The re-emancipation of markets is generally seen as desirable … Price discovery is making a comeback, but at what cost (figuratively and literally)?
That’s from “Theme Overload“, published here last Saturday.
The reference to the “re-emancipation” of markets harkens back to the characterization of the post-crisis policy regime as a “state of exception” – the paradoxical short-term suspension of market rules in the interest of restoring normal functioning over the longer-term.
That characterization was originally put forth by Deutsche Bank’s Aleksandar Kocic in a July 2017 note. The application of a political concept (the “state of exception”) is an example how employing a cross-disciplinary approach to market analysis creates useful and durable frameworks for understanding the current environment.
“Engineering a state of exception comes with considerable risk”, Kocic warned, more than a year ago, adding that “the Fed (and central banks in general) carries an implicit responsibility for orderly re-emancipation of the markets, which makes stimulus unwind especially tricky.”
In short, the trick is to roll back the state of exception (normalize policy) without something going “wrong”, a task that’s complicated immeasurably by the fact that, as Kocic put it in 2017, “traditional transmission mechanisms have atrophied and investors’ mindset has changed in a way that has altered irreversibly their behavior, the market functioning and its dynamics.”
Selloffs following record highs should probably be viewed as some semblance of cathartic, but that’s not the way people think about things in the post-crisis world. Drawdowns are generally seen as offensive these days. Selloffs are an affront to decorum; a sign that something went “wrong”.
The only way for policymakers to avoid facing the inevitable, is to constantly move the goalposts for what counts as “winning” and to engage in a tacit dialogue with markets so that policy unwind progresses only with the market’s consent.
In many respects, strict data dependence is the opposite of that regime and it’s why Kevin Warsh was such a dangerous option for Fed Chair. Recall the following passage from a Kocic note released a year ago when Warsh was still in the discussion for who would run the Fed:
Warsh is talking about the same rules the current Fed is using. However, when it comes to divergence between his and Fed’s views, the problem is that the numbers that go into these rules have become ambiguous and circularity of the Fed/market interaction that comes with the removal of the fourth wall — the dynamics that involve the market as a co-writer of the script – insures a one-dimensional interpretation of these ambiguities. Under market’s pressure the Fed’s interpretation of the ambiguity of the economic numbers which enter the policy rules has taken a predictable path of least resistance after the markets are consulted. Warsh wants to withdraw that ambiguity of interpretation from the dialogue and make it the Fed’s discretionary right. Unlike the Fed which has been using these rules conditionally (subject to markets’ approval), he wants to switch back to their unconditional usage. In itself, this is effectively a withdrawal of convexity from the market.
That brings us to Jerome Powell, who is generally seen as “data-dependent” in his own right and who, even if you don’t quite agree with that characterization, is certainly going out of his way to talk up the economy on the way to persisting in what counts as a “hawkish” lean by post-crisis standards.
Back in April, Kocic outlined how, under Powell, the FOMC is restriking the Fed put and in the course of that analysis, he underscored the last sentence in the excerpted passage from the Warsh post above.
“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”, Kocic wrote, adding that “effectively, convexity is being withdrawn from the market and equities are reacting to it.”
Well, in light of what happened to equities last week, Kocic revisited all of this in a note making the rounds on Thursday afternoon.
“February was the first time Fed restruck its put [and] October is its second restriking,” he writes, noting that for the most of the current hiking cycle, the high beta of equities represented “monetary policy [that] was protective of risk” or, said differently, the “Fed put post-2014 had been struck very close to ATM.”
That marks a stark contrast to a beta of ~10 during “normal” hiking cycles. The dashed lines in the following chart represent the implied path of the S&P assuming lower betas to the short rate:
As Kocic concludes, “the October repricing is consistent with the strike of the Fed put around 2400.”
So, you can think about the restriking of the Fed put as the normalization of beta and the equity selloff as stocks’ reaction to the FOMC’s attempt to re-emancipate markets – to lift the state of exception.
It’s a delicate exercise and one that is fraught with peril. In the end, we might all end up wishing for the reimposition of market martial law.