A Unified Theory Of Everything: From The Fed, To Volatility, To LIBOR To BTFD

Over the past, oh, I don’t know, four weeks or so, we’ve talked a lot about what “caused” February’s rout (inflation scare coupled with the realization of the VIX ETP rebalance risk, subsequent VIX spike and forced de-risking by the systematic crowd) and what factors have recently conspired to constrain the market’s ability to fully recover from that rather harrowing episode (trade war jitters, domestic political turmoil, geopolitical tension catalyzed by an escalation in Syria, etc.).

Playing out in the background is the Fed’s effort to continue along the path to normalization. That effort, combined with a safe-haven bid for the long end, has of course helped catalyze a relentless flattening of the curve following a brief steepening episode that accompanied the early February, inflation scare turmoil (more on the “breather” dynamic here).

Complicating this – and thus adding to the generalized sense of consternation – is the increased Treasury supply associated with the Trump administration’s ill-conceived foray into late-cycle fiscal stimulus. The knock-on effects of the tax cuts and the spending bill (e.g., repatriation effects and T-bill supply) have themselves conspired to help push up funding costs and all of this comes as the Fed is attempting to wind down the balance sheet.

 

Clearly, all of this can’t peacefully co-exist. Over the weekend, in “Inner And Outer Limits: Resolving An Inconsistency And What It Means For Risk“, we brought you some highlights from the latest by Deutsche Bank’s Aleksandar Kocic and Steven Zeng who talked at length about the the dynamics discussed two weeks ago in a note from JPMorgan, whose Nikolaos Panigirtzoglou flagged the first signs of inversion in the U.S. curve. We ultimately tied Deutsche’s discussion back to the idea that the Fed “put” needs to be restruck. Here’s how Kocic and Zeng explain that in the context of the Eurodollar curve (and this goes to a discrepancy between what 3y / 2y looks like it’s saying about the end of cycle, and what, 1y / 2y fwd is saying):

The inconsistency priced beyond the Green sector can be resolved through two modes: bull steepening or bear steepening. Despite both being steepeners, their causes and implications are quite different. A rally led by Greens would be a bull steepening resolution. Continued turbulence and weakness in equities could propagate through financial conditions and force a softening of the Fed path. The market reprices more dovish Fed and Reds and Greens rally (parallel of steepening), while Blues remain static together with long rates. The policy gap remains unchanged, but now the wider spread between Greens and Blues is consistent with the rest of the curve. This is also bullish for risk. It presents effectively restriking of the Fed put closer to ATM and as such is a convexity supply to equities.

Ok, so all of that is the setup to a piece from BofAML which, if nothing else, is ambitious.

We’re just going to kind of run through it quickly using short excerpts and some of the visuals. This is supposed to be a unified theory on the implications for gold (they call it “the gold big bang theory”), but from where I’m sitting, it’s more useful as a reiteration and/or addendum to the discussions found at all of the links above.

BofAML begins by noting that “tighter Fed policy is helping lift OIS and LIBOR.” To wit:

The Fed has already been hiking rates at a steady pace for 9 quarters now (Chart 1). Looking forward, with a tight labor market backdrop and rising commodity prices, our economics team believes that the Fed will likely complete three more hikes this year. In addion, we believe that Fed balance sheet tapering has been an important contributor to the rapid widening in the 3m LIBOR-OIS spread (Chart 2).

Next, the bank notes the obvious which is that rising rates could well push up macro volatility and, by extension, volatility in markets. Here are the visuals that accompany that discussion:

As noted above, and as discussed here in the following articles (plus dozens of others that I’m not going to go back and track down right now)…

• Goldman Warns On U.S. Fiscal Policy: ‘We Are Heading Into Uncharted Territory’
• ‘Is Nobody Gonna Tell Him?’ MAGA And The Pedal To The Metal Economy
• ‘This Is Poorly-Timed’: Credit Suisse Ups Rate Hike Forecast Amid Budget Boondoggle
• Albert Edwards: ‘Trump’’s Grotesquely Ill-Timed Stimulus Will Be Trigger For Market Implosion, Recession’

