On Friday evening, we brought you some excerpts from the latest note by Deutsche Bank’s Aleksandar Kocic, in which the best analyst on the Street reminds you that the ECB decision represents a continuation of a regime characterized by a communication loop between central banks and markets.
That communication loop (call it “transparency”) effectively makes it impossible for market participants to form a long-term view, and thus it optimizes and entrenches “bad behavior” (everyone is a vol. seller, everyone is a carry trader, etc. etc.). Here’s where we left off:
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. But what happens if there is an exogenous circuit breaker and we can no longer pretend?
That “exogenous circuit breaker” could be inflation or deficit spending – something that would bear steepen the curve and thereby force central banks to withdraw transparency, breaking the communication loop and ushering in a return of volatility in the process.
Well, Kocic’s next step is to trace the evolution of volatility in the context of leverage using a coordinate plane and quadrants while channeling Minsky and Maurice Sendak in a section called “The forgotten horizon: where the wild things are”. Here’s Kocic:
There is a relationship between leverage and vol which defines the dynamics of the economy. Generally, reduced uncertainty engenders higher levels of leverage which in turn leads to additional compression of risk premia and a buildup of risks. Ultimately the system becomes unstable and results in a crisis, which in turn forces the system to deleverage in a highly volatile manner. In a way, continued prosperity and stability in itself is destabilizing leading to riskier lending as the asset prices of collateral decline. This is the essence of Minsky’s take on financial markets.
And here is the visual which, as Kocic explains, “captures generalized trajectories of volatility and leverage as seen in the last 10-15 years [and is] is a conceptual relative to the Minsky’s idea of endogeneity of financial crises”:
If that looks intimidating, don’t worry, because Kocic is going to help you. To wit:
To illustrate the market evolution in this context, we start our journey somewhere in the lower left quadrant and follow the trajectory along the ellipse in the clockwise direction. We can think of this starting point as being some time around the middle of the last decade. As the risk premia compress, leverage increases leading to higher levels of risk taking, which results in a crisis. The volatility spikes up while the system begins to deleverage. At some point the government steps in and for awhile there is an uncertainty about whether it would be able to contain the crisis without causing serious longterm side effects. Volatility continues to grow despite the decline in leverage until there are first signs of relaxation and market stabilization. As vol goes through a turnaround the system continues to deleverage, we are leaving the upper half of the plane. The success of policy response up to that point brings in some optimism about future economic growth and risk premia begin to compress.
Ok, so the question is, what happens when the policy unwind starts? That is, what happens when we move from the lower-right, to the lower-left quadrant and then must make a decision? Because there are some potential pitfalls.
The “base case” in the visual assumes that the policy response will be wound down with concurrent regulations that are strict enough to keep all the excess liquidity sloshing around in the system from finding its way into something that has the potential to convert that liquidity into inflation. Here’s Kocic:
However, and this is where the risk lies, as there is political pressure to deregulate the markets and inject additional fiscal stimulus, the door is being open for unprecedented liquidity injection to backfire in the long run.
But you don’t want too much regulation, because then you risk falling into a deflationary trap. You also don’t want a rapid, forced unwind of accommodation, because then you get catapulted right back into the lower right quadrant (that’s the “tantrum”). Now let’s go back to Kocic to explain that red arrow in the graph that takes you from the lower-left quadrant to the upper-right:
At around the same vol levels, during the 2016 presidential elections, new risk is resurfacing. With protectionist rhetoric and promises of additional fiscal spending, the risks of opening corridor to high inflation and currency crisis is back on the table, but this time, due to massive growth of retail balance sheet this becomes entangled with uncertainty about the long-term monetary policy response in this context.
That right there may be the greatest risk of all, of course it’s one you won’t hear discussed a lot from alt-Right bloggers because it suggests that the populism they love to champion is inflationary.
We’ll leave you with that for now, but do check back later for a third installment.