On of the key themes running through some of the macro research of late is the extent to which the “trigger” for a disorderly unwind of the prevailing dynamic that’s perpetuating the self-feeding loops that sustain the short vol. trade and push risk assets to ever loftier levels will come from a combination of fiscal spending and the sudden emergence of inflation.
Essentially, the idea is that should central banks find themselves caught offsides – i.e. woefully and hopelessly behind the curve – they will be forced to withdraw transparency. Put differently, they will be forced to strip markets of their role as a co-author of the policy script in order to ensure that they can act fast enough and forcefully enough.
This has been explicitly discussed by Deutsche Bank’s Kocic, specifically in a note out late last month as follows:
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.
Well earlier this week, Kocic’s colleague Alan Ruskin made a similar argument in the context of explaining what the “displacement trigger” might end up being for the Minsky cycle anno 2017.
Consider this stylized Minsky cycle chart:
Ruskin notes that the mini-rates tantrum that followed Sintra could be perhaps be thought of as the “triggering moment.” You’ll recall that in the wake of Draghi’s warning that he will look through “transitory” weakness in inflation, DM yields spiked, catching CTAs off guard and briefly raising the specter of a 2013 tantrum redux.
Well since then, it’s become clear that the Sintra sea change will need to be amplified in order to mark a true turning point. Submitted for your approval are excerpts from Ruskin’s note…
Via Deutsche Bank
The Minsky cycle is a useful demarcation of how a macro shock/displacement sets in train a sequence of psychological states as the asset appreciates and depreciates. In the past, DB Research has taken readers through the full Minsky asset cycle, from the macro shock ‘displacement’, to ‘healthy expansion’, to ‘leveraged driven gains’, to ‘euphoria’, ‘insider profit-taking’, ‘liquidation and panic’ and onward and downward to ‘revulsion and discredit’.
Sometimes it is obvious, but deciding which state any asset is in at any point in time is a true art form, and the most important decision from an investment standpoint. While assets often sequence as Minsky suggested, assets can get stuck for prolonged periods, or, some stages are so fleeting they can count as being skipped.
Figure 1 above, is one read on what seems to be going on with the Minsky cycle and the state of major global assets in 2017. The main difficult with the Minsky framework currently is properly identifying the displacement or macro trigger.
The Sintra message of an end to emergency easing, and rate normalization, is one likely displacement or macro ‘triggering’ event. The question is whether this will be amplified or not? This displacement could be greatly added to if: i) US fiscal policy drives a sharper increase in USD yields; and/or ii) will be enormously influenced by the extent to which developed market disinflation surprises on the up or downside. A genuine large displacement/triggering would be if rate normalization is now combined with even a small increase in goods and services inflation that leaves Central Banks behind the inflation curve. Very small shifts in goods and services inflation are capable of having outsized asset cycle implications. In contrast, global disinflation can temporarily dissipate the rate normalization shock by allowing Central Banks to tighten gradually and on their own timetable.
Ultimately this only adds to risky asset’s upswings and creates a longer potentially bigger Minsky cycle.