“Where It All Goes Wrong”

So the story of the week was Mario Draghi and a procession of born-again hawks at Sintra.

The whole thing started “innocently” enough on Tuesday at around 4 a.m. EST when Draghi decided it would be a good idea to “sum up [his] assessment of the outlook for inflation and for monetary policy in three messages.”

One of those “messages” was this:

While there are still factors that are weighing on the path of inflation, at present they are mainly temporary factors that typically the central bank can look through.

That triggered a furious euro rally and it was all downhill (or maybe “uphill” is better) from there for the single currency, but more importantly for DM yields which spiked on the perceptible shift in the rhetoric (which continued into Wednesday).

This was perhaps most readily apparent in bund yields, which doubled:

Stocks were hit or miss after that, with a bias towards “miss” and that, in turn, got the risk parity deleveraging conversation going again.

Simply put: we’re back to worrying about about “tantrums.” How far do yields need to rise over a short period of time to trigger a freakout in risk?

If stocks and bonds sell off together, will that prompt a risk parity unwind? How exposed are those funds? And what about “homemade” risk parity (retail wittingly or unwittingly replicating the strategy)?

These worries aren’t entirely unfounded. After all, Tuesday’s move in German yields qualified as a “tantrum” (whether or not positioning will exacerbate it is another story):


Of course this isn’t as simple as picking a number on 10s (say 3%, for example) and saying “there, that’s the threshold beyond which bonds and stocks both sell off). It’s a more nuanced discussion than that.

And when it comes to nuanced discussions, Deutsche Bank’s Dominic Konstam is always happy to have one. Indeed, sometimes he crosses the fine line between “nuance” and “trying to incorporate every possible contingency,” but that’s fine. Better thorough than superficial.

Below, find excerpts from his latest entitled “Fumbling In The Dark?”…

Via Deutsche Bank

There is every possibility that global central banks have a good handle on the pulse of the global economy and know what they are doing. There is also every possibility that they don’t. The key will lie in the adjustment process for risk assets, particularly equities as well as the data. And as we demonstrate below precisely because of the manner in which risk assets have performed since 2013, investors should not be complacent.

We think the apparent shift towards a more hawkish policy stance from the likes of Draghi as well as some of the smaller central banks needs to be viewed in terms of the complexity surrounding the Fed’s own normalization process.


A key issue for the QE variable is its correlation with term premium and within that real term premium. The hypothesis is that shifts in monetary policy affect interest rates in two separate ways. Short term rate changes ultimately translate into the “(risk) neutral” expected long term average of short term rates over the relative time period while the QE variable affects term premium. We can then model term premium on the QE variable but specifically in terms of its constituents of individual central bank purchases as well as net supply. Given the outlook for QE amid Fed taper and with the BoJ at its reduced pace, 10 year premium currently at -34 bp (which is too rich to the model by over 50 bps anyway) would rise another 50 bps to +70 bps by late 2018 consistent with 10s trading above 3 percent. This is still low by historic standards but represents an important step in normalization.

Note the model below interestingly highlights the relative importance of BoJ purchases to Fed and ECB. For a 100 bn in annualized purchases of each, the BoJ has been associated with a 15 bps decline in term premium, almost twice the impact of either the Fed or the ECB. While the market is rightly concerned about the extent and timing of ECB taper, the BoJ is potentially much more important to the rate outlook as it was in the middle of last year.


The issue is how should that impact risk assets. If the hypothesis is that term premium explains the performance of risk assets more so than just the actual yield level, the concern is that higher term premium may derail risk assets – which would show up for example in the reaction of central banks either to delay rate increases or to slow or halt QE taper in its various forms.

We can test this hypothesis by regressing SPX price on the neutral interest rate and/or term premia. The results are interesting in that we can observe the shift in regime before and after 2013. As we highlighted last week post crisis SPX was better explained by decomposing the nominal yield into its real and breakeven constituents but in particular during 2007q1-2012q4 real yields alone matter (breaking of the liquidity trap). Since 2013q1 however this model is no longer valid (although we know at a sector level breakevens and reals are still important but their coefficients have shifted, especially for breakevens). At the aggregate levels we can now explain SPX performance in terms of nominal yields and term premium (we can also do this in terms of the neutral rate and term premium from the Fed model but since the Fed’s methodology suggests a potential direct inverse correlation we will use the actual nominal yield and the term premium component).

This shows a sensitivity of +0.42 for nominal yields and -0.32 for term premium. In other words if yields rise 10 bps, SPX may rally 4 percent for any given level of term premium but if yields rise by 10 bp due to term premium rising, the net increase in SPX is only 1 percent. This therefore suggests that as long as yields rise by at least as much as term premium, the net impact on SPX is positive. Where it goes wrong will be if yields rise by less than the rise in term premium – because the neutral short rate falls.


This is crucial for understanding the link between yields and SPX. If less qe raises term premia whilst the Fed’s expected neutral rate for Funds over the same (in this case 10 year time horizon) falls, the SPX is likely to perform badly in that rising yield environment. If on the other hand the neutral rate is perceived to be robust than the SPX might be stable and possibly advance albeit more modestly than if term premium just stayed low.

The beauty of this framework is that it encapsulates the Fed’s dilemma and reaction function. They want to normalize to a higher terminal rate; they are afraid that FCI may be too lose; there is a fine line between tightening up FCI and being able to execute to a high terminal rate. Ultimately it all depends on inflation and growth but whether or not these are structurally driven or endogenous to the Fed’s and other central banks policy rhetoric remains to be seen. We remain skeptical!


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