A couple of weeks ago, Deutsche Bank’s Aleksandar Kocic defined the “playground” for markets – we called it a “sandbox” in our post.
If you’re not inclined to explore this topic in any depth, there isn’t much that’s particularly complicated about it. And indeed, Bloomberg recently ran a pretty straightforward piece describing the situation and characterizing the Fed as either “impotent”, “lucky” or a little of both. To wit:
As policy makers have pushed the benchmark federal funds rate higher, long-term Treasury yields have barely budged, narrowing the gap with short-term yields to the smallest in a decade. That’s helped keep borrowing costs relatively low for consumers and companies, enabling steady economic growth and fueling continued gains in the stock market.
The upshot in that article is that the Fed is able to replenish its countercyclical ammo by sticking with gradual rate hikes while preserving the ubiquitous “punch bowl” effect along the way. That piece flags the standard concerns: the buildup of still more risk as financial conditions refuse to respond to Fed tightening, the risk that eventually the curve will invert, etc. etc.
Also enumerated are some of the standard explanations for why long rates won’t budge and included is the idea that QE and negative rates in Europe and Japan create insatiable demand for bonds from non-NIRP locales.
You get the idea. And while all of that is fine, we’re going to go out on a limb here and say that the above-mentioned Aleksandar Kocic thinks there’s a lot that’s being missed by the folks who are having this debate.
If you’re familiar with his previous work and if you also read our recent post entitled “It’s The Oil Stupid“, then you know that the factors influencing the long rate and thus ensuring that the curve continues to flatten are:
- tight fiscal policy
- positive supply shock to oil
Point three is elaborated in the oil post linked above and points one and two have been discussed at length by Kocic in a number of pieces describing what factors would need to conspire to trigger the tail risk that would come along with a bear steepening of the curve and a concurrent disorderly unwind of the bond trade.
Ok, so that brings us to Kocic’s latest which finds him revisiting the “shrinking playground.” Here’s an excerpt from a new note, out Friday evening:
The market and monetary policy are highly negatively convex to the risk of inflation, and a gradual but persistent Fed appears as a necessary condition for an orderly exit, requiring a very finely tuned strategy in terms of transparency and communication with the markets. This aspect alone has been a massive source of convexity supply and a source of complacency and compression of risk premia across the board, which has led to high levels of coordination across different market sectors as grab for yield became the new paradigm.
This led to further shrinking of the playground – the gap between the short rate and its final destination has been shrinking since the first days of policy unwind had been announced, and has now compressed to a mere 50-60bp. At this point, there are no apparent catalysts to create excitement in the markets. As a consequence, volatility continues to collapse across the board, with rates gamma leading the way.
The bolded bits there are important. This idea of policymaker transparency making it impossible for market participants to form a long-term view along with the characterization of the market as a co-author of the policy script (removal of the fourth wall, to put it in the theatre context) are two of the keys to understanding Kocic’s evolving take on markets. The fourth wall analogy is a bedrock principle here and it helps to explain what makes the feedback loops possible – why the current regime optimizes around itself – why the swarm effect has taken hold.
To illustrate the point made in the excerpted passage above re: the two-way communication loop serving as a source of convexity supply, Kocic first plots 3M10Y vol. with its levels implied by the risk premia in other markets (IG credit, curve risk premium and FX vol, all with positive loadings):
Well as it turns out, when you plot the residuals there in the context of the “playground” (i.e. the gap between the shadow rate and the long rate) they compress as the sandbox shrinks:
As the gap between the short and long rate closes, the Fed runs out of options. The market sees this deficit and positions accordingly with everyone rushing to the same trade (e.g. carry, risk premia compression, short vol etc.). In an attempt to change the course of things, and aware of the risks associated with policy unwind, the Fed consults the market through its communication channel, but the market disapproves any material change, which makes the Fed’s position even more difficult. The reduction of the maneuvering space in this way forces coordination of risk premia compression trades across different market sectors as they all become an expression of an accommodative Fed. This process continues to reinforce coordination of risk premia across different markets.
Again, this is why we continue to harp on the fourth wall analogy and why we described it above as a bedrock principle that helps to explain what makes the feedback loops possible – why the current regime optimizes around itself – why the swarm effect has taken hold. And here is Kocic to reinforce just that using the concept of systemic causation:
This mechanism of market functioning is a manifestation of systemic causation. Unlike the familiar concept of direct causation whereby application of force to something produces immediate change, systemic causation has a structure consisting of a network of direct causes, feedback loops, multiple causes, and probabilistic causations.
Not to put too fine a point on it, but this is what research should be about. Attempting to understand markets through an innovative lens, building on an existing body of work to push the discussion forward, and fleshing out the concepts proposed in that previous work as part of an ongoing effort to explain phenomenon by reference to frameworks that seem to have some explanatory power.
And so, this is another one of those times when we get to remind you that when it comes to talking about the prevailing dynamics driving markets, this is Aleksandar Kocic’s “sandbox.” You just “play” in it.