… expansionary fiscal policy is colliding head-on with a Fed that’s pulling away from supporting the bond market which, when taken together translates into a pretty dangerous distortion of the supply/demand dynamic:

And then you have to consider what it means for inflation when you pile fiscal stimulus atop an economy that’s operating at full employment and then you pile soaring crude prices on top of that:

Higher volatility means lower risk-adjusted returns:

So, will the Fed intervene? And by “intervene” I of course mean change course or otherwise put the brakes on the hiking cycle, restriking the Fed put as financial conditions tighten? BofAML says “not yet”, but it could be coming. This is where I’ll quote them directly again. To wit:

There is no playbook that can help manage a major central bank balance sheet reduction, as this exercise has never been tried before. And while our GFSI index does not signal major stress across all markets, we believe the blow out in funding spreads such as 3m LIBOR-OIS or the spike in the VIX index could be canaries in the ZIRP exit coal mine.

Our research suggests that funding spreads are a leading indicator of market stress (Chart 12). In fact, when we incorporate the 3m L-OIS spread to our VIX fair-value model, the R-squared jumps from 0.60 to 0.69. Importantly, we estimate that the recent widening of the 3m L-OIS spread alone can explain a 2 vol point pick up. The funding channel affects a lot of segments of the financial system from bank loans to crosscurrency swaps to margin loans.

Next is when the “ambitious” nature of this analysis starts to come in as they try to draw all manner of conclusions while hurdling reverse causality and sprinting through a minefield of impossible-to-disentangle feedback loops. Ultimately, they argue the following:

If LIBOR keeps rising at an accelerated pace, macro vol could spike again and eventually feed into higher gold prices. Potentially, a spike in macro volatility could even force the Fed to intervene to try to stabilize markets. And if the Fed decides to intervene to compress the LIBOR OIS spread, it will probably have to change its balance sheet tapering policy.

They go on to essentially suggest that when the “Powell put” finally does “kick in” – perhaps, as Deutsche Bank has suggested, when equity prices fall far enough that the market starts taking some of the hikes out, thereby repricing the Fed path for Powell – stocks will rise.

If you’ve followed BofAML’s work on the Fed “put” and the BTFD mentality, you know they’ve spent a lot of time talking about how it’s become self-feeding.

In short, the two-way communication loop between policymakers and markets became a self-fulfilling prophecy over the past couple of years. Markets became so conditioned to policymaker intervention and dovish forward guidance at the first sign of trouble that no one saw any utility in waiting around for it anymore. After all, if you know it’s coming, why wait on it? Why not buy the dip now?

Here’s how we put this in February:

Part and parcel of that dynamic is the idea that the central bank put has become self-sustaining — it runs on autopilot. Why wait on dovish forward guidance (or any other signal from the monetary gods) to buy the dip when you know with absolute certainty that in the unlikely event a drawdown proves to be some semblance of sustainable, policymakers will calm markets? If you know it’s coming, well then you should buy the dip now. This becomes a recursive exercise as everyone tries to frontrun everyone else and before you know it, dips and vol. spikes are mean reverting at a record pace as the prevailing dynamic optimizes around itself.

Concluding their piece, BofAML reiterates this, citing their own previous research on the way to suggesting that when this spell finally breaks, gold will be the beneficiary:

In sum, inflation pressures are likely to keep rising. An untested Powell is unlikely to change course on an untested balance sheet reduction policy. Macro volatility could thus keep rising as US interest rates normalize. But volatility tends to spike rather than rise gently. When this happens, we expect the buy the equity dip mentality to prevail (Chart 17), a pattern thoroughly researched by our equity derivatives research team. Yet, we see a growing rotation towards defensives too. After all, we may be finally starting to approach the end of the second longest US expansion in the last 9 years. When investors ultimately decide to rotate out of growth assets to defensives in their multi-asset portfolios, gold may be the ultimate beneficiary of the next VIX spike.

Got all of that?

I’m just kidding. It would well nigh impossible to understand that as part of a unified theory unless you were steeped in all of these discussions – fortunately, if you frequent these pages, you are thusly steeped, and that being the case, all of the above probably does make a lot of sense.

If, on the other hand, you’re not interested in the finer points, I guess you can just refer to that Kramer meme (Cosmo – not Jim).