“This time is different.”
The cliché of clichés. The most eye roll-inducing phrase of all phrases that elicit eye rolls. The gold standard of the doomsaying gold bugs. The go-to aphorism for a bear that’s run fresh out of ideas.
Stripped of legitimacy through overuse and persistent misapplication, “this time is different” has become the one thing you don’t say in polite company if you’re at all interested in having any company at all. “This time is different” has become the special domain of the fringe blogs – a title they use for the token market posts they manage to cram in between “Yellowstone Supervolcano Threatens To Swallow Midwest” and “Hillary Clinton Caught Having Lunch With Transexual Martians At Area 51”.
And see that’s unfortunate, because as my buddy Kevin Muir wrote earlier this week, this time actually is different. Like, for real. In fact, “this time is different” by design. It’s not a secret. It’s the furthest thing from a conspiratorial comment that one could make. Central bank policy in the post-crisis world is unprecedented in nature – that is, it’s “different”. And here’s what “different” looks like:
Of course it follows from the same dynamic that’s part and parcel of an unanchored system. If what you want is the flexibility and the policy toolkit to deploy countercyclical measures during downturns, well then what you’re going to end up doing is having to effectively inflate larger bubbles each time in a kind of spiral dynamic where the next boom has to be large enough to subsume the last. The only way that can continue to work in perpetuity is if it operates against a backdrop of a disinflationary shock or some other structural disinflationary dynamic that keeps it from spinning out of control. So in a sense, “this time” is just “last time” on steroids, but that’s another story.
For our purposes here, the point is that the post-crisis policy response was indeed “different” (by design) and therefore we should expect both the recovery and the unwind of that policy response to be “different” as well. One of the reasons why this might not be readily apparent to a lot of people is simply because, to quote Deutsche Bank’s Aleksandar Kocic, “the last time we saw a recovery from a conventional recession was about 14 years ago [and] for many, this is longer than their entire professional career.”
Right. Or, as we’ve put it on several occasions, it is entirely likely that a non-negligible percentage of market participants have never seen anything that approximates two-way markets because they were in high school (and maybe even middle school) when Lehman imploded.
Well in the same note mentioned above, Kocic takes a look at what he calls “the painful process of re-emancipation” for markets. Regular readers will be familiar with Kocic’s work, so he needs no introduction. There are multiple parts to his latest missive and we’ll get to them all over the course of the weekend, starting with the difference between this time and last time, where “last time” simply means conventional recession-recovery paths which Kocic illustrates with the following chart:
“We start at point 1: Recession typically begins with a steep decline in risk assets and allocation to bonds, monetary policy intervenes with rate cuts, which slows the selloff in risk, with rate cuts continuing until the economy stabilizes and the market turns around (2),” Kocic writes, taking you through the diagram. “As the defensive position (long bonds/short risk) is rebalanced, it moves the market naturally into the risk-on region (3) with more aggressive allocation to risk assets and underweight in bonds continuing typically until rate hikes slow the rise in equities (4),” he continues.
The key thing to understand here is that, as Kocic emphasizes, “recovery is a mirror image of the recession.” To wit, in more detail:
Unwind of the recession trade (in the conventional setting) goes along the grain of the market trade – its inertia leads naturally into the recovery trade. Because of this, past recoveries have been generally accompanied with lower volatility.
Ok, but “this time is different.” Really. Because again, the policy response was “unconventional” and “unprecedented.” No longer is the unwind of the recession trade risk-on – it’s now risk-off. Or, as Kocic puts it, “unwind of QE now becomes essentially a de-risking move — it goes against the grain of recovery.”
Below, find the recession-recovery path on unconventional policy. This is why it’s “different this time” (incidentally, Kocic calls this “Monetary policy pharmakon of why does it hurt when we unwind?”, a title which will invariably cause some folks who aren’t inclined to appreciate the utility of employing creative writing in the service of market analysis to throw a conniption fit, but thankfully, word on the Street is that no one has taken those folks seriously in at least five years). Here’s the chart:
So this starts out normally. Risk sells off and bonds rally as we move from (1) to (2). But when you throw QE (and especially the latter stages of QE) into the mix, “the action moves (and stays) on the off-diagonal where both bonds and equities rally,” Kocic notes, referencing (3) in the chart.
At that point, you’re fucked. Because when you start to try and unwind stimulus, it all sells off and as the diagram shows, you eventually reach a pivotal juncture where a stagflationary quagmire is one eventuality and recovery is the other.
But avoiding the former in favor of the latter is obviously going to be a challenge for all of the myriad reasons Kocic has described in previous pieces over the last six or so months. Getting to “recovery” in that diagram “is the biggest challenge for the Fed at the moment, which is further complicated by the ongoing rise in volatility,” he continues, adding that “this complication, which appears to come naturally in this context, is further amplified by the Fed’s negative convexity exposure to inflation.”
Ahhh yes, and that gets us directly to what everyone has been talking about this month. Here’s what Kocic has to say about what’s on everyone’s mind:
Inflation is producing an Icarus effect: Although negative convexity of inflation is a far OTM risk, it is significant even at remote distances from the strike, due to its enormous size. The accumulation of relatively illiquid long-dated bonds on retail balance sheets is at toxic levels and a substantial rise in inflation, to which there is no adequate policy response, could threaten to trigger a bond unwind that the market would be unable to absorb.
And see that bit about there being “no adequate policy response” is something Aleksandar has been pounding the table on for a while, although that’s probably not a fair characterization because from what we can tell, he doesn’t seem like the type that’s predisposed to violently beating inanimate objects like tables.
Anyway, here’s the key point from this particular section of what, again, is a larger discussion:
Locally, the main problem for risk assets is a rise in real rates: Having UST bonds with strong dollar or high real yields will be more attractive than holding US stocks, which means accelerated de-risking and higher volatility in the stock market. Higher inflation, on the other hand, would be supportive for equities and could cause another leg of selloff in bonds. What complicates things is that the behavior of real rates at this point is also a function of expected inflation: Higher inflation warrants a more hawkish Fed and therefore pricing in higher real rates. The reaction of stocks is a non-linear function of inflation – although risk assets might “like” higher inflation, this would remain true only up to a certain point.
That bolded bit represents a particularly vexing scenario and is especially relevant in light of recent events. More than a few people have asked me for my take on precisely the dynamic described in those bolded passages and so henceforth, I will simply (and happily) refer those questions to the above.