Over the past year, we’ve variously argued that when it comes to providing unique frameworks for thinking about and analyzing markets (in general) and the low vol. regime (specifically), Deutsche Bank’s Aleksandar Kocic is peerless.
Making sense of markets of course requires a certain set of skills and technical expertise, but just like any other subject of inquiry, one’s understanding can be enhanced in proportion to one’s willingness to think about things holistically and creatively.
An inability or unwillingness to employ creativity leads directly to the mechanical production of undifferentiated, dry analysis that’s useful only to the extent it saves the reader from crunching numbers. To be sure, that’s not nothing. That is, there’s a lot to be said for saving people the trouble of devoting hours to tedious number crunching and to the extent a given analyst is particularly adept at knowing what numbers to crunch to produce compelling visuals, well that’s exceptionally helpful. Still, no one reads sellside research expecting to come away feeling especially enlightened or otherwise inspired.
Fortunately, there’s a cure for mundane, run-of-the-mill research and that cure is to be found in anything that comes from the desk of the above-mentioned Aleksandar Kocic.
One of the most useful frameworks Kocic has put forth is the “fourth wall” analogy that explains the reflexive relationship between central banks and markets in the theatre context. The two-way communication loop between central banks and markets means market participants (the audience) are no longer “watching” a self-contained narrative. Rather, there is no preset course. The observers can alter. Market participants are a co-author of the policy script.
This arrangement of course doesn’t mean the Fed (in the U.S. context) is not exercising power over the market. On the contrary. Markets are effectively operating under martial law; a “state of exception” – to quote Kocic again. But by definition, this is a transient state of affairs (it’s an “exceptional” state instituted in order to allow the market to get back to functioning normally). But if this goes on long enough, the existing dynamic and the behavior it encourages will optimize around itself and increasingly, change becomes impossible. How then, does the Fed (for example) relinquish that power?
On Thursday, Kocic is out with a brand new piece that underscores the notion that the two-way communication loop with markets is in fact the optimal strategy for exercising power. To wit:
Power, in its traditional restrictive form, is an ineffective way of imposing a rule — its influence can be only temporary, it always encounters resistance. “Smart” power, one that aspires to be effective, cannot be restrictive; it must be permissive in order to eliminate a possibility of resistance. It should operate seductively and not repressively – it has to say “yes” more often than “no”. By the same token, smart power has to be a “good listener” calling on us to confide and share our preferences. In other words, smart power needs to be transparent.
But transparency has a dark side. “Excessive” transparency makes it impossible to see outside of the communication loop. Formulating a long-term view is impossible. That environment is conducive to short-termism. We’ve been over that before. In his Thursday note, Kocic explains how that has evolved, in the process leading to the only outcome that it can lead to: a binary selection. Here’s Kocic:
However, and this is where complications arise, transparency suppresses deviation: When everyone is watching everyone else, “invisible moderators” replace the “invisible hand” — they smooth out communication and calibrate it to what is generally understood and accepted. Free choice is eliminated and replaced with a free selection (from among the options on offer). When selections are many, there is not much difference between choice and selection — controlled markets can camouflage as free markets. However, when selection is binary, resemblance to free markets disappears.
This is where we are now. You either become part of the swarm or else attempt to rebel (e.g. long vol.) knowing that unless you are joined in that rebellion by a non-negligible number of others (who have no incentive to join you), resistance is futile.
Through their communication with the markets Central banks, and the Fed in particular, have become “good listeners” with their decisions and actions made with markets’ consent. After years of this dialogue, the markets have gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting. Not much of a choice, really. In this process, Central banks have reached a point of enormous power and control where market dissent is practically impossible. We believe that such levels of market control remain uncontested with anything we have seen in recent history and that the markets’ dynamics have never been further from that of the free-markets. Low volatility is a perfect testimony of that.
Where this gets particularly interesting is when Kocic contrasts what happened initially when markets were allowed to trade off something other than breakevens with what’s happened over the last three years. Here’s residuals to breakevens for stocks and IG credit plotted out to 2014:
Note the breakout there on the right.
Now here’s the amount of 3M10Y vol. not explained by IG credit, FX vol, curve risk premium, and rate levels (you’re looking at the narrowing of the range since 2016):
As the Fed started hiking, anything that allowed investors to pick up some carry became basically the same trade. “Different asset classes became interchangeable,” Kocic writes.
So we are exiting stimulus but instead of expanding, markets are behaving as though the list of available options is actually shrinking. It’s all one trade. It’s almost like the market doesn’t want this. “Paradoxically, as the Fed is exiting, the markets are becoming increasingly monochromatic,” Kocic notes, before concluding as follows:
Compared to the first years of QE, this could be characterized as an auto-repression (in contrast to traditional or allo-repression).
How did it come to this and how do we escape?
Well, that’s a story for another time, children.