As Geopolitical, Policy Risks Build, This Is The ‘Hierarchy Of Vulnerability’

Exactly a week ago, I suggested that it was starting to feel bit like we had returned to a dissensus-driven regime for markets. That is, a regime characterized by a lack of ability to form consensus about anything, whether on the policy front, from a geopolitical perspective, and/or what the incoming data and price action seem to be conveying about the economy and the near-term trajectory for markets.

Previously, dissensus led to vol. selling, because as Deutsche Bank’s Aleksandar Kocic famously put it last summer (and I’m paraphrasing here) 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 that “waiting time”.

In the wake of the short vol. blowup that unfolded in early February, the predisposition to sell vol. seems to have faded a bit. This, I gently suggested, may have something to do with the unwind of the QE trade. The whole “flow” versus “stock” argument (i.e. whether it’s the ongoing monthly central bank bid for assets that matters or the overall size of the Big 3 banks’ balance sheets that’s important) is set to become less relevant precisely because both the flow and the stock are in decline.

I also noted the obvious last weekend, which was that the political turmoil in Washington has reached a fever pitch. The staff shakeups and the extremely contentious decision to fire Andrew McCabe two days before his retirement add to what was already an exceptionally fraught backdrop on the domestic political front. At a certain point, markets may simply become exhausted with that situation and assume the worst.

Or perhaps the “noisy status quo” will return. The “noisy status quo” bit was another allusion to a Kocic note.

Well on Friday evening, Aleksandar was out with his latest and happily, he addresses the dissensus point and the noisy status quo, effectively giving us a window into how he’s thinking about the frameworks that I’ve variously adopted and hijacked in my own analysis (hopefully he doesn’t mind the hijacking, considering I’m scrupulous in my citing and attribution). Here’s what he says:

For over a year now, markets have learned to discount the effects of political volatility and growing political entropy. Noisy politics (of the new kind) was interpreted as an obstacle to ability to produce consensus and legislate changes. Political uncertainty became synonymous with status quo and, as such, remained bearish for market volatility. To a large extent, this is still the case. However, with the escalation of political risks new modes of market vulnerability are emerging at the intersection of politics and policy.

You’ll note that “the intersection of politics and policy” and how that intersection itself intersects with markets is part and parcel of the Heisenberg raison d’être.

All of this is of course playing out against the backdrop of new Fed staff projections with an updated SEP that one bank described as “mix and match” and taking into consideration the new dot plot and the fact that communications strategy is now being run by a non-economist, a development I have variously (and loudly) suggested is a bad idea.

Ok, so Kocic next asks one of the only questions that matters, which is simply this:

What is the hierarchy of vulnerability in this context — which market sectors are going to be more vulnerable than the others?

The short answer is: equities. You’ve probably noticed that the long end seems to have benefited from a safe haven bid of late and as Kocic notes, “based on last week’s finale, rising geopolitical risk and trade tariffs [may] provide support for bonds which, when coupled with a more hawkish Fed, could add more flattening bias.”

The other thing last week’s “finale” (i.e. the egregious selloff that saw Dow futs plunge ~1,500 points from the post-Fed knee-jerk) seems to suggest is that geopolitical risk and the tariffs are likely to reinforce the hierarchy of vulnerability that Kocic lays out which, as alluded to above, “pushes vol. away from rates.” To wit:

It argues in favor of outperformance of equity vol over credit, with a possibility that further escalation of political risk taking rates deeper into gamma bearish territory. We have already seen the onset of this pattern of repricing. The two figures show comparison of credit, rates and equity volatilities.

That, in brief, is how Kocic describes the “hierarchy of vulnerability,” which is one of what he says are two narratives.

The other, of course, is rate normalization (i.e. the Fed).

The steeper path of policy telegraphed last week and curve dynamics could mean that, to quote Kocic one more time, “although an aggressive/hawkish Fed is seen more disruptive for risk than for rates or credit [in the short run], that could change in the long run.”

We’ll bring you more on that later (hopefully, although I’ve promised myself I’m going to actually get out of the house this afternoon, so there’s an outside chance I manage to forcibly extract myself from this chair and tear my eyes away from these monitors and get down to the beach – fingers crossed).