The narrative in 2017 revolved around two things: “Goldilocks” and the low vol. regime.
“Goldilocks” of course refers to the synchronous upturn in global growth and well-anchored inflation. Inflation needed to be low enough to keep DM central banks from falling behind the curve or, perhaps more importantly (because really, with all of the models now broken, what even is “the curve”?), to keep the market from thinking that policymakers are behind the curve.
Of course there was always an inherent contradiction buried in that narrative. It stands to reason that if global growth continues to accelerate, inflation pressures will build and while that’s ostensibly a good thing, it’s only “good” up to a certain point. Therein lies the irony of the entire post-crisis reflation effort. We’ve spent nine years chasing something no one really wants to catch.
If it’s crisis-era policies that are underpinning risk assets, underwriting the carry trade, and keeping the vol. sellers (both implicit and explicit) solvent and if the durability of those policies depends on inflation remaining subdued, well then the implication is that everyone is looking for plausible deniability when it comes to inflation. Even if there’s evidence that price pressures are building (and there’s been some evidence of that lately), policymakers need to manufacture reasons to doubt the data while at the same time pretending to not understand structural disinflationary factors on the way to downplaying the possibility that the deflation bogeyman is still lurking around somewhere.
In short: policymakers need to be able to argue both sides of the coin. They need to ensure that the “target” remains elusive and not well defined so as to avoid a scenario where the market can point to the data as “evidence” of progress towards a goal which, once reached, will definitively spell the end of accommodation. At the same time, they need to couch every downside miss on the inflation front as attributable to “transient” factors so as to avoid a scenario where the market gets spooked about the possibility of a return to deflation at a time when policymakers are out of ammo.
So before you go calling DM central bankers “incompetent,” think about what it is they’re managing here. Whether you agree with the side effects (bubbles in financial assets, the tacit approval of speculation, etc.), the effort is a kind of performance art and as Jerome Powell learned on Tuesday, playing the part successfully is not easy.
If you can pull that performance off (as a policymaker), then you can give yourself an excuse to stick to a gradualistic pace of normalization and as long as something doesn’t come along that delivers an inflation shock, well then you can effectively engineer “Goldilocks” as accommodation fosters robust growth.
That plan probably would have worked, but expansionary fiscal policy has thrown a monkey wrench in things. To be clear, fiscal stimulus would have been welcome some years ago as it would have allowed central banks to pass the baton, but thanks to a confluence of factors (not the least of which was the pressing need for austerity in various economies to return things to some semblance of “sustainable”) it wasn’t feasible and so monetary policy was forced to shoulder the burden for the entirety of the recovery. Well now that the recovery is finally here, you can’t simply pile fiscal stimulus on top of things. It’s too late for that. If you adopt expansionary policies at this stage, you risk delivering just the kind of inflation shock that will force central banks to abandon the gradualistic pace of normalization that’s part and parcel of the obfuscation outlined above. Simply put, you make it more difficult for central banks to continually move the goalposts. That, in turn, puts the low vol. regime at risk.
As Goldman writes in an expansive new note, “a Goldilocks backdrop of accelerating growth and anchored rates and inflation has been common for most low vol regimes in the past 100 years.” Therefore, “a worsening growth/inflation mix will likely result in the end of the low vol regime that started in mid-2016.” Consider this, from the same note:
While this low vol regime has lasted just 19 months, shorter than many of those since the 1990s, levels of vol were lower – it saw the most consecutive days with S&P 500 1-month realised vol below 10% since the 1970s (Exhibit 7). With strong growth and low recession risk, a shift to a high vol regime (>18%) seems unlikely – but realised vol is also unlikely to settle below 10% again without a Goldilocks backdrop. For asset allocators, that points to lower risk-adjusted returns, especially for equities. At the beginning of 2018, the 12-month return / volatility ratio for the S&P 500 peaked at 4.2, one of the highest levels in the last 100 years; such high levels are often reached during low vol regimes, which makes ‘boring’ markets ‘exciting’ for asset allocators. The last time similarly high risk-adjusted returns were reached was in the mid-1990s and the 1960s.
History suggests that if the correction we saw earlier this month ends up being, as most people seem to assume it will be, a correction within a bull market, vol. should normalize quickly. That said, Goldman notes that “what has been unusual about this correction was the size of the vol spike after the long period of low vol.” Here are the relevant charts on those points:
Just to kind of connect the dots here to everything we’ve seen over the past several weeks (and especially since the Fed minutes), real rates are in the driver’s seat for equities and real rates have become a function of inflation expectations as the market’s perception of the outlook for inflation feeds back into everyone’s outlook for the Fed. Powell reinforced this on Tuesday with his comments about how the incoming data since December has influenced his outlook on the inflation target. Have a look at real 10Y yields plotted with S&P futs:
Now let’s bring in Goldman one more time:
Historically, a vol spike during a bull market correction has reversed within three months, but it could settle at higher levels given elevated rates volatility. While inflation fears seem to have driven a higher VIX YTD, this correlation has turned negative again (Exhibit 11). However, the correlation with real yields has stayed positive, indicating further increases in real yields could put upward pressure on the VIX.
Coming full circle, you better hope Jerome Powell gets better at managing the two-way communication loop (i.e. the reflexive relationship) with markets.
Because if he doesn’t, we’re gonna be pourin’ out a little liquor for the low vol. regime in the very near future.