Listen, if we get a bond tantrum catalyzed by an unexpected uptick in inflation that forces central banks to effectively revoke the market’s license to co-author the policy script in 2018, no one can say they weren’t warned.
Black swans are by definition unpredictable, so the notion that everyone has identified the “most likely” tail risk is inherently paradoxical. That said, there is almost universal agreement that a sudden resurgence of rates vol. is the biggest risk to markets going forward.
“Goldilocks” is the meme for 2018 and part of that narrative revolves around inflation remaining subdued enough to allow central banks to remain gradualistic in their approach to normalizing policy.
Another way to think about central bank gradualism is in the context of transparency. Policymakers effectively consult the market on upcoming policy tweaks using a combination of trial balloons, speeches, and interviews with the media. The market thus gets a chance to “vote” on what’s being proposed.
If this or that trial balloon isn’t met with a violent reaction from markets, well then central bankers are free to proceed. If, on the other hand, a trial balloon is met with a vol. spike, policymakers effectively interpret that as a thumbs down from Commodus:
Ok, so this is why everyone is so concerned about the possibility of a material uptick in DM inflation. If we get that, the stage is set for policymakers to act without the market’s consent. That would entail a policy shock and in all likelihood, the knock-on effect would be a spike in rates vol. which would then spill over. The stock-bond return correlation would flip positive, triggering a quant freakout, and then the dominoes start falling.
So that’s the context for the latest fund manager survey from BofAML’s FX and rates strategy team. Appropriately, the piece that documents the results is called “What If Goldilocks Throws A Tantrum?”
“The majority of respondents see a 2018 bond market tantrum as likely or very likely, with inflation seen as the main potential trigger,” the bank writes, adding the obvious: “This ties in with concerns that inflation surprises are being underestimated.”
Here’s the chart for the tantrum risk (do note the references to policy shocks – i.e. “unexpected central bank action/communication” – and systematic strat risk – i.e. “very likely on technicals, CTA positioning unwind, risk parity”):
And here’s the inflation chart:
One thing you should definitely note about the first chart there is that yellow, green, orange, and purple are all interrelated. That is:
- inflation surprise —–> unexpected central bank action/communication ——-> bond tantrum ——–> systematic position unwind ——-> tantrum exacerbated ——–> more unwinds
Those are the dominoes. Don’t tip one.