What is rattling U.S. financial markets?
An ongoing surge in eurozone government bond yields pushed U.S. equity futures down sharply on Thursday morning, with the Dow Jones industrial average trading back below the 18,000 threshold that the index first crossed back in December.
A number of catalysts are in play, from fractious Greek bailout negotiations, as Athens nears a deadline on Friday for a $375 billion debt payment to the International Monetary Fund, to signs of inflation in the eurozone and comments from European Central Bank chief Mario Draghi on Wednesday that recent bond market volatility is here to stay.
How bad is it? The 10-year German bond yield has already suffered its largest two-day rise since 1998, while the 30-year U.S. Treasury yield surged above 3.1 percent yesterday to return to levels not seen since early October. Currency is volatile as well, with the euro surging more than six percent against the dollar over the last two weeks.
Greece and its creditors are considering proposals that would avoid a possible default, which could lead to the cash-strapped nation exiting the euro. Hopes remain high a deal will eventually be reached as the two sides narrow the differences on issues like budget surplus targets.
But as Alberto Gallo at RBS outlined in a note to clients earlier this week, the risks remain high that any small stumble -- in timing, in the ECB's response to any signs of a run against Greek banks, in parliamentary approval of any new funding deal -- could result in a number of negative outcomes. These include new elections, a referendum on euro membership and Cyprus-style capital controls to limit deposit outflows.
While none of this would necessarily result in a "Grexit" from the eurozone, it could result in additional cross-asset volatility.
This comes at a time when bond yields are being pushed higher by the fact euro area inflation increased 0.3 percent in May, beating the consensus estimate and posting the first positive inflation reading since November. Core inflation increased to a 0.9 percent year-over-year rate from a record low of 0.6 percent in April. Real GDP growth looks set to accelerate as well with eurozone retail sales posting their largest increase in April since January 2014.
Both higher inflation and better economic growth were cited as reasons Draghi was comfortable with the rise in European bond yields. But he also mentioned more technical factors such as overcrowded trades, a lack of trading liquidity, and the risk that selling begets more selling as banks and other institutions are forced to sell (for more on this, read up on VaR risk controls).
If all this continues, it will be hard for U.S. stocks to remain so tranquil. Low long-term interest rates have helped boost valuations by funding cheap corporate share buybacks. And a sustained lift in rates risks ending the more than 30 year bull market in bonds -- an event that, when it happens, will unravel many assumptions about the true value of financial assets.
No surprise, then, that Jason Goepfert at SentimenTrader finds "smart money" traders in volatility derivatives are preparing for a downside move in stocks on a scale not seen since last summer.
