Speaking to Reuters’ Jennifer Ablan, Gundlach also said that bitcoin was the “lead horse” of risk assets and its recent plunge has had a cascading effect on other risk assets. Incidentally, last Friday we highlighted the oddly close correlation between bitcoin (inverted) and the VIX, when we asked if the VIX “tail” is wagging the Bitcoin “dog.”
Two weeks ago, Deutsche Bank’s Masao Muraki also discussed this peculiar relationship:
First, implied volatility. Implied volatility is an index calculated from the price of a derivative product (options) of an underlying marketable security. However, we now have a “tail wagging the dog” situation where the price of the derivative product is feeding back into the price of the underling marketable security.
Next, cryptocurrencies. Cryptocurrencies are closely watched by retail investors, affecting their risk preferences for stocks and other risk assets. Although institutional investors recognize that stocks and other asset valuations may have entered bubble territory (US equities’ average P/E is around 20x), they cannot help but continue their risk-taking. Now, a growing number of institutional investors are watching cryptocurrencies as the frontier of risk-taking to evaluate the sustainability of asset prices. The result is that institutional investors, who are supposed to value assets using their sophisticated financial literacy, analysis, and information-gathering strengths, are actually seeking feedback about the market from cryptocurrency prices (which are mainly formed by retail investors).
Which explains why, unwittingly, bitcoin may have become a systematically important asset class: if it were to crash too far, too fast, the reverse feedback loops would cascade into traditional risk assets, although the cause-effect direction is still up for debate.
One thing that is clear, however, is that the recent dramatic plunge in bitcoin roughly coincided with the biggest point drop in the DJIA and the biggest jump in the VIX on record. It is this coincidence that is clearly troubling to Gundlach.
In addition to his discussion of bitcoin and volatility, Gundlach also touched on what many agree was the proximal catalyst for last Friday’s market plunge which in turn triggered this week’s vol eruption: “Clearly, the market gets shaky when the 10-year hits 2.85 percent,” Gundlach told Reuters. “Just look at this week, and today. Makes one consider what could be coming if 10s push over 3 and 30s (30-year Treasury bond) over 3.22 percent.”
During his January webcast, Gundlach correctly predicted that if the 10-year U.S. Treasury note yield went above 2.63%, U.S. stock investors would be spooked. The 10-year yield is currently trading around 2.84%, and its spike today on the heels of the “deficit-busting” Senate agreement which would lift spending caps by $300 billion above current levels, sent the markets into the red after an impressive morning rally.
In little comfort for equity bulls, Gundlach said it is “hard to love bonds at even a 3 percent” yield. “Rising interest rates are a problem and the U.S. is in debt and there is massive bond supply.”
Well, if the Senate passes its bipartisan spending deal, which has been blessed by Trump, it is virtually certain that the 10-year is going above 3%, and stocks will not like it, prompting more angry outbursts from Trump who wants both the spending deal and daily all time highs in the S&P, which – absent a new Golden Age for US economic productivity – looks virtually impossible.