Where The Wild Things Are: Revisiting The Forgotten Horizon In The Volatility- Leverage Space

Call it the logical progression of things in a world where the United States seemingly takes another step down the road to authoritarianism every, single day or just call it a manifestation of the Trump administration’s intention to institute a weak dollar policy by proxy via its aggressive stance on trade, but whatever you call it, don’t call it inconsequential.

Donald Trump’s attacks on Jerome Powell and the Fed over which he (for now) presides grabbed all the headlines on Thursday and if Friday morning’s tweets are any indication, the President is seemingly intent on disabusing market participants of the notion that his comments to CNBC were a one-off.

While there’s probably something to be said for not overreacting, the issue with this administration is that every time the public gives Trump the benefit of the doubt, he subsequently sets out to “prove” something. It’s a kind of pernicious dynamic where he seems to interpret benign assessments of his bombast as a challenge – a test of his populist mettle, if you will. He then sets about doubling and tripling down until he elicits criticism, which only serves to exacerbate the situation to the extent he interprets that criticism as yet another test of his will.

Because so many of his policies are inextricably bound up with one another, the dynamic described above has a tendency to feed on itself and snowball. His deficit-funded tax cuts were criticized for being out of step with the GOP’s commitment to fiscal rectitude and rather than accept that criticism, he doubled down by backing more spending just months later. Those policies risk overheating the economy, a risk the Fed needs to head off by hiking rates. Of course rate hikes are supportive of the dollar which means it’s possible that his fiscal policies, via their read-through for the Fed and the greenback, will end up undercutting his trade policies. Rather than accept that reality, he’s going to demand rate cuts in order to supercharge the effect of his aggressive trade posturing. Trade escalations risk serving as a drag on global growth. If that spills over into the U.S. economy, the Fed will be under even more pressure to cut rates.

But what happens when the Fed is cutting rates and the U.S. fiscal position is worsening at the same time? Who’s going to sponsor the U.S. long end in that scenario? Is that not a recipe for dramatic bear steepening? And is current Fed policy not conducive to the buildup of stretched short bets in the short-end that would be unwound in dramatic fashion in the event there’s suddenly a U-Turn?

“Long yields would likely fail to rally or could even sell off in an easing cycle”, Deutsche Bank’s Aleksandar Kocic wrote in an April note, adding that “the persistence of Fed hikes and curve flattening could become an incubator for vicious steepeners in the future” in the event it “forces one-sided positioning and [thereby] makes potential recessionary Fed intervention only more disruptive.”

That’s disconcerting in and of itself, but at a more general level, the trajectory here is starting to look increasingly worrisome in the context of the vol.-leverage space.

Last October, the above-mentioned Kocic warned that the deregulation push in America combined with protectionism and fiscal stimulus threatens to catapult the U.S. into the precarious upper-right quadrant of the following chart:

“We are currently in the lower half plane [and] as we transition from the lower right to the lower left quadrants, the policy unwind begins”, Kocic explained, walking you through the visual.

“During taper tantrum, the system faces a dilemma between forced deleveraging (e.g. unwind of the Fed balance sheet and disorderly bear steepener) or gradual deleveraging with uneventful exit and transition deeper into the lower left quadrant (this is denoted as the ‘Base case’)”, he continued.

Obviously, you want to avoid slipping into a deflationary quagmire but whatever you do, you want to steer clear of the previously unthinkable scenario denoted by the red line captioned “MAGA”. Here’s Kocic:

High-vol/high-leverage would correspond to the period of unsustainable public or private debt, such as the ones observed in certain emerging market economies, with typically high inflation and a currency problem.

With protectionist rhetoric and promises of additional fiscal spending, the risks of opening corridor to high inflation and currency crisis is back on the table, but this time, due to massive growth of retail balance sheet this becomes entangled with uncertainty about the long-term monetary policy response in this context.

All of that is part of a longer discussion about the extent to which, thus far, tighter regulation and the absence of an asset class capable of transforming abundant liquidity into inflation have together kept things under control.

Without going into any more specifics, suffice to say this conversation is more relevant now than it was back in October, especially considering the ongoing pressure to roll back the post-crisis regulatory regime and now, the addition of Donald Trump into the monetary policy decision-making process.

The quotes and chart excerpted above are from a subsection of Kocic’s October 27 derivates note. The title of that subsection:

Nothing further.