It’s Friday evening and do you know what that means?
That means it’s time for the best analyst on the Street to deliver his weekly masterpiece.
Putting out something outstanding is difficult for most people. When it comes to sellside strategists, the burden of having to be both rigorous and some semblance of articulate is usually too much and when you throw in time constraints, you’ve got a recipe for notes that are bland, that state the obvious, or worse, both.
True, there are some folks who do manage to deliver outstanding analysis, but you only hear from those folks every so often. The time between notes is likely at least in part attributable to the fact that for mere mortals, putting together something that’s all at once eloquent, accurate, and relevant takes a while. That’s why you only hear from Citi’s Matt King about once every quarter (or at least that’s what it seems like). And that’s maybe why Albert Edwards’ “weekly” missives aren’t actually “weekly” (of course Albert has probably earned all that time he spends “warming his weary bones” on the beaches of Barbados).
But again, those are mortals we’re talking about. Deutsche Bank’s Aleksandar Kocic, on the other hand, is somehow able to paint the sellside note equivalent of the Girl with a Pearl Earring on a weekly basis (Kocic may not be a Vermeer fan, but you get the idea – we’re talking about masterpieces).
Friday is no exception and indeed, this week’s missive finds Kocic revisiting several of his previous notes, including our personal favorite, the “Fourth Wall” analogy for the interaction between markets and central banks.
The gist of what you’ll read below is that the reflexivity “problem” (and that assumes you think it’s a “problem”) may have made this whole thing inextricable. We may, at this juncture, be stuck in what Kocic calls “a permanent state of exception” in which the goal posts are constantly moved in order to ensure that the battle is never won.
This conversation is particularly illuminating in light of the Fed’s perceptible dovish lean – most recently evidenced in Janet Yellen’s testimony on Capitol Hill.
Read below and do us two favors:
- note the bit about how, because financial assets tend to be concentrated in the hands of the wealthy, the so-called “wealth effect” engineered by accommodative policy has actually served to create a “universal basic income for the rich”
- take a minute to appreciate the artistry
Via Deutsche Bank
Umbilical limbo
For a short while, last week’s FOMC meeting and Janet Yellen’s testimony were perceived as a disruption of the Fed’s narrative from relatively hawkish towards a softer, more dovish, version. Subsequent bull steepening has signaled the Fed’s convergence to the market. In our view, this apparent change in Fed rhetoric should be understood in a broader context. Since it was first announced, unwind of stimulus has been a source of anxiety for both the markets and the Fed. And, as the Fed had already established a channel of communication with the markets, in the recent months, their dialogue has revolved mostly about the two sides reassuring each other. Although the recent shift towards a more dovish stance might be seen as an inconsistency, on a deeper level it is perfectly in line with the existing order of things.
Permanent state of exception and a new status quo
Crises are about contradictions, but when we move beyond the crisis things become paradoxical — we are no longer content with rehabilitation of the traditional rules and values, but require a different type of thinking. And, while contradictions usually have resolutions, paradoxes generally don’t, although their understanding is not always beyond conjecture. Some 18 months ago we argued that the concept of the state of exception offers another perspective on the post QE market functioning. We summarize it briefly again, to have everything in one place.
In its core, policy response to the crises was an extension of what in a political context is known as the state of exception: Market laws had to be suspended to restore normal functioning of the markets. The intrinsic contradiction of this maneuver is resolved only by understanding that suspension is temporary. Stimulus will have to be unwound. However, the accommodation has been in place for a very long time, during which traditional transmission mechanisms have atrophied and investors’ mindset has changed in a way that has altered irreversibly their behavior, the market functioning and its dynamics.
Engineering a state of exception comes with considerable risk. The Fed (and central banks in general) carries an implicit responsibility for orderly reemancipation of the markets, which makes stimulus unwind especially tricky. This highlights the deep dichotomy of power: While a state of exception is an exercise of power, there is a clear tendency to disown that power. And the only way to avoid facing the underlying dilemma is to never give up the power. This creates a new status quo — a permanent state of exception.
In essence, it is all about diluting the possible downside of stimulus unwind — an attempt to have an option to obfuscate without losing one’s credibility. With traditional market rules and relationships breaking down, central banks appear to be chasing the illusive target, which means that victory and the final goal are not well defined, which in turn insures the persistence of the “battle” and indefinite continuation of the state of exception. This implies indefinite suspension of traditional market exchange, which means continuous uninterrupted exercise of power that must be won every day.
Everyone is incentivized to participate in the reinforcement of the state of exception, while various forms of contestation of the power are inhibited. For example, attempts at shorting bonds are penalized by a steep curve, protection against volatile unwind is discouraged through wide vol calendars, negative carry etc. The fuzziness of its objectives, as seen through obfuscation of the objective function and metrics (a.k.a. moving the goalposts), has become a policy tool that undermines the power of a reality check. Collapse of short-dated volatility is a referendum on the near-term power of central banks, and softening of long-dated (and forward) vol represents first signs of acceptance of its extension and possible permanence.
The Fed is acting as a non-economic actor. With its communications with the markets (“removal of the fourth wall”), excessive accommodation, unconditional support for risk, convexity supply to the market, etc. in place, its role is aimed more and more at achieving “social” and not necessarily financial goals. Monetary policy continues to be supportive for stocks, bonds and USD at the same time. This has been a radical departure from traditional relationships across different assets (in the long run, the two can only rally if the third one sells off). These correlations are the gift to the market. In the past years, owners of US risk assets and bonds (as a “hedge”) have been enjoying persistent positive externalities allowing them to make money on both stocks (the underlying) and bonds (the “hedge”) . In this way, the accommodation and QE have acted as a free insurance policy for the owners of risk, which, given the demographics of stock market participation, in effect has functioned as universal basic income for the rich. It is not difficult to see how disruptive unwind of stimulus could become. Clearly, in this context risk has become a binding constraint.
In our view, as long as the Fed remains dovish, there is little upside in holding gamma. Although the market is vulnerable to event shocks, in the absence of additional information, it would be difficult to endure the time decay of a long gamma position. If anything, reshaping of the curve is likely to lead to steepeners and more curve volatility. Curve gamma is currently trading at all-time lows and could be perceived as a better value as a potential hedge against event risk. Vega is a different story. Given the continued tension between the Fed and the market, from this vantage point, higher vol in the future looks almost inevitable, but given a possibility of a (semi-) permanent status quo and the state of exception, this might be a long shot. We see forward volatility as the best way to hedge this risk without the consequences of time decay.
Greenspan couldn’t have written that any clearer.