Well, equities stateside have lapsed into a listless nadir as traders “await fresh catalysts” (to trot out one of the worst market clichés in the repertoire).
Monetary policymakers the world over have done their part – the BoC slapped a dovish spin on their tightening bias on Wednesday and as is customary, the ECB telegraphed what we can expect from them a day early (via a media leak).
A Sino-US trade deal appears to be largely priced in, Donald Trump’s expectations for another trade-truce-inspired leg higher notwithstanding.
In light of the now across-the-board dovish pivot from central banks and in the context of questions about how effective monetary policy can be when it comes to supporting risk assets going forward, this seems like an opportune time to highlight some excerpts from a short client note penned by Deutsche Bank’s Aleksandar Kocic who, you’ll recall, literally nailed the S&P in 2018.
For anyone who needs a refresher on how Kocic went about deriving what amounted to a 2,300-2,400 SPX “target” last year, we’ll briefly rehash the backstory.
Starting in February 2018, Kocic began to expound upon the mechanics of the Fed’s efforts to restrike its put. His discussion of that dynamic generally revolved around his characterization of policy normalization as a transition (by the Fed) from convexity supplier to convexity manager in the course of re-emancipating markets. Kocic suggested folks think about the restriking of the legendary Fed put as the normalization of equities’ beta to the short rate.
“February was the first time Fed restruck its put [and] October is its second restriking,” he wrote in October, 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.” A reversion to how things “used to be in previous cycles” (i.e., when the beta was ~10), would translate to SPX 2,300-2,400, Kocic contended.
By the end of 2018, that was looking remarkably prescient. In fact, almost nobody pegged the S&P with that level of precision and the irony of the whole thing is that Kocic doesn’t even have the official DB SPX call. His prediction for where the benchmark would end up last year came about as part of his analysis of the policy normalization process.
Well, in a client note making the rounds on Wednesday, Kocic updates all of this. He starts by noting that the S&P has “converged back towards levels consistent with fundamental economic indicators like the manufacturing PMI”, a development he attributes to the Fed’s convexity management efforts (and again, you really need to read the “convexity wonderland” post linked above to truly appreciate the mechanics here).
He continues, as follows:
The mechanism of convexity injection is illustrated in the figure below which shows the effect of re-striking the Fed put closer to the ATM. The figure shows recent history of the S&P 500 overlaid with 3M S&P vol on the inverted axis. The idea is that when the Fed put is re-struck, this is a supply of convexity which pushes vol lower for a given level of equities. The new strike emerges as a consequence.
If you’re wondering whether Aleks actually endeavors to compute what the new strike is, the answer is “of course he does.”
After describing what you see in the chart (i.e., that SPX 2,700 in October corresponded with volatility around 17% whereas SPX 2,700 now corresponds with volatility at 14%), Kocic notes that “the math consists of finding the strike that corresponds to the put with lower volatility.” Here’s the formula:
So, if the Fed put was struck at ~2,350 in October when vol was 17%, “then the new strike corresponding to the same value of the put option with vol at 14% is 2,450”, he writes.
After noting that equities’ beta to the short rate has now “settled” around 23 after bouncing off 10 late in December, Kocic concludes by reiterating that everything described above is generally consistent with his framework for understanding the Fed as a convexity manager during the normalization process.
“‘Liberating’ the S&P with a Fed pause has allowed financial conditions to ease and will eventually justify (and make it easier for the market to accept a possibility of) additional hikes while at the same time opening up scope for another round of pension fund hedging, if equities register another 3-5% rally from here, effectively capping the rate rise”, he says, on the way to driving the point home by emphasizing that in that eventuality, the convexity supplied by the Fed “would get properly recycled from equities to the long end of the curve.”
So, there you go, sports fans. An update on the Fed put from Kocic who, apparently, understands the Fed’s normalization strategy better than they do.