Revisiting The Subverted Perspective: Normalization Parallax

Back on December 24, we noted that there was at least one strategist on Wall Street who managed to “nail it” regarding where the S&P would end up by the close of 2018.

Deutsche Bank’s Aleksandar Kocic spent a good bit of time last year elaborating on the mechanics of the Fed’s efforts to restrike its put. Kocic’s efforts in that regard date back to Q2 (at least) and he revisited the subject at regular intervals throughout the year. His discussions of that dynamic generally revolved around his characterization of the Fed as a convexity manager.

Generally speaking, he suggested on a number of occasions 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, 2,400 SPX was about right.

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There Was One Analyst Who Told You S&P 2,400 Might Be Coming

Well, needless to say, that call turned out to be remarkably prescient, and by “remarkably”, we actually mean “mind-bogglingly” considering the analytical process that went into deriving it.

Three days after we published the linked post above, Kocic penned a quick note to clients, and in characteristically understated fashion, acknowledged that his pseudo-call appeared to have panned out. To wit:

Although the equities whipsaw continues around the Fed put, the strike around 2,300 as we predicted in February and reiterated in October seems to be doing all right.

Yes, it “seemed to be doing all right”, where that means this:

Had any strategist other than Aleks made that call (i.e., told you in February that the restriking of the Fed put could be couched in terms of the normalization of equities’ beta to the short rate, which in turn entailed SPX 2400-2300) and then watched as stocks entered that zone and then subsequently rallied ~14% in a matter of weeks, you would have probably needed to call in the Air Force to shoot them down after they scaled the Empire State Building, beating their chest like a giant gorilla, but Aleks being Aleks, we got a nonchalant “this prediction seems to be doing all right”.

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Deutsche’s Kocic Explains The Best 2018 S&P Call On Wall Street

On December 31, Bloomberg ran a story documenting Kocic’s call called “Market Strategist Who Nailed S&P 500 This Year Has a Fed Theory“, the last line of which reads as follows:

A spokeswoman for Deutsche Bank said Kocic was unavailable for comment.

Fast forward a couple of weeks and while Kocic might still be “unavailable for comment” when it comes to DB figuring out how to get him on the record for a media story about the call documented above, he is apparently “available to write”.

His latest note is called “Normalization parallax”, and it picks up where he left off midway through last month when he described recent market turbulence as “a function of a subverted perspective.” This is the beauty of these notes. You’re not so much reading a discrete piece of analysis as much as you are enjoying the latest chapter in a book documenting what, at this point, can very fairly be described as a comprehensive framework for understanding the interplay between markets and policy. Because it’s being written in real time, you can actually observe the evolution of that framework as it interacts with markets.

Kocic kicks things off by reiterating the notion that while the turmoil across markets has been interpreted as sending a signal about the economy (a signal which is then seized upon by market participants to de-risk), what unfolded in Q4 is entirely consistent with the normalization process, characterized as it is by the Fed’s transition from convexity supplier, to convexity manager.

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‘Through The Looking Glass’: Aleksandar Kocic And The Fed In Convexity Wonderland

Over the past four months, we’ve variously attempted to document the extent to which market participants’ efforts to interpret what’s going on is complicated by their own role in shaping reality. Kocic elaborates on this and, as usual, his exposition is superb.

“The problem of conceptualizing the economic signals from current market behavior lies in the fact that the markets are a potentially key driver of the picture they are interpreting [and] as a consequence, the reality which they experience is never fully complete, not because a large part of it eludes them, but because the entire configuration contains a ‘blind spot’ due to the market’s inclusion in it”, he writes, before couching this confusion in terms of the subject/object divide.

Here is Kocic elaborating (and we’re going to use a block quote here, because as you’ll see, paraphrasing this would be to do it an unforgivable injustice):

Subject and object, the nouns, in their normal grammatical usage, imply that the subject is an active origin of action, while the object is a passive element that deals with the consequences of the action. However, the two corresponding verbs reveal an inverted relationship: to subject means to submit and to object is to protest, oppose, or make an obstacle. Like subject and object, the market and monetary policy are inherently “mediated,” so that a shift in the market’s point of view reflects a shift in monetary policy itself and vice versa. The shift in the direction of action from the noun to the verb mode of the subject/object functioning captures the distinction between the Fed-market interaction pre- and post-2008. The source of confusion is, thus, that after 2008 the roles have been reversed with regard to the standard notion of the active subject (markets) working on the passive object (Fed): markets over the last decade have displayed passivity — they have submitted to the Fed’s policy actions and guidance — and the Fed has become the source of action. The last few months represent hints of a reversion to the pre-crisis dynamic. The key challenge involved in stimulus unwind and the market’s re-emancipation consist in convincing the markets to revert to the original mode of the subject/object interaction.

Kocic believes there’s some confusion at play here – misunderstandings that have created what he calls “a subverted perspective” which has led to a “self-referential circularity.” He traces this to inversions out through the five-year sector.

The front-end inversions are not, he says, attributable to a risk-off trade but rather an acute repricing of the Fed. These inversions are, for Kocic, “the main source of the reinforcing loop as it brings in the uncomfortable mode of what we think is a misidentified alarm and incorrect interpretation of its economic significance.”

