Last week, Deutsche Bank’s Aleksandar Kocic took you back “behind the fourth wall.”
The reference there is to how Kocic has used the theatrical context to describe the communication loop between the Fed and markets. Here’s how we briefly recapped things last weekend using quotes from Kocic’s classic 2015 note:
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 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.” You are “observing yourself from another angle as an observer of the observer of the observers.”
The transparency inherent in that relationship has been described by policymakers and by many market participants as something that is helpful and indeed necessary. In a post-crisis environment characterized by extraordinary policies, the argument seems to be that because of the extraordinary nature of the policy response, absolute transparency is necessary as those policies are rolled back. In the absence of that transparency, the potential exists for surprises and, by extension, for adverse and/or potentially destabilizing market outcomes.
The problem though, is that this transparency has a way of perpetuating the existing order and entrenching the market behavior that order has encouraged and facilitated. Additionally, and this is perhaps the most dangerous part, transparency “inherently creates blind spots and residual risks that in the long run become difficult to manage,” as Kocic puts it. Here’s another quote from last week’s note:
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.
It seems profoundly unlikely that the Fed would move to alter this state of affairs anytime soon. After all, this is how they are managing the risk inherent in their efforts to gradually normalize policy. But it isn’t immediately clear from the above that things will ever be truly “normal” again, which hints at a possible “permanence” (or at least a “semi” permanence) of the “state of exception” (more on that here).
So what could change this? For Kocic, the answer seems to be something that would cause a rapid bear steepening of the curve – so inflation or deficit spending.
Meanwhile, as the transparency inherent in the communication loop between central banks and markets makes it harder and harder for anyone to formulate a long-term view, political shocks are summarily dismissed or to the extent they are notable, they ultimately feed back on themselves and perpetuate a state of dissensus (see here and here).
That’s the context for Kocic’s latest note, which can be found below.
Via Deutsche Bank
Noisy status quo
As transparency became the word of the decade, by its very nature it created the forces that push everything to the surface. Things exist thanks only to the attention they produce. There is no room for ambiguity. Although shocks (political and other) keep arriving in the market, they seem to be appearing at what looks like predictable time intervals (usually, on Fridays). Practically every week, there is a new issue that eclipses the previous one, and we lose interest in past issues, before there is any semblance of resolution. But shocks, if they are predictable, lose their spell and gradually become facts of life. Predictable political shocks feed back into their source. Due to their antagonistic character, they gradually erode the ability to make consensus and reduce the ability to legislate, making further reforms at least questionable, if not highly unlikely. The market “euphoria” (aka the Trump trade) that followed immediately after the elections is being perceived as increasingly remote. Despite all the promises of reflation of the economy, fiscal stimulus, expectation of economic turnaround, no change is on the horizon. We are stuck with the status quo, albeit a noisy one.
During this time, despite all the distortions and disruptions introduced by the central banks’, which has created a semi-permanent state of exception, markets have not lost one main characteristic, their adaptability. As the markets are getting inoculated against event risk, volatility continues to be under pressure. While we are distancing ourselves from the idea of political change, the Fed is seen, once again, as the main source of volatility. However, the Fed’s position is an uncomfortable one. The main problem it faces is the balance between preventing inflation from becoming a risk while at the same time not causing a rapid and substantial rise of rates. This requires a high level of fine tuning. It means that the Fed has to continue with rate hikes, but the hikes have to be done carefully without triggering the bond unwind.
This in turn implies that the market gradually, and reluctantly, trails behind the Fed, one hike at a time, and adjusts expectations on the go, without taking a longterm view on the Fed.
It is difficult to see how this can lead to any excitement capable of inspiring higher volatility. As long as things evolve according to this scenario, everything should remain “predictable” with occasional noise that the market has learned to ignore. This is an environment that is bearish for volatility. It fosters further complacency and encourages continued vol selling.