Earlier this month, we talked a bit about the 2s5s inversion and the extent to which some market participants might be getting caught in their own reality distortion loop.
Part and parcel of our admittedly metaphysical missive was the notion that folks are forgetting about their own role in all of this and thereby bringing forward end-of-cycle trades across assets due the perception that the bond market is “saying” something about the economy, when in reality, the bond market cannot “say” anything of its own accord because after all, the bond market isn’t a thing that exists independently of the people who comprise it.
“The ongoing collapse in UST yields along with concerns therein surrounding the nascent inversions in the front-end of the UST curve (3s5s, 2s5s, 2s5s swaps, 1m USD OIS 2Y-1Y fwd spread) have markets again ‘reverse-engineering’ a growth-scare”, Nomura’s Charlie McElligott wrote on December 4, adding that “with [the] UST term premium again melting to lows last seen in September, the risk is that a negative feedback loop develops where the ongoing rally in USTs is viewed both as confirming a US slowdown and ‘pulls forward’ the already extraordinarily heightened market concerns surrounding the timing of a US recession.”
This dynamic is self-feeding and goes a long way towards explaining the readily apparent disconnect between various assets and the economy. Here’s a visual:
“We believe that the recent turbulence in the market has been a function of a subverted perspective, driven largely by the new way of conducting monetary policy during stimulus unwind, not seen in the past”, Deutsche Bank’s Aleksandar Kocic said this week. “Because of that, the apparent dispersion between otherwise robust economy and volatile financial markets is creating a reinforcing loop”, he added.
That underscores the points made here on December 4. Of course Kocic being Kocic, he puts it more elegantly than we did. “This is creating a financial parallax whereby the market is mistakenly reading the curve dynamics as an indication of economic problems and, in our view, false signals of ‘imminent’ recession, which in turn is creating further derisking and amplifying the existing flows in financial markets”, he went on to suggest.
The recession story, then, is the product of confused perspective – a kind of fata morgana – not a real thing.
You’ll note the reference above to the “new way of conducting monetary policy during stimulus unwind”. This harkens back to the Fed’s transition from convexity supplier to convexity manager a reference, of course, to Kocic’s recent magnum opus in Fed analysis as detailed here last weekend.
The disconnect between the economy and risk assets is the somewhat “natural” consequence (although that’s a bit of a misnomer here given that the re-emancipation of markets is proceeding from a highly unnatural state of exception) of the Fed’s transition.
As Kocic wrote last week, “the divergence between financial markets and the economy emerges as the logical consequence of the recovery process, a mirror image of the early stages of the crisis when monetary policy engineered a stabilization and a rebound in financial markets as a precursor of the subsequent economic recovery.”
He elaborates on all of the above in a new note called “The uprising”. As the title suggests, he frames things in terms of the market attempting to “force explicit consent” from the Fed, but being unsure whether that consent is forthcoming.
“The flows and price action suggest a substantial duration extension with the long-end led buying amidst USD-neutral backdrop, consistent with the market’s interpretation of the global growth slowdown”, he writes, on the way to saying that the inversion in the cash curve is indicative of those flows and also a product of ongoing expectations for rate hikes in the very near-term.
Here’s the dollar, the S&P and the 2s5s where the shaded blue boxes are breakevens on 1M straddles.
“As big international real money flows are causing the moves across different markets, they are creating substantial distortions”, Kocic says, before describing the visual as follows:
At the moment, equities markets appear to be internally consistent: the S&P range is completely in tune with the breakevens on VIX (the 6% realized range coincides with 22% VIX breakevens). Rates market, on the other hand, is not fully internally consistent in the same metric: the repricing of the curve slope has been a 3 sigma event (18bp) and implied vols (at 18bp) have not adjusted to it. In addition, rates and equity markets are not mutually consistent.
Kocic is skeptical of curve inversions as predictors of recessions and says the assumed reliability of inversions is “especially questionable now.” But, again, this is Aleks we’re talking about, so if the question is whether he, like so many strategists, isn’t fully cognizant of market psychology and how that can feed on itself especially as it relates to curve inversion, the answer is “no”. He’s fully cognizant of seemingly everything, and notes that you certainly cannot “exclude the possibility of [curve inversions] impacting some of the action.”
Behind what you’ve seen recently in markets, is a realization that things are different now than they were pre-crisis and that the Fed, being aware of that, may not relent and could still continue to hike, albeit at a slower pace (maybe taking one out in 2019). Here’s Kocic:
So, the market is effectively trying to force explicit consent from the Fed, but is also skeptical that the Fed would agree to it. It is already pricing in that refusal, but not completely.
As far as the view from volatility goes, the “hierarchy of risk” (something Kocic has been talking about since February), predictably has equities in the trenches with credit not far behind and rates vol. still suppressed. This is not surprising. Indeed, it is intentional. It proceeds from the Fed’s new role as convexity manager, part and parcel of which is ensuring that rates vol. cannot take off (as outlined in the “Wonderland” post linked above).
And so, where to from here? Well, Kocic has a lot of thoughts on that, but from a kind of 30,000 foot level (i.e., excerpting the passages that will likely be the most applicable for the most readers), he notes that “a compromise” scenario between the market and the Fed is possible. That would entail the Fed proceeding to hike, but at a reduced pace while the market continues to price in a recession on a 2-3Y horizon.
“This is a flattener of the curve for the next 6-12 months [and] it is likely that equities, and risk in general, will continue to be testy or even have another leg of downward correction, but that remains unclear”, he writes, of the “compromise” scenario, adding that “the opposite can happen as well [whereby] current levels could be perceived as attractive and entice a wave of new longs [because] after all, if we insist on following historical patterns (which most likely do not apply to the current market configurations), except for maybe the last two to three months, support for equities persists almost all the way to recession.”
Elaborating further, he reminds you that “there has never been a case that [an] equities selloff goes on for three years before the recession kicks in.”
That said, Kocic notes that conditions as they persist now can be viewed in one of two ways. Either the flow dynamics noted above have led to a dislocation that “will correct once the year-end risk aversion is over, or as a prelude to Fed relent.” On the surface at least, steepeners would appear to be the correct trade. After all, Kocic notes, if you look at 2s5s swaps spread, “these levels of inversion are uncontested by anything in rates history, except for a short period at the peak of the tightening cycle in late 2006.”
Coming full circle, we would reiterate what we said above. Namely that for the time being, the recession story might well be the product of confused perspective – a kind of fata morgana – not a real thing.