A couple of days ago, we penned something called “‘If You See A Vol. Spike, Try To Kill It, Ok? It’s Not A Pet.‘”
The first thing we want to point out about that post is that the title is a reference to what is possibly the most underrated Will Ferrell movie ever produced – a campy, crude, R-rated masterpiece of slapstick comedy called “Semi-Pro.” If you haven’t seen it, you have inadvertently done yourself a disservice and you should correct that oversight at your earliest convenience.
With that out of the way, recall what we said about the extent to which discussions of the low vol. regime have become generic by virtue of being obligatory:
Who wants to talk some more about the low vol. regime?
Why, everybody of course! That’s the “great” thing about persistently suppressed vol. – if nothing is moving, the only thing to talk about is why.
This has been parsed to the point of absurdity and unless your name is Aleksandar Kocic, there is virtually no chance that you have anything new to add to the discussion.
Well on Friday evening, Kocic is back to rescue everyone from vapid vol. discussions by way of yet another instant classic.
If you read Kocic’s recent post on transparency, you can probably guess what he thinks about the ECB’s “dovish” taper. In short: by extending APP through next September and explicitly stating that the pace of asset purchases can and will be adjusted in the event something unfavorable should occur, Draghi has preserved (indeed perpetuated) the communication loop between policymakers and markets. The market is still a co-author of the policy script.
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 put it late last month, 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 wrote, “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.”
That’s the context for his critique of the ECB decision. To wit, from his latest:
After last week’s ECB meeting, it became clear that Central Banks’s main agenda is management of the risk of policy unwind. This has two different aspects. On one hand, it is reassuring that Central Banks are cognizant of severity of the risk and are showing appropriate flexibility in adjusting their reaction functions to incorporate these realities. On the other hand, this is less good because it does not allow the market to reposition and, thus, normalize. By soliciting feedback from the markets, Central Banks are further encouraging bad behavior making things potentially worse by postponing the resolution further into the future.
Again, transparency makes it impossible for anyone to take a long-term view and so, bad behavior is encouraged as the feedback loops the prevailing order has served to embed in markets are optimized. Let me bring in a quote from a Citi note that came out way back in February:
When spreads are low and volatility 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.
As Kocic puts it this evening, “money managers are pressured to deliver in an increasingly challenging environment as risk premia continue to compress across the board [and] the dilemma they are facing is either to engage in short term risky strategies or face redemptions.”
Well once that becomes entrenched – i.e. once market participants become so conditioned by nearly a decade of policies that create self-referential dynamics and self-fulfilling prophecies – withdrawing transparency risks triggering a catastrophic unwind. To avoid that, policy makers simply keep the communication channel open. The fourth wall is never rebuilt. What’s happening on the policy stage is not, to paraphrase Kocic’s original fourth wall piece from 2015, a self-contained narrative with a preset course. Rather, “you are observing yourself from another angle as an observer of the observer of the observers.”
Now this is where it gets really fun, because I get to bring in yet another reference to a campy comedy which, while not nearly as entertaining as “Semi-Pro” (mentioned above) still has its moments. Here’s one of the “best” clips from the truly awful “Dodgeball”:
That is the perfect clip for the dynamic that exists between markets and central banks. Every time there’s a policy meeting or better yet, anytime things get dicey and the market needs reassurances, that’s effectively the exchange:
I mean come on, I know you. You know you. And I know that you know that I know you.
And here’s Kocic basically saying just that, while simultaneously bringing the concept of “metastability” (more here) back into the discussion:
The markets appear to be locally stable, but are effectively dancing on the edge of metastablity whereby practically any non-trivial shock can be destabilizing.
People had abandoned any long-term agenda and have concentrated all the efforts on extracting as much as possible in the near term. With overhang of almost a decade of unprecedented stimulus and one-sided positioning, the market is vulnerable to violent selloffs. This is a consequence of Central Banks’ complicity and shrinking of the horizons – the future is degrading into an optimized present.
At this point, there is an implicit symbolic pact between Central Banks and the markets: The Fed knows that the market knows and the market knows that the Fed knows that the market knows, so everyone knows, but pretends that nobody knows and the game goes on.
So it’s a kind of virtuous stalemate. And the only question is what breaks it. Because as Kocic wrote earlier this year:
A totally innocuous event can trigger a cataclysmic event (e.g. a skier’s scream, or simply continued snowfall until the snow cover is so massive that its own weight triggers an avalanche).
On Friday, he poses that as a question:
But what happens if there is an exogenous circuit breaker and we can no longer pretend?
For now, we’ll leave you with that. But do check back tomorrow, when we’ll bring you the second installment which contains a (partial) answer to that question.