Back by popular demand: More Fed put analysis.
All week long, market participants have been at pains to determine how far U.S. stocks would need to fall in order to trigger the “Powell put”, which to date has never been observed in the wild.
What’s clear is that the days of the Fed put being struck close to at-the-money are over.
On October 18, we highlighted a couple of quick excerpts from an analysis that conceptualized 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.
Specifically, “Re-Emancipation Proclamation And The Re-Restriking Of The Fed Put” contained the following chart from Deutsche Bank, where the dashed line represents the implied path of the S&P assuming lower betas to the short rate.
Post-2014, that beta was close to 30, a scenario representing “monetary policy [that] was protective of risk” – to quote Deutsche.
Fast forward nine days and the bank is out with a more expansive take on the same concept that builds on the analysis highlighted in the linked post above and incorporates some of the points presented here on Friday evening in “Why October’s Selloff Doesn’t Look Systemic”.
“Having the Fed put in place is like appending an insurance to stocks and thus, its desirability and price should reflect it”, Deutsche Bank’s Aleksandar Kocic writes, adding that “lowering the strike Fed of the put is equivalent to increasing the deductible of the insurance.”
In other words, equities are now more exposed and prices will obviously need to reflect that. That’s what you’ve seen in October.
Kocic goes on to reiterate his characterization of these mechanics as “a withdrawal of convexity from the equities market” or, more simple, “a convexity supply shock”. Readers should note that this is something he’s been discussing for quite a while when circumstances warrant.
The read-through for volatility is obviously that in equities, it should increase, resetting higher to reflect the above and rising relative to other assets.
“A new equilibrium vol levels is achieved by equating the original put at previous vol levels to the new, lower strike, put at higher vol.”, Kocic writes, on the way to delivering “a back of the envelope calculation” which he says “suggests equity vol should rise by 5-8%” as the Fed put is restruck. Here’s a visual that shows the reset of the equity/rates vol. ratio in light of the restriking:
It isn’t hard to predict where this analysis is going next. This goes back to convexity flows and what Kocic previously described as “the Fed 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.”
The Fed is, as folks have seemingly come around to this week, attempting to tighten financial conditions via the equity channel. Of course tightening financial conditions is tantamount to a rate hike. As Kocic goes on to say in his Friday note, “this means that rates could potentially have less need to rise in the future [and] by withdrawing convexity from equity, Fed is passing it to the rates market by supplying implicit rate caps.”
The 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. That would appear to be the longer-term goal. 10-year yields were lower by 11bps on the week, which looks like the second biggest weekly rally of the year from where I’m sitting.
In the short-term, though, equity weakness is likely to further undermine the rebalancing bid for the long end. “A selloff in equities would temporarily withdraw pension funds’ sponsorship”, Deutsche goes on to say. Presumably, that could lead to a near-term rebuilding in the term premium.
All of the above underscores the notion that if you think about October’s U.S. equity weakness as the natural consequence of the strategic restriking of the Fed put, this month needn’t be seen as a systemic event. Supporting that contention is the relatively benign reaction in, for instance, IG and HY credit mentioned earlier on Saturday here.
As far as rates vol. goes, Deutsche Bank says the knee-jerk flows “reflect not a bid for protection, but rather less supply from yield enhancement players.” Obviously, it’s possible that the reset higher of gamma will be sustained if markets remain somewhat chaotic, but if the above characterization is correct (i.e., if what you’re seeing is in fact a withdrawal of convexity from equities and an implied supply of convexity to rates over the longer haul), then things should remain “orderly”.