Here he notes that during the last two tightening cycles, bear inversions were attributable to rate hikes, while over the last three months, we’ve experienced a bull inversion. “This departure from history highlights a potential flaw in the logic behind the connection between inversion and recession”, Kocic writes, before noting that for bull inversions and rate hikes to be consistent, the Fed would have to be “totally detached from the realities of the market” as it suggests they’re persisting in hikes, creating restrictive conditions which in turn cause the economy to contract, inverting the curve and tightening financial conditions. To wit:

If this were how things work, the recent market dynamics would be consistent with the US economy already being in a recession. With rates already rallying, the implication is that the Fed deliberately and mistakenly continued to hike. This is the territory of a serious policy mistake.

For Kocic, this doesn’t line up well with the Fed’s response to recent market volatility nor does it appear consistent with the Fed having “gone to great lengths throughout this normalization process to prepare the markets for its exit and take care not to generate additional problems along the way.”

Rather, what you’ve seen since October is a “give and take”, where the Fed allows financial conditions to tighten in order to head off the risk of overheating, while remaining cognizant of the fact that past a certain point, that tightening will render them unable to avoid a “hard landing.” When that point of no return appears to be approaching, the Fed should be expected to respond, and indeed they have (in case you somehow haven’t noticed).

Next, Kocic delivers an alternative take on recent curve dynamics and it leans heavily on his previous discussions regarding the normalization of the curve mode (you can read a summary of those discussions in the “Wonderland” post linked above).

“A closer look at the recent repricing suggests that this narrative of a policy mistake may be misleading and market dynamics reveal something very different from a recessionary market mode”, he writes, on the way to explaining that if you look closer, you find that the Fed appears to be proceeding apace in their efforts to normalize the mode of the curve.

To illustrate, he plots daily changes in the curve (inverted) with the short rate. The key point is that the correlation in the daily changes tells a different story than the actual levels. That is, to quote Kocic, “from a daily change perspective, the curve mode has been one of bear flattening, as higher short rates have coincided with a flatter curve… in contrast to the signal one would take from how levels have behaved, which has been consistent with a bull flattening of the curve.”

(Deutsche Bank)

If you’ve read Kocic’s previous work, you know what he’s driving at here – namely that the Fed is engaged in an effort to normalize the mode of the curve so that shocks arrive at the front end rather than the back end, as the latter is only a viable state of affairs as long as the front remains anchored (i.e., as long as it’s glued to zero). Here’s Kocic:

This dichotomy displayed by different commonalities of trends and changes is reflected in the average levels of change, highlighted by the dashed lines in the figure. Note that both series of changes, although negatively correlated, have the same sign in terms of their means. As a result, while their levels are trending in the same way the correlation between their changes are negative. This is the main twist associated with the most recent repricing of the curve: what looks like a bull flattening inversion and thus a serious policy mistake has actually been a very normal (from a pre-crisis perspective) bear flattening.

He goes on to demonstrate the point made above (i.e., the point about the Fed wanting to normalize the mode of the curve by restoring a negative correlation between the short end and the slope) with the following set of visuals:

(Deutsche Bank)

Followers of his work have seen those charts in one form or another before (older versions are more colorful though, and typically included a fun blue-to-red gradient which was aesthetically pleasing). Long story short, the green box in the left pane effectively validates Kocic’s previous work on this. Here’s a bit of color:

Clearly, the recent curve mode reveals that, despite recent market turbulence, normalization has remained intact. By sticking to its script, the Fed has forced another leg of normalization. The two aspects of this are shown both in the decline of the correlations back into negative territory as well as the migration of volatility to the front end of the curve, both corresponding to the pre-2008 curve functioning.

Finally, Kocic updates the normalization effort in the context of the equities market, which, naturally, entails revisiting the S&P call outlined in these pages on too many occasions to count last year and which finally made its way to the mainstream financial media in the form of the Bloomberg piece linked above.

“The third aspect of normalization has already taken place in the equity market where stock prices have re-aligned with pre-2008 betas corresponding to ‘normal’ tightening cycles”, he writes, on the way to updating the chart and noting that “the recent moves in equities and short rate expectations represent a move closer to the historical beta between these two series.”

(Deutsche Bank)

Again, what you want to note about that chart is that Kocic called for stocks to revert (if that’s the right term) to their traditional beta to the short rate back in February — look how far the green line was from the dashed black line in early 2018 when he made that prediction. Now look at how close things were at the SPX lows last month. That’s a remarkable call.

In the end, Kocic thinks the normalization effort should remain focused on the fed funds rate, as opposed to tweaks to balance sheet runoff which, he says, “should remain predictable and controlled.”

He sums up his take as follows (one more time: understanding why normalizing the mode of the curve is necessary is key to digesting all of this and we would highly recommend readers take some time to peruse previous posts linked above for context):

Putting aside the complexity of simultaneously calibrating two policy tools, if bear steepeners and bull flatteners were to continue as the dominant curve modes, monetary policy shocks are at risk of being amplified. The potential for a disruptive unanchoring of the back end of the curve, with its hazardous ramifications for risk assets and credit in particular, would thus be heightened. In our view, the Fed’s response confirms that they have a detailed understanding of the underlying risks related to the policy unwind and their responsibilities in that context including their role as a manager of risk and convexity flows.