On Friday, following the hotter-than-expected average hourly earnings print that accompanied the August jobs report, we brought you “Cheshire Cat’s Smile Redux: ‘Not Exactly A Party Cocktail’”, a kind of rambling missive that attempted (successfully or not), to tie together i) trends in wage growth, ii) the disparity between the scorching ISM manufacturing data and the far less ebullient Markit survey, and iii) equities.
The reference to Alice In Wonderland in the title was an allusion to a June note from Deutsche Bank’s Aleksandar Kocic and his characterization of the Phillips curve as “an organ without a body” that falls apart in each cycle “but after every annihilation, re-composes itself and continues to play an important role.”
Hours after the first linked post above was published, Kocic was out with his latest piece and he updates his Phillips curve chart and commentary, noting that the August AHE print is consistent with the most recent read on the ECI and generally supports the contention that this time is no different in terms of the curve’s propensity to reassert itself in late-stage expansions. That said, Kocic also says DB’s base case is still that a marked acceleration of hikes isn’t yet warranted by the incoming data.
“After a slightly hiccup, wages are rising again — the latest payroll and inflation numbers are back on track with the existing trend of the Philips curve”, he writes, adding that “at this point, the Fed pause appears less likely and repricing of continuing hikes might be in order [but] there does not seem to be indication of further steepening of the Phillips curve, so accelerated hikes are not warranted.”
He goes on to flag the sleepy nature of rates vol. this summer. 10Y yields have been rangebound this quarter and Kocic notes that except for Friday, 10Y swap rates haven’t moved more than 5bps up or down in three months. “It feels as everything else is financed with low rates volatility”, he continues, adding that “with annualized realized vol in the low 40s, implieds have been trading in excess of 25% premium.”
If you wanted to, you could probably chalk up a well-behaved long end to the persistent suppression of the term premium (Goldman does), but Kocic harkens back to a far more nuanced analysis of things that we parsed back in May.
The week before the May Fed statement, Kocic outlined the extent to which “the Fed is daisy chaining the two ends of the curve with the equities market, effectively buying back convexity from equities, recycling it through the front end and sending it as convexity supply to the back end of the curve.” Here’s the schematic:
Any destabilization in equities catalyzed by the persistence of the Fed helps underpin the long end as volatility in equities engenders a safe haven bid for Treasurys while Fed hikes underpin the dollar and help cap inflation expectations, with the latter effort helping to ensure the tail risk of an unwind in the bond trade isn’t realized. As a reminder, you don’t want that tail risk to be realized – that is, you don’t want the long end to become unanchored.
That gets back the discussion about the “normal” (i.e. pre-QE) versus the QE-era functioning of the curve. “Normally, the curve evolves through bull steepening or bear flattening modes but during the QE period, directionality of the slope was reversed”, Kocic wrote in mid-May, adding that “as the front end remained anchored at zero, shocks arrived through the back end with the curve repricing through bear steepening and bull flattening modes.”
He illustrated that with the following chart, which shows the regime shift at the beginning of the QE era, when suddenly, the typically negative correlation between the 2Y rate and the 2s10s flipped:
That’s fine as long as short rates are sitting at zero and the Fed is on hold. But what happens in that environment when short rates are no longer static? Would the QE-era functioning of the curve suggest that hikes would be amplified at the long end potentially destabilizing things? Possibly, which is why the Fed needed to restore the pre-crisis functioning of the curve and ensure a supply of convexity to the long end.
Unfortunately (albeit predictably), the above effort (to the extent it manifests itself in a stronger dollar), has turned into a train wreck for emerging markets.
Kocic picks back up on all of this in his Friday piece. After going back over the dynamics outlined above, he notes that “as an indirect consequence, firming up of the USD has remained disruptive for EM.” As a reminder, the ratio of EM FX vol. to G7 FX vol. has surged of late.
Kocic describes the same relationship in terms of the Brazilian real and the yen. “The ratio of BRL to JPY is at 15Y high, with similar, and even more extreme pattern, seen with TRY”, he writes, before warning that “these problems, if remain unresolved or escalate further, could bring higher volatility to the US starting with risk assets and ultimately propagating to rates.”
So, what comes next? Well, if the Fed continues along the path to a more data-dependent regime (i.e., they become less good at “listening” to the market), and the later stages of tightening afford them less in the way of flexibility and wiggle room, they would withdraw “transparency” (to employ Kocic’s vernacular). “We see a case for being long vol next year”, he concludes.
Meanwhile, do note that with the Fed’s balance sheet running down, the ECB tapering to €15 billion/month from September on the way to a hard stop (investment flows notwithstanding) in December, and with the BoJ tying itself in knots trying to figure out how to taper without tapering (a precarious exercise), some analysts see a QT-driven spike in rates vol. as a possibility through year-end.