago, as we approached the anniversary of last year's August 24 ETF flash crash which showed just how broken ETFs can get in a coordinated market selloff during a liquidity vacuum, we previewed “one month ago”, the same funds which suffered acute losses last August just after China devalued its currency and roiled global markets. One of the catalysts listed was a sharp spike in bond yields.

A few weeks later, with bullish positioning across the systematic investor universe (risk-parity, CTAs, etc) at all time, levered highs as JPM observed two weeks ago, that is precisely what happened, when none other than a central bank provided the spark to catalyze the latest episode of risk imparity, a technical term for a mass quant puke. Thanks to the relentless barrage of Bank of Japan trial balloons, which ultimately unleashed a dramatic steepening of the bond curve first in Japan and then everywhere else (as we first explained on September 8), the “risk-parity” rout indeed arrived.

The bond sell-off since last week illustrates this: equity/bond correlations have increased sharply (Exhibit 4). This likely led to a day of very poor returns for traditional balanced funds and risk parity portfolios: the latter have likely suffered more, as the significant decline in equity volatility over the summer has likely led to increased equity allocations. Exhibit 4, which shows daily returns of a simple risk parity portfolio (using 3-month volatility to scale weights), suggests that they would have had a similarly bad day recently to during the ‘taper tantrum', ‘Bund tantrum' and the two China/commodities drawdowns (August 2015, December 2015). Performance pressures in the event of a pick-up in volatility and correlations could drive more de-risking from risk parity investors and vol target funds.