When last we checked in on Deutsche Bank’s derivatives strategist – and man who is infinitely smarter than you – Aleksandar Kocic, he was busy discussing what he calls the “permanent state of exception.”
This was an extension of Kocic’s previous work on the reflexive character of the relationship between the Fed and markets.
For those unfamiliar with the “fourth wall” analogy, recall this from a 2015 note penned by Kocic describing how the committee made the implicit explicit:
Going into the FOMC meeting, we had to face multiple nested contingencies, from Fed reaction function, to ambiguous signals given by the economic models which largely underwent structural breaks post-2008 and eroded market’s already low confidence regarding economic forecasts. The Fed decision showed that when everything fails, common sense remains the best guide. And common sense prevailed.
This changes everything. Power relations have been revealed; nothing will ever be the same. In that sense, despite seeming status quo, the FOMC was a true Event in the sense of being an encounter which retroactively creates its own causes.
What we now have is another data point which outlines the contours of the Fed reaction function. Fed’s communication strategy, it is becoming clear, is an equivalent of what in theater context is referred to as Removing the fourth wall whereby the actors address the audience to disrupt the stage illusion — they can no longer have the illusion of being unseen. An unalterable spectator becomes an alterable observer who is able to alter. The eyes are no longer on the finish, but on the course — what audience is watching is not necessarily an inevitable self-contained narrative. The market is now observing itself from another angle as an observer of the observer of the observers.
You can see how that lends itself to an indefinite suspension of normalcy.
The longer the state of exception (i.e. crisis-era accommodative policy) remains in place, the more it reinforces the investor behavior it created and engendered. But because the market now understands itself as “an alterable observer who is able to alter,” investors are aware that they can effectively shape policy outcomes by virtue of their participation in a reflexive dynamic.
So this drags on. And on. And on.
“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,” Kocic wrote last week, in the piece linked above.
Therein lies the risk for policymakers. “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,” Kocic went on to say, adding that for central banks, “the only way to avoid facing the underlying dilemma is to never give up the power.”
And so the goal posts get moved. Maybe on purpose, but perhaps because the policies themselves have distorted the way markets function and so, the goal posts effectively move themselves. It’s no longer clear what’s being sought and so, lacking a clear definition for what it means to “win,” central banks can effectively justify a continuation of the “fight.”
“This implies indefinite suspension of traditional market exchange, which means continuous uninterrupted exercise of power that must be won every day,” Kocic concludes.
You see this manifested in daily pronouncements from central bankers who make themselves available for any number of speeches, interviews, etc. And you’re now starting to see it find expression in leaks from the ECB, which has developed a penchant for effectively instructing Reuters to print articles citing unnamed sources at the bank when policymakers believe the market has “misinterpreted” some previous pronouncement.
What does this mean for markets? Well, it means rebellious behavior will be punished and conformity rewarded.
That’s a choice that isn’t really a choice for anyone whose performance is measured by short-term metrics. Recall this from Citi’s credit team, out earlier this year:
If there is such a thing as a ‘Holy Grail’ in the credit market anno 2017 then surely the no-cost decompression trade is it – the trade that performs, if spreads widen, but doesn’t cost a bundle of carry if they don’t.
Instead, we’d argue the principal concern people have with decompression trades here is that they tend to be negative carry. When spreads are low, volatility is low and dispersion is low, a few basis points of carry can matter a lot to a fund’s percentile performance against peers. And against the short-term metrics by which performance tends to be measured many will struggle to forego the incremental carry – until a negative trigger becomes immediately obvious. And so the game of musical chairs continues, even as the stakes seem to be getting higher and higher.
Not only is nonconformance punished, it is also meaningless. Resistance, as it were, is futile. As Kocic writes in this week’s note, “you can say no, but it is inconsequential.”
This, he says, is the “the swarm effect.”
It would seem that the rational thing to do if one wanted to rebel (i.e. not embrace the carry trade), is simply channel your inner Michael Burry, adopt a stoic fortitude that would make Marcus Aurelius proud, and suffer the negative carry until you are one day vindicated as “the swarm” is summarily wiped out when the state of exception comes to an unceremonious end.
But the Fed is not an economic actor. And the surreal possibility that this state of exception may be permanent creates a scenario where it isn’t entirely clear if tail hedges will ever pay off. There is not, to use the Michael Burry analogy, an easily identifiable moment beyond which the adjustable mortgage rates kick in.
With all of that in mind, here is Kocic’s most recent missive, out late this week…
Via Deutsche Bank
The swarm effect: What to do when choices become difficult?
Markets are calm, but they are not content. Although nominally things do not look bad, there is no joy when it comes to the state of the US economy. Despite tapering of Fed purchases, rate hikes and announcement of balance sheet unwind, financial conditions have not tightened.
This triggers flashbacks of the troubling aftermath of the 2004-2007 tightening cycle. Then, why is vol so low? This question continues to puzzle market players and inspire its commentators. We know there will be tears at the end, but can we be certain that if we internalize this message and “do the right thing” along the way, there won’t be tears in the meantime?
The current mode of market functioning is really not so much about complacency as a result of willful blindness or ignorance as it is about difficult choices and high costs associated with those choices. More than eight years of monetary stimulus and forced status quo have created a situation where change has become impossible. To facilitate a change that would improve market conditions, there have to be multiple concessions to those forces against which change is directed. This has set in place the swarm effect: You can say no, but it is inconsequential. The resulting calm of the markets we have been experiencing lately has a special quality to it, like the calm one sees in people who have been talked into believing that they have found their peace.
When it comes to trading options, there are many more considerations to take into account besides delta. Being long convexity means that your prospects are inversely correlated with the fate of the market. You will monetize only in an adverse scenario, when the rest of the market posts losses – your profits have negative correlation to the profits of the market. This is the main feature of an insurance policy – and a reason convexity carries a premium relative to other assets. By selling vol, your prospects are positively correlated with everyone else’s. Those assets generally trade at a discount — you get paid to sell convexity.
At the end, it is all about the decision whether to aligning your prospects with or against everyone else’s. At the moment, investors face a difficult choice. On one side, you are tempted to join the crowd. After all, the Fed is the “guarantor” so, despite the downsides, embracing the carry trade might not be a totally unsafe option (and you get rewarded for that). For most people who operate over a short time horizon, this is the only option. However, it is well known that collective IQ is always considerably lower than the average IQ (the evidence is purely empirical, but supporting examples are convincing). So, there is some wisdom in not joining the crowds (2008 financial crisis is a good example). If you can endure time decay and negative carry and are looking over a long time horizon, why not go against the consensus?
Framed as a financial decision problem, one faces a choice between two scenarios: 1) A small probability of losing all of your money all at once at an undisclosed time in the future, or 2) A high probability of gradually losing small amounts over an indefinitely long period of time, keeping in mind that persistent small losses over an indefinite time period could lead to large cumulative losses.