One of the “miracles” of forward guidance is that if it’s credible, it quickly becomes self-fulfilling.
That is, if policymakers convey their intention to keep rates on hold for an extended period and that promise is seen as credible among market participants, well then the vol. suppression that goes along with perpetual dovishness means everyone is incentivized to chase (back) out the risk curve and (back) down the quality ladder.
Irrespective of whether you think that’s a good idea, you know that everyone else is likely to re-engage and get swept up in the carry mania, which means you either join the crowd, or else risk underperformance which, if it goes on long enough, will put you out of business.
That’s not really much of choice, which is why, at various intervals post-crisis, everyone was short vol. in one way or another. As Citi wrote in late 2017 just months prior to “Vol-pocalypse”, “trades and strategies which explicitly or implicitly rely on the low-vol environment continuing, are becoming more and more ubiquitous.”
But again, market participants really don’t have a choice – it’s a kind of reluctant conformity, and that optimizes around itself until any and all dips are bought/vol. rips are sold, because everyone knows that everyone else is thinking the same thing. Before you know it, you’re buying “the prospective dip”, as we’re fond of putting it.
Last year, however, a simple buy-the-dip strategy failed.
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Heresy! For The First Time In 16 Years, Buy-The-Dip Has Failed
Fast forward from the Q4 malaise to April, and here we are staring down one the best starts to a year for risk assets (and really, for assets of all kinds) in recent memory. That’s thanks mostly to the resumption of dovish forward guidance from policymakers, which by all appearances looks set to be embraced by the market as entirely credible.
In fact, as BofAML writes in a note dated Tuesday, “central banks’ increasing dovishness has totally offset the lack of CSPP buying [in Europe].”
The bank defines the central bank put as the difference between the “dovish” and “hawkish” story count (4-week rolling differential). Needless to say, that figure has spiked of late, offsetting the wind down of net corporate bond purchases by the ECB.
(BofAML)
“We note that the combined effect of the two forms of policies (verbal and actual) is stable over the past three years since the announcement of the corporate bond buying program”, the bank’s Ioannis Angelakis and Barnaby Martin write, adding the following color which underscores the extent to which last year’s stumbles have morphed into this year’s tailwinds thanks to the forced CB pivot (this is through the lens of the bank’s European credit team, but the general thrust of it is applicable pretty much across the board):
Who would imagine that 2019 Q1 would have been the strongest quarter since the global financial crisis. Despite a macroeconomic data slowdown, credit has managed to stage a rally that can match those seen post QE announcements. This comes in contrast to the performance over the last two months of 2018 where credit markets have suffered a sharp re-pricing as investors’ sentiment had to battle between the end of QE and a deteriorating macroeconomic environment. What changed? It seems all these headwinds have become actually a synchronized tailwind. A synchronized “whatever it takes” across the globe instigated a “reach for yield tailwind” that is matching what we saw back in 2009 (GFC) and in 2016 (CSPP announcement).
For credit, these are ideal conditions. Angelakis goes on to reiterate what Martin wrote in his last note, namely that in the absence of a sharp deterioration in the economic backdrop (i.e., an outright global recession), credit should remain supported.
“A monumental U-turn from central banks across the globe has prompted a risk rally rarely seen before [and on top of] that, another relatively rare phenomenon is now also playing out: dovish central banks not only push government bond yields lower, but also keep squeezing credit spreads tighter”, Angelakis says, adding that “the end result is vertical price action – in total returns terms – across credit.”
(BofAML)
There’s a ton more in the full note including an in-depth discussion of disinflation trends in Europe, but for our purposes here (i.e., in keeping with what we said at the outset), the overarching point is that, to quote Angelakis one more time, “the rally so far this year has been the result of the strongest ‘reach for yield tailwind’ backdrop since the GFC.”
As ever, the ultimate question is whether plunging DM government bond yields and the aggressive dovish pivot from central banks can properly be separated from their proximate cause. That is, to the extent an acute growth scare is behind the plunge in DM bond yields and also the dovish relent from policymakers, the only way it makes sense to chase risk is if you believe that i) that growth scare will be seen as overdone in hindsight, or ii) central banks will be effective at warding off a downturn.
Nobody knows whether either of those two assumptions are safe, but judging by the behavior of risk assets and collapsing cross-asset vol., nobody is willing to play the “policy impotence” card just yet – at least not if that requires putting on trades that cost a bundle of carry in the meantime.
