Ok, who’s ready to take another look behind the “fourth wall?”
This was a Fed week and as such, every commentator, pundit, analyst, and finance blogger was compelled to weigh in on what the new dot plot tells us about how the Fed’s reaction function has (or hasn’t) changed over the past several months. So let’s revisit what it is we’re really talking about when we talk about the reaction function of the Eccles cabal.
Recall that you ceased to be a passive spectator in the drama that is monetary policy long ago. No longer are you merely an observer of a play unfolding before you on the stage. You are, to quote Deutsche Bank’s Aleksandar Kocic, “an alterable observer who is able to alter.” That is, you are helping to write the script. You are part of the reaction function. This is a reflexive relationship. “What you’re watching is not necessarily an inevitable self-contained narrative,” Kocic wrote back in 2015. You are “observing yourself from another angle as an observer of the observer of the observers.”
That’s Kocic’s application of what, in the theatrical context, is known as the removal of the fourth wall, to the interplay between the Fed and markets (i.e. between the Fed and the audience or, more to the point, between the Fed and you).
By making you a part of the play, policymakers are essentially long an option to act on your behalf and that option is financed by selling an OTM option on the Fed’s credibility. As Kocic writes in a new note out Friday evening, “the ‘credibility’ short has been the major source of volatility supply to the markets – the reason why, despite all the risk associated with policy unwind, carry trade and volatility selling remain dominant across a range of market sectors.”
There are any number of problems implicit in this arrangement, not the least of which is that it transforms policy into a referendum. There are no clearly identifiable anchors. The goal posts aren’t fixed. Or, as Kocic puts it, there’s an absence of “rigid reference point[s], like a well specified reaction function, objectives, and triggers.”
So this is just a kind of rolling plebiscite. Clearly, that creates substantial risks in terms of encouraging mass myopia. Thanks to near-daily speeches and media appearances by Fed officials, this is quite literally a real-time information exchange between markets and policymakers. No one can see outside of this information exchange and if you’re a trader, there’s really no utility in trying.
In this way, transparency introduces risk in a paradoxical way. As Kocic writes, “transparency as a way of stabilizing the markets has become a tool of suboptimal control, one that reinforces the future risk in order to diffuse it — it is a tactics of delaying, rather than reducing risk.”
Unless the Fed decides to be less transparent, volatility is likely to remain suppressed even as the very act of suppressing it effectively raises the long-term risks by making it impossible for markets to appraise things outside the context of the day-to-day information exchange.
Below, find Kocic’s full note.
Via Deutsche Bank
Transparency and suboptimal control
Post FOMC excitement has proven to be short lived. The market has reverted again to what appears to be a familiar pattern, whereby gamma becomes a way of event trading. It is difficult to see anything in the near term that can provide a sustained support for vol. As long as there is no structural shift – and it is becoming increasingly clear that such a shift is not on the horizon — regardless of the content of the event, volatility is unlikely to sustain a bid.
In our view, primary reason for persistence of bearish pressures on gamma is excessive liquidity on the exchanges and transparency of the Fed. As much as transparency has been elevated as a tool intended to inspire trust, it inherently creates blind spots and residual risks that in the long run become difficult to manage. Transparency forces everything inward and numbs the awareness of anything that resides outside of the existing channels of informational exchange, making it difficult to have a non-consensus view against the background of total transparency. In this way, transparency becomes a method of control.
In the environment of abundant information, everything becomes short term. A long term vision becomes progressively more difficult to construct and things that take more time to mature receive less and less attention. Given the magnitude and severity of policy response during the financial crisis, Fed has been running significant addiction liability in the context of stimulus unwind. The communication loop between the Fed and the markets has become a way of controlling the residual risks associated with their exit. Excessive transparency has been perceived as the most effective way to stabilize the system. When used in this context, it confirms and optimizes only what already exists. The markets remain blind to what lies outside of the context of informational exchange. However, without a rigid reference point, like well specified reaction function, objectives, and triggers, policy risks to deteriorate into a matter of referendum. More information or more communication does not eliminate fundamental absence of clarity and does not necessarily lead to better decision. Most often, it only heightens confusion.
Transparency as a way of stabilizing the markets has become a tool of suboptimal control, one that reinforces the future risk in order to diffuse it — it is a tactics of delaying, rather than reducing risk. As a result of post-2008 regulatory changes and eight years of accommodation, there is currently more than $2tr of duration parked in mutual funds, not all of it very liquid. This is happening at the same time as regulatory restrictions are limiting dealers’ ability to extend liquidity in a way they used to. Anything that would force a disorderly unwind of this trade presents the biggest tail risk and the challenge of its managing requires creation and maintenance of the environment which ensures that: 1) probability of unwind remains infinitesimal, and 2) even if triggered, unwind cannot be realized. Managing these two barriers is likely to remain one of the main objectives of any policy making.
Predictable monetary policy and tightly controlled Fed exit, in general, defines the background against which everything else will play out. Fed is long an option to hike (or not to hike), depending on the market conditions and assessment of market’s reaction – they can expand their reaction function/mandate in such a way that it keeps smooth operation without raising the fear of tail risk. At the same time, Fed is running a risk of upsetting the markets and/or creating a perception of eroding confidence. Fed is short a “credibility” option – their actions have to be credible and the market must not challenge them. This “credibility” short has been the major source of volatility supply to the markets – the reason why, despite all the risk associated with policy unwind, carry trade and volatility selling remain dominant across a range of market sectors.
Withdrawing that option, i.e. being less transparent, and less concerned about the market reaction, could raise the stakes and push vol levels higher. It would restore risk premia as it would represent an implicit withdrawal of convexity supply to the market. However, Fed’s transparency is the key factor for managing risk of their exit. It is unlikely that they would willingly give it up. We see inflation and deficit spending (releveraging) – anything that would cause a substantial bear steepening of the curve – as the only factors that could force Fed’s hand. Either one could create conditions where unwind of the Fed’s “credibility” short becomes inevitable. That would represent a withdrawal of convexity from the market and, as such, would be bullish for vol.
Without either deficit spending or inflation, the market will be reluctant to take a longer view on the Fed. The most we can expect is repricing of the Fed path, rather than the long end. In the absence of indication that the range of long rates is likely to be violated, we do not expect to see anything but short rate adjustments. We see this as another side of Fed’s transparency.