Stock market crash: Current scenario reminds Chris Wood of October 1987 Wall Street selloff. Here's why

Christopher Wood of Jefferies in his latest GREED & Fear note said he finds potential similarities between the prevailing market action with that of historic Wall Street crash in October 1987, which was preceded by a selloff in the 10-year treasury over the summer months.

The 10-year US bond yields have jumped to 4.7 per cent from around 3.3 per cent in May this year. Wood noted that 10-year treasury bond yield had jumped 203 basis points to 10.23 per cent on October, 15, 1987 from 8.2 per cent on June 17, 1987. He was, however, quick to point out that when the S&P500 index collapsed 28.5 per cent in four days, and by 20.5 per cent on October 19, 1987 alone, the treasury bond market subsequently staged a classic flight-to-safety rally in the context of a then dramatic decline in the 10-year treasury bond yield.

"The 10-year bond yield fell from a peak of 10.23 per cent on October 15, 1987 to 8.72 per cent on October 26, 1987," he said.

"The interesting point now is whether treasury bonds would behave in a similar fashion in such circumstances given the current debate, as to whether the recent treasury bond market sell-off has been driven primarily by supply-side concerns as opposed to the “higher for longer” narrative. Meanwhile, if the former explanation is the chief driver of Treasury bond weakness, it is also the context where the role played by treasury bonds as collateral for the system will also start to be questioned," he said.

Wood cited a BIS paper published recently suggesting a “seismic shift’’ taking place in the financial system in recent years in the sense that the use of collateral, notably in the form of government securities, has become “ubiquitous” as opposed to the old practice of basing collateral on borrowers’ cash flows.

The BIS report, Jefferies said, goes on to argue that excessive reliance on government bonds as collateral can “reduce incentives to screen and monitor borrowers” while raising aggregate leverage. It also notes that the widespread use of government paper as collateral raises liquidity risks in the event of a risk-off event.

"This in turn raises the issue of the declining liquidity in the treasury bond market which Fed officials have been

warning about of late, as also discussed here last week. Such an outcome, where the “risk free” status of Treasury bonds is questioned, even if only temporarily, may seem to many an extreme event. But in GREED & fear’s view it is no longer far-fetched to think about, as is also evidenced by the fact that such a paper has been written," Jefferies said.

Jefferies said the near-term impact of GREED & fear’s still anticipated Fed fudging of its 2 per cent inflation target will confirm that treasury bonds, and most likely all other G7 government bonds, are in a bear market, which has been GREED & fear’s view since early 2020.

"This bear market view of Treasury bonds is also supported by the breaking of the trend line in the long-term chart of the ten-year Treasury bond yield going back to the beginning of the 1980s," it said.

Also read; PB Fintech shares in news as Softbank may sell 2.54% stake today via block deals

Also read: Sensex rises over 200 points, Nifty tops 19,600; RBI policy outcome in focus; Kalyan Jewellers, Jindal Steel jump up to 4%