Over the past month, we’ve spent a considerable amount of time talking about the extent to which, last week’s selloff through 3% on 10s notwithstanding, the long end could continue to find sponsorship for a variety of reasons including, most obviously, a safe haven bid associated with acute risk-off episodes but also the assumption of a stable currency thanks in no small part to the Fed and expectations that Fed hikes (and the accompanying USD strength) will ultimately serve to cap inflation expectations.
In “Are We Living In A Self-Regulating System?“, for instance, we noted that if the dollar continues to rise it could ultimately cap commodities prices, serving as a brake on inflation expectations:
We also noted that in the event yields continue to push higher on the back of reals, that could be bad news for equities…
If stocks sell off enough, it could well end up creating a safe-haven bid that could benefit Treasurys, thus capping yield rise.
The acute risk-off episodes that have, at various times this year (most obviously the panic bid that sent 10Y yields sharply lower at ~3:15 ET on February 5 when the bottom really began to fall out for U.S. equities), manifested themselves in sharp declines in stocks, should be seen in the context of the ongoing process of restriking the Fed put.
The Fed has stayed the course even as equities have faltered, but at some point, the read-through for financial conditions from falling stock prices could ultimately prompt the market to take some the additional hikes out, thus restriking the Fed put, the implication being that the main positive externality for equities could come from the Fed.
“Transmission of equity selloff through financial conditions could act as a circuit breaker and trigger repricing of the rates path,” Deutsche Bank’s Aleksandar Kocic wrote earlier this month, adding that “this could lead to bull steepening of the curve [and] could be seen by the market as restriking of the Fed put and supply of convexity that should be embraced by risk.”
The dynamics outlined above have had the effect of pushing vol. away from rates – this is part and parcel of Kocic’s “hierarchy of vulnerability” and it can be seen clearly in vol. ratios:
In his latest piece, Kocic outlines this dynamic further. To wit:
Restriking of the Fed put is a withdrawal of convexity from equities. It is effectively a removal of a put spread from the market. However, in the environment where everything is bound to sell off (a market mode that is a mirror image of QE), volatility is one of the key decision variables. More volatile equities are less desirable than less volatile duration. In that environment, convexity withdrawal creates a reinforcing loop where more turbulence in risk assets tends to cause stability in fixed income. The figure shows the convexity flows across the two markets.
Restriking of the Fed put is re-syphoning of convexity. Withdrawal of convexity from equities means higher volatility and their underperformance, which fosters preference for bonds and reinforces their stability. This becomes a supply of convexity to rates and, as monetary policy remains in place, this means: higher real rates, stronger USD, and lower expected inflation (which reduces the tail risk of the bond unwind). All of these make bonds more desirable than risk assets
Meanwhile, the persistence of the Fed (which is desperately attempting to head off a scenario where Trump’s late-cycle plunge into fiscal stimulus ends up overheating the economy) continues to push investors out the curve (short rates climbing to their highest levels since 2008), fostering further stability at the long end which in turn, makes the Fed hikes appear impotent and thereby forces them into still more hikes. Those hikes then destabilize equities further, and around we go until the decline in equities is steep enough for the financial conditions circuit breaker to be triggered, at which point some of the additional hikes are priced out. Here’s Kocic one more time:
As the long end is getting stabilized, tail risk is shifting from bear steepeners to bull steepeners. This is a function of the flows, combined with the policy mix. We see this risk on a longer time horizon beyond 2018. However, the longer the current mode of curve persists against the economic backdrop, the more dramatic the snapback should be.
One wonders (or actually one doesn’t “wonder”, but we’ll pose it as a question here) the following: what would happen were that to collide with the scenario outlined in “Behold: An Incubator For Vicious Steepeners“?