The ‘Fear Trade’ Is in Effect, but the Early Stages Are Over

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The “fear trade” that emanates from destructive inflation is in effect, but it is starting to look less appealing.

The fear trade is when investors buy mostly safe assets to ride out economic turbulence. Usually, that means they pile into cash, the U.S. dollar and government bonds, while they sell stocks. 

Right now, though, there’s a slight wrinkle to that trade, given the currently unique economic environment. Since the recent global economic pain has resulted from out-of-control inflation, investors have not been buying bonds, sending bond prices lower and yields higher. Inflation both reduces the current value of future interest payments and prompts central banks to lift short-term rates. This year, investors have piled into cash, the dollar and commodities, while selling stocks and bonds. 

The most obvious evidence starts with a quick look at how markets have traded. The

S&P 500

is down about 19% for the year. The price of the two-year Treasury yield has tanked, as the yield has risen more than five times to 3.91%. The

U.S. Dollar Index

(DXY) is up about 15%. The price of West Texas Intermedia crude oil is up about 13%. Cash as a percentage of holdings by the average equity portfolio manager surveyed by Bank of America has risen to 6.1%, the highest level since 2001. 

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Unsurprisingly, investors have already positioned themselves into this fear trade. A net 60% of investors surveyed by BofA are overweight cash, the highest overweight out of any other asset. The majority of respondents are overweight commodities and underweight stocks and bonds. The bank does not provide positioning data on the dollar, but the “most ‘crowded trade’ = long U.S. Dollar,” wrote Michael Hartnett, chief investment strategist at Bank of America. 

These developments make those trade less attractive.

Let’s start with cash. Holding more cash now means that money would lose value should the price of stocks and bonds rise. 

Maybe bond prices could indeed rise as yields could top out soon; they’ve already charged higher. The two-year yield is near 4%. That’s where many in the market see the Federal Reserve lifting the fed-funds rate to. And the two-year yield attempts to forecast the level of the fed-funds rate a couple of years from the present, so it could be finished rising soon. 

That could provide relief to the stock market. The end of rising rates would limit the economic pain to come—and stock prices would begin going up. 

As market fear subsides—albeit with stops and starts—global capital would stop piling into the dollar. After all, the buck has already surged this year. 

In this scenario, inflation could finally get under control, which doesn’t bode well for oil. Crude oil is already down to the mid 80s in dollar per barrel, below the level it traded at just before Russia invaded Ukraine, spurring expectations for an oil shortage. 

So while the fear trade might have more room to run, it’s certainly no longer in the early stages. 

Write to Jacob Sonenshine at [email protected]