“We’re Approaching A Margin Call” – The “Trump Put,” Volatility, & One Analyst’s Masterpiece

Here it is folks.

Deutsche Bank’s Aleksandar Kocic’s is out with a follow-up to one of his masterworks.

Regular readers know Kocic. He’s the derivatives strategist who has a penchant for penning stream-of-consciousness-style missives about markets. Perhaps most notable (or at least on my end) was Kocic’s characterization of the Fed’s reflexivity problem as the “removal of the fourth wall,” a nod to theatre.

Although Kocic’s notes are probably a bit too metaphysical for some, the fact is he’s a really good writer, something that doesn’t seem to come natural to most sell-side strategists (and a skill that’s deteriorating over time among some previously celebrated commentators). You can read his take on populist “buyer’s remorse” here.

The last time I checked in on Kocic he was busy describing the market’s Wile E. Coyote problem. If you missed that, it’s definitely worth your time and can be found here.

Well on Friday evening, Kocic was out revisiting the fourth wall analogy mentioned above. In his latest take on a truly brilliant interpretation of the Fed’s interaction with the market “audience,” Aleksandar posits the reinstatement of the wall between the Fed “performers” and the market “observers,” but describes the removal of another fourth wall – that which previously existed between politics and markets.

Read below as Kocic takes on Trump, the Fed, tweet risk, and how it can all be explained via the same theatre analogy sprinkled with a little bit of options parlance.

Via Deutsche Bank

For a good part of the last 5-6 years, the Fed had made a point of establishing an open channel of communication with the markets. We have viewed this phase of market introspection as a maneuver equivalent to the removal of the fourth wall in the theatrical context: The audience (in this case the markets) is no longer a passive spectator, but assumes an active role in shaping the script (policy). In consulting the markets, the Fed has retained an option to be flexible and act in the market’s interest without disturbing it. They have financed that option by selling an (out of the money) option on their credibility. This is a tradeoff that worked for everyone. The Fed could tailor its exit in an optimal way, while the market could voice its view at each step of that process so that both sides are happy at the end. Because of that, it was not in the market’s interest to challenge Fed’s credibility.

With the arrival of the new President, there appears to be some coordination between politics and monetary policy in their communication channels. The Fed communications with the markets gave way to presidential tweets, press briefings and general media appearances, which took center stage as another form of shaping the narrative jointly with a wider audience. So, while the Fed’s fourth wall had to be reinstated, another fourth wall came down. It makes perfect sense for the two communication channels not to coexist at the same time — removing two walls at the same time would have produced two parallel narratives resulting in a significant “cognitive draft” and potential loss of coherence of the resulting script.

The two communication modes of removal of the fourth wall, while on the surface similar, have (at least) one notable difference. When expressed in options language, the Trump put has the same decomposition as the Bernanke put during the QE period. Effectively, this is a supply of equity vol to the market financed by “selling puts” on President’s credibility. However, in contrast with the Fed whose communications with the markets reduced volatility, the new political transparency, as communicated through presidential tweets and political discourse, has been generally volatility increasing. This communication caused volatility is the main difference between politics and policy. Originally, the market has been willing to accept this volatility because the promises at the end look attractive (tax cuts, deregulation, fiscal spending,…). But, this volatility presents the key risk for the President’s brand. The collateral asset behind president’s “credibility put” is his ability to pass the promised reforms, which is conditioned on his ability to form consensus within the party, the House and the Congress. Excessive volatility erodes the value of this collateral and increases the risk of a “margin call”.

This was highlighted by the last week’s events: The latest political developments outlined the lines of fractures in the political consensus and the market’s reassessing of the probability of a “margin call”. As a consequence, volatility sellers were caught off guard as gamma rebounded. The awareness of this possibility alone is likely to provide a lower bound for vol — as long as political uncertainty prevails, vol is unlikely to be pushed to new lows. As the Trump trade took the center stage by the end of the last year, the highest level of uncertainty was perceived to be in the FX channel and the lowest in the risk assets, with rates market somewhere between the two. In itself, the political “margin call” would be unwind of this mode and, as such, most disruptive for equities pushing VIX significantly higher, as it means withdrawal of convexity from that market, and somewhat less supportive for rates and FX vol.