Two weeks back, after explaining what the “hierarchy of vulnerability” for markets will likely be going forward in the event the proximate cause of market turmoil continues to be geopolitical in nature (e.g. trade war jitters), Deutsche Bank’s Aleksandar Kocic outlined how the Powell Fed is attempting to reassert policymaker control over the normalization process.
Essentially, Kocic framed things in terms of curve dynamics where the post-crisis period has been dominated by abnormal “explosive rates dynamics” or, more simply, shocks manifesting themselves at the back end. To wit:
For more than seven years after 2008, bear steepeners and bull flatteners were dominant modes of the curve — while short end hardly moved, back end articulated response to market shocks. These two modes of curve response were effectively a referendum on success of stimulus.
The explosive process does not present a problem as long as the front end is in a “sleeper” mode, but as soon as it starts moving – when rate hikes commence – the risk of the long end getting unhinged becomes a problem.
Kocic ties this to the “breather” discussion as articulated last month. To wit:
Every violent bear steepener has been encountered with an appropriate response of the short end of the curve causing a gradual flattener in such a way to shift the action closer to the front end. This is the “breather” mode of the curve. Effectively this was an attempt to recalibrate rates market and remove the risk of “exploding” back end. As a result, with time the bear steepening eruptions became less volatile and more limited arguing in favor of Fed’s success in their effort.
Now, the Fed appears to be trying to take control of their own destiny (i.e. gain some level on control over the possibility that the tail risk associated with a disorderly unwind of the bond trade is realized). “Instead of risking that markets raise rates, they are taking control of that process,” Kocic wrote, a couple of weeks back.
Ok, so all of that leads us to the latest from Kocic in which he outlines the “restriking of the Fed put.” As you’re aware, financial conditions in the U.S. remained loose as the Fed gingerly embarked on the path to normalization. Here’s Kocic:
So long as rates rise did not significantly undermine S&P support, the strike of the Fed put remained unchanged and convexity supply to equity market constant. This was an important aspect of policy unwind. After years of unprecedented positive externalities when everything rallied, the market was transitioning to a new regime of policy withdrawal where unconditional support of different assets was up for reconditioning and where, by logical extension, everything was bound to sell off. In that environment, repositioning is as much about volatility as it is about performance. Volatility is the key decision variable: when everything sells off, one retains the most stable assets and reduces the risk by exiting the volatile sectors. This is the logic behind stability of the strike of the Fed put and its fine tuning.
Note that when Kocic talks about “everything” being “bound to sell off”, he’s alluding to the hierarchy of vulnerability discussed at length in the two posts linked here at the outset. Remember that equities have been on the front lines lately, while HY has paradoxically become less risky than IG owing to IG’s connection to macro-systemic risk, while bonds have found support from the safe-haven bid that accompanies “pure” or “simple” (if you will) risk-off episodes like those which have accompanied the trade war jitters in recent weeks. Therefore: Rates < HY < IG < Equity.
Getting back to Kocic’s latest, he argues that eventually, if equities fall enough, the market will begin to doubt the ability of the Fed to hike further owing to tighter financial conditions:
With equities selling off and Fed staying the course, strike of the Fed put has been moving further out of the money on both accounts: short end of the curve continues moving higher while equities are selling off. Effectively, convexity is being withdrawn from the market and equities are reacting to it. While in the short run, such divergence/dispersion could be reinforcing, in all likelihood, there would be a breaking point when further weakness in equities tightens financial conditions that the market begins to take additional hikes out of the curve.
He goes on to say that while “the market continues to be (about one hike) behind the dots,” positioning suggests everyone (or damn near everyone) is betting on more hikes and to the extent that’s a contrarian indicator, it sets the stage for a reversal. That’s one side of the equation and on the other side are equities which, if they continue to decline, could effectively test Powell’s mettle.
The bottom line here for anyone who isn’t inclined to try and play short end instability directly (and if you are, Kocic has some trades for you), is that financial conditions are what short circuits what could end up being a rather pernicious feedback loop. And on that note, we’ll leave you with one last quote from Aleksandar:
In our view, Fed put is currently moving deeper out of the money. This is effectively a withdrawal of convexity and risk assets are reacting with what at the moment appears as a reinforcing loop. Transmission of equity selloff through financial conditions could act as a circuit breaker and trigger repricing of the rates path. This could lead to bull steepening of the curve. This could be seen by the market as restriking of the Fed put and supply of convexity that should be embraced by risk.