Heisenberg Report

Here Are The Remaining Risks And Here’s What Jerome Powell Can Do In A Crisis

Needless to say, it’s probably prudent to reserve judgement on whether we’re out of the proverbial woods until we get a day that doesn’t see the type of manic price action witnessed on Wall Street Tuesday.

I’m not entirely sure swinging from 500+ points down to 560+ points higher on the Dow is indicative of things “calming down” per se. Additionally, something seems to have been a bit off with the VIX around the open, just after it spiked to 50 for the first time since 2015.

In the same vein, it’s not at all clear that the underlying issue has gone away. Amid the VIX ETP unwind, we seem to have skipped straight from worrying about the bond market rout to panicking about a market structure breakdown in relatively short order. Over the past 48 hours, folks seem to have forgotten that what helped cause this in the first place was rapidly rising yields and indeed, the safe haven bid associated with the acute risk off move on Monday helped to ameliorate that situation (have a look at what 10Y Treasurys did right at 3:00 p.m. ET on Monday when the bottom fell out for U.S. equities).


But it’s entirely possible that once the shock wears off, we’ll be right back to focusing on the potential for upside surprises on the inflation front to force central banks to withdraw transparency by effectively cutting the cord with markets and leaning aggressively hawkish in order to avoid falling behind the curve. If, on the other hand, the Fed (for instance) were to stick with a gradualistic approach to hiking in the interest of not risking a policy mistake (like say bear flattening us into a fucking recession), they risk seeing the curve aggressively bear steepen on them as the market prices in not only rising inflation pressures but also expansionary fiscal policy and the prospect of more supply from Treasury at time of waning foreign demand and Fed balance sheet rundown. In other words, we may be out of the woods on the technical risk associated with the VIX ETP rebalance by virtue of the deck being cleared, but what happens when everyone remembers why we were worried in the first place?

“[When] long-term UST yields rose to a four year high of 2.88%, driven by inflationary concerns, the over-confident market got a huge surprise,” Deutsche Bank’s Masao Muraki reminds you, in a new note, adding that “the fiscal stimulus measures conducted under conditions of near-full employment have exacerbated inflationary concerns [and] former Fed Chair Janet Yellen and Vice-Chair Stanley Fischer warned that fiscal stimulus measures in the current employment environment were unnecessary, and would cause side-effects.”

Right. And again, that situation has not changed over the past two days. The only thing that’s changed is that the market found something more urgent to worry about, namely the liquidation of the VIX ETP doomsday vehicles and concurrent concerns about whether the super-charged vol. spike could tip the next domino in the doom loop, which would entail forced selling from the systematic crowd.

As usual, the quants are out saying everyone is wrong to suggest that they will be forced to deleverage into a falling market. You can read much more about why they think you’re wrong in the latest from Bloomberg’s Dani Burger here.

While the quants may be correct to say that everyone is exaggerating the potential for systematic selling to meaningfully impact markets in a crisis, that’s not going to keep analysts from writing about it and indeed, there has been a rather contentious back-and-forth between the buyside and the sellside on this for years. The above-mentioned Masao Muraki had this to say on Tuesday:

As we have repeated since November, funds adopting a volatility-targeting strategy have become enormous, and macro funds and CTAs adopting a systematic management approach appear to be managing near the upper limit of VaR. Funds adopting volatility-targeting strategies will increase their holdings of risk assets, irrespective of valuations, when implied volatility declines. The flip side, however, is that when implied volatility rises, they will immediately dump their risk assets, again, irrespective of valuations.

He goes on to note the following:

Market stresses, and the unwinding of the consensus trade, can occur suddenly without any sign. In 2007, in the face of difficulties in short-term funds raising, funds and financial institutions that had procured short-term funds with CP and repos in order to invest in mortgage-backed securities, sold their assets off at fire sale prices. In December 2015, a mutual fund which had promised next-day conversions into cash to solicit short-term funds from retail investors to invest in long-term distressed bonds, suspended surrenders, leading to a selldown in corporate bonds and leveraged loans by other funds. The defining features of these crises are maturity transformation and liquidity transformation. Fed Chair Jerome Powell calls that these mutual funds are providing the liquidity illusion. We believe mutual funds’ maturity transformation and credit risk-taking are at historically worst levels.

To be clear, Muraki’s piece is characteristically meandering (that’s kind of his style and we don’t mean that derisively), so it’s not so much that he’s trying to make some kind of dire prediction as much as he is just describing the prevailing environment and laying out some possible risk factors.

One thing he notes towards the end is that it could ultimately fall on Jerome Powell to figure out how to calm the market down in the event things get any worse. Here is what Muraki says Powell may be forced to do (or not do):

Fed Chair Powell has begun his term with difficult issues thrown into his lap. First, he needs to assess the risk of inflation accelerating. He will have no choice but to steadily hike rates if he judges the risk of inflation accelerating to be high. Assuming no letup in the fire sale of long-term bonds, one option to rein in rising long-term interest rates would be to alter the Fed’s balance sheet reduction program (reinvestment policy), currently in auto pilot; this could entail an operation twist policy to encourage a flattening of the yield curve.

Separately, in the face of surging volatility and tightening financial environment, we believe Powell will need to hold off on his planned communication strategy of intentionally reducing transparency of the Fed’s guidance.

There you go. Will Powell’s mettle be tested immediately? And if the market does force him to rethink whatever it is he was planning on doing in terms of forward guidance and the rate path, will Trump make things worse by heaping pressure on him via Twitter?

We kind of hope not, but then again, it sure would be funny if the market collapsed another 1,000 points and everyone woke up to a Trump tweet blaming “Jerk-off Jerome” for the implosion of America’s 401ks.