Reinforcing The ‘Noisy Status Quo’

Who cares about the government shutdown?

Not investors, apparently. On Saturday morning, we brought you a summary of the Wall Street commentary surrounding the gridlock in D.C. The overall message: this isn’t likely to derail the economy, let alone the market.

A couple of days ago, Citi noted that “there is generally a risk-off move into the event but the moves are usually relatively small and subsequently reverse.” Well, if all we had to worry about was a “risk-off move into the event”, then we can just go ahead and pretend like this never happened because stocks hit records this week even as it became increasingly apparent that a shutdown (however fleeting it may ultimately prove to be) was inevitable.

Past experience suggests that shutdowns don’t do much damage to equities. Here are two charts from Credit Suisse we highlighted earlier:

Given the euphoria that’s characterized markets in the first three weeks of 2018, one struggles to see why this time should be any different, even taking into account the fact that we now have a President who exactly no one would describe as any semblance of “predictable”.

And indeed it could be that the more unpredictable this is, the more deeply embedded the existing market dynamic will become. When does volatility decline? It declines when, to quote Deutsche Bank’s Aleksandar Kocic, “markets are predictable or when there is no consensus.” When there is no consensus, indecision becomes to order of the day. And what does one do when one cannot make a decision? Well, one waits. And what is a vol. seller? A vol. seller is a seller of “waiting time”.

To the extent the most recent drama is just the latest in a series of “predictable” political shocks, it reinforces what one might call the “noisy status quo” which is part and parcel of the market’s inability to form a consensus. That in turn, means it’s conducive to dissensus and to the perpetuation of the dissensus-driven vol. selling regime.

In light of this and in light of recent events, we thought this was an opportune time to reprint the following excerpts from Kocic’s classic “noisy status quo” note originally released back in September following the debt ceiling debate.

Via Deutsche Bank

Noisy status quo

As transparency became the word of the decade, by its very nature it created the forces that push everything to the surface. Things exist thanks only to the attention they produce. There is no room for ambiguity. Although shocks (political and other) keep arriving in the market, they seem to be appearing at what looks like predictable time intervals (usually, on Fridays). Practically every week, there is a new issue that eclipses the previous one, and we lose interest in past issues, before there is any semblance of resolution. But shocks, if they are predictable, lose their spell and gradually become facts of life. Predictable political shocks feed back into their source. Due to their antagonistic character, they gradually erode the ability to make consensus and reduce the ability to legislate, making further reforms at least questionable, if not highly unlikely. The market “euphoria” (aka the Trump trade) that followed immediately after the elections is being perceived as increasingly remote. Despite all the promises of reflation of the economy, fiscal stimulus, expectation of economic turnaround, no change is on the horizon. We are stuck with the status quo, albeit a noisy one.

During this time, despite all the distortions and disruptions introduced by the central banks’, which has created a semi-permanent state of exception, markets have not lost one main characteristic, their adaptability. As the markets are getting inoculated against event risk, volatility continues to be under pressure. While we are distancing ourselves from the idea of political change, the Fed is seen, once again, as the main source of volatility. However, the Fed’s position is an uncomfortable one. The main problem it faces is the balance between preventing inflation from becoming a risk while at the same time not causing a rapid and substantial rise of rates. This requires a high level of fine tuning. It means that the Fed has to continue with rate hikes, but the hikes have to be done carefully without triggering the bond unwind.

This in turn implies that the market gradually, and reluctantly, trails behind the Fed, one hike at a time, and adjusts expectations on the go, without taking a longterm view on the Fed.

It is difficult to see how this can lead to any excitement capable of inspiring higher volatility. As long as things evolve according to this scenario, everything should remain “predictable” with occasional noise that the market has learned to ignore. This is an environment that is bearish for volatility. It fosters further complacency and encourages continued vol selling.