It’s safe to say that Monday, December 24, is a day that will live in market infamy.
Between Steve Mnuchin’s ill-advised decision to try out his Hank Paulson impression, an abrupt mini-flash crash/fragility event and Donald Trump’s 10:55 AM “Jerome Powell can’t putt” tweet, the 2018 Christmas Eve massacre on Wall Street was a comedy of errors.
When considered in the context of the current domestic political environment, characterized as it is by a government shutdown brought about by Trump’s demands for $5 billion in taxpayer money earmarked for the construction of a 2,000-mile long “steel slat barrier”, the whole thing is mind-bogglingly absurd.
While it’s easy to look back on 2018 and say that everyone should have seen this coming considering Trump’s domestic and foreign policies were on a collision course with Fed tightening, the midterms and the Mueller probe, you would have been laughed out of the room had you tried to float a year-end S&P target of 2,400 back in January. Indeed, during the first three weeks of the year, the U.S. benchmark blew through multiple analysts’ year-end price targets amid an avalanche of retail inflows catalyzed by tax cut euphoria.
After the last couple of days, even Morgan Stanley’s Mike Wilson looks like a bull. Remember, Wilson’s year-end S&P target was 2,750, a number that, back in July when he started really pounding the table on his Tech correction thesis, seemed wildly far-fetched (to the downside).
Now, we’re at SPX 2,351 – and falling. The S&P has now (basically) joined the Nasdaq and the Nasdaq 100 in a bear market.
Not a single sector is green for 2018 in the wake of Monday’s rout.
At this juncture, you’re probably thinking that virtually nobody on Wall Street got this one right where “right” means tossing out 2,400 as a logical consequence of the prevailing dynamics.
You would be correct in that assessment, but this seems like a great time to remind everyone that there was at least one analyst who quite literally said 2,400 was the level consistent with the Fed’s new reaction function. That analyst: Deutsche Bank’s Aleksandar Kocic, the derivatives strategist who we have variously described as being in a league all his own.
Of course Kocic doesn’t have the “official” Deutsche Bank year-end equities call, so he didn’t flat-out say “we see the S&P at 2,400 by year-end”, but what he did do, on at least four occasions that we can think of, is explicitly state that if you 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, if you will), 2,400 was about right.
Kocic’s efforts to expound upon the mechanics of the Fed’s efforts to restrike its put date back to Q2 (at least) and he’s revisited the subject at regular intervals since. His discussions of this dynamic have generally revolved around his characterization of the Fed as a convexity manager.
“Effectively, convexity is being withdrawn from the market and equities are reacting to it”, Kocic wrote back in April, adding that “while in the short run, such divergence/dispersion could be reinforcing, in all likelihood, there would be a breaking point when further weakness in equities tightens financial conditions such that the market begins to take additional hikes out of the curve.”
That’s pretty much exactly what started to happen in October and what’s been unfolding rapidly since then.
In an October 18 client note, Kocic laid it all out for folks. “February was the first time Fed restruck its put [and] October is its second restriking,” he wrote, noting that for 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 represented the implied path of the S&P assuming lower betas to the short rate:
Kocic’s conclusion on October 18 (so, just a week after the October 10 selloff that started it all):
The October repricing is consistent with the strike of the Fed put around 2400.
Fast forward to Monday and we are at 2,351 with the entire world now fixated on when the Fed will ultimately relent in the face of tightening financial conditions.
Kocic reiterated all of this in a note out earlier this month. He used the same language and the same chart. To wit, from a sweeping piece on the Fed as convexity manager dated December 4:
In the current hiking cycle until earlier this year, the beta between equities and yields was unusually high, around 30, suggesting that monetary policy has been protective of risk – i.e., the Fed put between early 2014 and early 2018 had been struck very close to ATM. This relationship broke down earlier this year in February when Fed officials made it clear that they were willing to accept tighter financial conditions without adjusting their expectations for the appropriate future path of monetary policy. At that time, equities corrected sharply but expectations for short rates continued to march higher as the Fed did not relent (Figure 14). This disconnect re-emerged with the equity sell-off in October. This is the re-striking of the Fed put in practice. It is a reduction in the sensitivity of short rate expectations to financial conditions.
Again, the date on that note is December 4 or, more to the point, the day after the S&P hit its post-G20 peak on the way to what has now morphed into the worst December since the Great Depression.
The most amusing thing about all of the above (and this is a point we’ve emphasized when covering Kocic’s notes before), is that this all follows naturally from the various frameworks he’s adopted and adapted over the years to describe the interplay of Fed policy and markets. These “calls” just kind of materialize in the course of his missives. He does make specific trade recos, but they are in the rates/vol. space. These other astonishingly accurate pseudo-predictions just kind of show up in the course of the analysis which, again, is what makes it all the more amusing.
Despite having apparently nailed this, he is not in the camp that believes a recession is looming. Rather, he believes that the disconnect between markets and the real economy – and thus the equity rout – follows logically from the normalization push in its current incarnation.
And with that, we’ll leave you with a passage from his latest note, additional excerpts from which you can find in the linked post below.
In this context, 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.