In Search Of A New Fed Put Strike Equilibrium

What can you say about the week that was?

A lot, if you want to.

When it comes to the trade war, the Trump administration was clearly perturbed with the market’s reaction to reports out Monday that barring a truce between the U.S. President and Xi at the G-20, Washington intends to move ahead with the publication of a list in conjunction with tariffs on the remainder of Chinese imports.

Just about the last thing the GOP needed headed into the midterms was for stocks to careen lower still following the October rout. So, Trump tweeted about a “very good, very long” phone call with Xi and thanks to a Bloomberg article that suggested a truce was being drafted, Asian equities exploded higher on Friday.

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That was obviously a pre-election gambit designed solely to stave off another leg lower in U.S. stocks, and the irony is, Trump needn’t have bothered. By the time he got around to calling up Xi to give himself an excuse to tweet, forced buying, systematic re-risking and rebalancing flows had already catalyzed the best two-day rally for U.S. equities since February (on Tuesday and Wednesday), although that was small comfort considering the depth of the October rout.

This week’s manic action notwithstanding, nothing has actually changed if you look at things through the lens of the Fed restriking its put. There’s good news and bad news on that. If you think about things in the context of the Fed using the equity market to tighten financial conditions, you come away with a relatively benign read on the drawdown. The bad news is, there’s probably still further to go in that regard on equities. We’ve been over this on too many occasions to count of late and Deutsche Bank’s Aleksandar Kocic was out with some fresh commentary on the topic in his Friday note.

“Volatility continues to trade mixed across different market sectors [and] despite considerable political entropy and approach of the mid-term elections, there does not seem to be signs of major rise in risk aversion”, Kocic writes, adding that “at this point, it appears that the market has adapted to persistent political volatility and has learned to discount it as noise.” (Remember the “noisy status quo”?)

In the vol. context, he writes that the turmoil continues to be concentrated in equities, although he flags the short end of the curve as well. “Benchmark 3M10Y rates gamma, while up for the month, is still underperforming the upper left corner, equities, and credit”, he notes.

(Deutsche Bank)

Kocic goes on to reiterate his points made in October which were themselves a reiteration of his take on the February selloff. He characterizes the mechanics of the Fed put restriking as “a withdrawal of convexity from the equities market”. That’s recycled through rates and doled out as a supply of convexity to the long end, which in turn ensures the real tail risk (a disorderly unwind of the bond trade) isn’t realized.

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“When viewed through financial conditions, a 15% decline in S&P accomplishes the same effect as a 25bp rate hike”, Kocic reminds you, before rehashing the points made above.

“Higher vol in equities (implicit in convexity withdrawal through restriking of the Fed put), is also a supply of caps to rates market”, he continues, noting that “even if market turbulence persists, it is likely to be concentrated in risk assets, while rates might trade sideways or as an echo, maintaining the existing vol level hierarchy.”

Implicit in all of this is the notion that if an equity market drawdown is couched in terms of a repricing in financial conditions consistent with the Fed’s desire to effectively transmit the equivalent of a rate hike through equities, the beta of the short rate to the S&P should increase. Here’s a regression of weekly changes in the short rate with weekly changes in the S&P. “Generally, their beta is low, around 0.12 [but] when financial conditions are being repriced, as in February or October, their beta should increase (around 0.6 = 15/25)”, Kocic writes, describing his chart.

(Deutsche Bank)

The bottom line, for Deutsche Bank anyway, is that “the process of finding a new ‘equilibrium’ corresponding to the lower Fed put strike is still not over and could continue in the near term.”

That’s broadly consistent with consensus, and if that’s true (i.e., if we didn’t reach such an equilibrium at the lows last month), well then the Tuesday/Wednesday rally means we’re even further away from that equilibrium now.