‘Enjoy!’ The Powell Put, Rates Vol. And Other Thoughts On Another Horrific Friday

Blame J&J, the ongoing deceleration in the Chinese economy, Donald Trump’s worsening legal woes, an unwillingness to carry risk into the weekend, doubts about the viability of the fledgling trade truce or, when all else fails, just blame the robots (we already did), but the bottom line is that the volatility and ongoing “chop” in equities shows no signs of abating.

Indeed, Friday was an outright horror show with healthcare and energy pacing across-the-board declines.

(Bloomberg) 

This was, basically, the 13th session of 2018 during which the S&P has fallen 2% or more.

For reference, the number of days the S&P fell by ~2% or more from 2014 through the end of 2017 was 16.

“Come and play with us Danny.”

 

The “Powell put” – observed in the wild for the first time on November 28 – has proven to be decidedly ineffective and Trump’s attempts to tweet the market higher with trade reassurances are falling flat on their face. Of course it’s not clear the President really “gets it”. Nobody wants to hear about how poorly the Chinese economy is doing, even if it’s couched in terms of an ostensibly reassuring message on the future of global trade and commerce.

China just announced that their economy is growing much slower than anticipated because of our Trade War with them. They have just suspended U.S. Tariff Hikes. U.S. is doing very well. China wants to make a big and very comprehensive deal. It could happen, and rather soon!

— Donald J. Trump (@realDonaldTrump) December 14, 2018

In any event, if you’re wondering how far BofAML’s clients think the S&P needs to fall for America’s beleaguered Fed chair to step in with something more definitive, the answer is somewhere between 2,400 and 2,200 SPX, not exactly a comforting subjective assessment.

(BofAML)

That chart is from the latest edition of the bank’s rates and FX survey and it also contains the following chart which suggests clients overwhelming expect a Fed pause in the first half of 2019.

(BofAML)

A quick check shows the market is still pricing in just ~10bps of tightening next year and still expects easing at the margin in 2020.

(Bloomberg)

When it comes to the Fed and their reaction function in 2019, market participants appear to be expressing some conviction in at least one thing: the current regime is no longer tenable.

“One-year, two-year swaption implied volatility has surged relative to its one-year, 10-year counterpart in a way not seen since the taper tantrum meaning the path of short-term rates are seen to be much more in flux than longer-term rates”, Bloomberg’s Luke Kawa writes, in his weekly newsletter, adding that while “there’s seasonality at play, the move is indicative of the market pricing in a monetary-policy regime change.” Here’s a chart on that:

(Bloomberg)

There’s some nuance here, though. Generally speaking, 1y2y was right there with 1y10y until midway through 2011 or, more to the point, up until the Fed tipped “low for long”, prompting a wholesale collapse of Fed expectations. Until then, short dated vol. on short tenors (e.g., 3m2y) had flatlined because the Fed was inactive and rates were at zero. But, 1y2y stayed bid, given the risk premium associated with expectations that a shift was likely in the cards as the traditional cycle for the Fed was ~ two years.

The taper tantrum suggested the Fed had emerged from cryosleep and so, 1y2y woke up too and reset to what might be described as normal levels – that is, the vol. surface started to normalize.

“Note that for the rest of post-taper tantrum period, the ratio between 1y2y and 1y10y traded close to normal, so its recent excursion to the top of the range is nothing dramatic”, one strategist we spoke to on Friday said, adding that “it is at its 2010 levels, and you can’t say that 2010 was a turnaround in the economy or monetary policy and that the vol. market was pricing that in.”

Also, bear in mind that the Fed’s convexity management efforts revolve around pulling the action back to the front end (i.e., normalizing the mode of the curve and in the process, ensuring that the risk of a disorderly unwind of the bond trade remains low).

“What is interesting is probably the skew story which also has two sides”, the same strategist mentioned above went on to note, on the way to observing that “low strike receivers have been well bid for quite some time (in 1y2y much more than 1Y10Y) which means the rally at the short end of the curve is a pain trade – so people are short the front end, and the skew reflects the insurance premium and is not not a forecast of rates.”

In any event, we’ve veered off course into the esoteric (as we’re wont to do), but steering this sucker off the rumble strips and back onto the highway, the bottom line on Friday is that the Dow closed down 500 points.

“Enjoy!”

Stocks and the economy have a long way to go after the Tax Cut Bill is totally understood and appreciated in scope and size. Immediate expensing will have a big impact. Biggest Tax Cuts and Reform EVER passed. Enjoy, and create many beautiful JOBS!

— Donald J. Trump (@realDonaldTrump) December 19, 2017