Gray Rhino Or Black Swan? Characterizing Vol. Spikes In A ‘Smart Power’ Regime

If you look out across the smattering of notable policy headlines on Tuesday, it all seems to underscore the narrative that’s driven gains so far in 2019.

The RBA minutes showed policymakers discussed a “rate cut scenario” at their April meeting, a dovish development that further cements the global policy pivot. Although the bank didn’t see “a strong case” for a cut in the near-term, they noted that “a lower level of interest rates could still be expected to support the economy through a depreciation of the exchange rate and by reducing required interest payments on borrowing, freeing up cash for other expenditure.”

That’s amusingly straightforward and, as SocGen’s Kit Juckes wrote on Tuesday, it “fuels expectations that not only will the next move be a cut, but that it will come this year.” “The detail of the Minutes did seem more dovish than the initial statement”, Juckes added. In many ways, Australia is in the same spot as the US and others – there are signs of economic weakness, but unemployment is low. Policymakers did suggest the outlook for the labor market could be more “mixed” going forward.

This is set against a backdrop where policymaker after policymaker parrots some derivation of the same line. For instance, it wasn’t really “news” when the Fed’s Evans suggested yesterday morning that rates will be unchanged though the fall of 2020, but that’s just indicative of the extent to which forward guidance (either “official” as communicated in policy statements and meeting minutes or “incremental”/”ad hoc” in various soundbites) is being deployed aggressively, with the effect of driving cross-asset volatility into the floor. We talked about this at length on Monday in “It’s Quiet — But Is It Too Quiet?”

“We talk about the return of volatile markets as a ‘gray rhino’ and like to make lists about all of the potential catalysts, but unfortunately, this situation is much more like waiting for the black swan”, former trader and fund manager Richard Breslow wrote Tuesday, adding that “investors are, quite understandably given the environment, behaving as if it remains a low- probability event and central bankers are praying it is a no- probability event.”

Of course that latter group of market “participants” (and you can take “participants” figuratively or literally there – after all, if you’re printing money to buy assets, that’s active participation), arguably doesn’t have to “pray”. Considered in a certain light, the “lose control” narrative doesn’t really make a whole lot of sense. Doomsayers, click-bait bloggers and commission-generating gold coin salesmen have been penning headlines about central banks “losing control” for the better part of a decade while simultaneously bemoaning how much control those same policymakers actually exert. There’s something contradictory about that.

It’s easy to play the boy in the crowd from “The Emperor’s New Clothes” when you’re not managing other people’s money. The situation is a bit different when P/L actually matters. Remember “smart power”? Here’s Deutsche Bank’s Aleksandar Kocic (from a January 2018 note):

Through their communication with the markets Central banks, and the Fed in particular, have become “good listeners” with their decisions and actions made with markets’ consent. After years of this dialogue, the markets have gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting. Not much of a choice, really. In this process, Central banks have reached a point of enormous power and control where market dissent is practically impossible. We believe that such levels of market control remain uncontested with anything we have seen in recent history and that the markets’ dynamics have never been further from that of the free-markets. Low volatility is a perfect testimony of that.

Of course volatility returned last year (with rates standing out as the exception), but that was down to the Fed attempting to gradually re-emancipate markets. That effort wasn’t digested well even if the dynamics themselves were consistent with an internal normalization plan. And so, here we are, back in vol.-suppression/carry mania mode. While the peanut gallery (for whom paying the mortgage depends on maximizing clicks) will continue to retell Hans Christian Andersen fables, actual market participants will either fall in line, or else risk underperformance (see the quote above from Kocic).

“Over the last 24 hours, there has been the usual diet of dovish central bank speakers ready to soothe the markets”, Breslow went on to write, in the same Tuesday note cited above. “‘Soothe’ is just a euphemism for volatility suppression and there are no indications that the litany of speeches will abate anytime soon”, he continued. “It suits the interests of too many market participants.”

Right. And there’s plenty of scope for this right now. In addition to the tried-and-true “still-subdued inflation” rationale, we’re now in an environment where global growth concerns are rampant. That’s just another justification for dovish policy and even if things are going ok in your own locale, you can always cite “international developments” as a reason to remain cautious (oops – “patient”).

To be sure, there are risks in overstating the case as Mario Draghi learned at the March ECB meeting when the cuts to the outlook were deep enough to rattle markets. As BofAML’s Hans Mikkelsen put it last month, “communicating dovishness is always tricky as there is a delicate balance between the benefit of stimulus and the underlying driver, which is economic weakness.”

But in order for the “underlying driver” to “win” out (where that means overwhelming the risk-on signal from a decisive dovish policy slant), things would presumably have to deteriorate rapidly and markedly to the point that everyone actually begins to worry that no policy response would be sufficient to avert a catastrophe. That kind of downturn is, by very definition, historically anomalous.

On Tuesday, Reuters ran what, on the surface, sounded like a foreboding story. “Several ECB policymakers think the bank’s economic projections are too optimistic as growth weakness in China and trade tensions linger”, the first line reads. And it gets “worse”:

A “significant minority” of rate-setters in last week’s policy meeting expressed doubt that a long projected growth recovery is coming in the second half of the year and some even questioned the accuracy of the ECB’s projection models, given their long history of downward revisions, the sources said.

Is that actually “worse”, though? Maybe not. Because the next sentence is this:

With the ECB using the these projections as a key input into policy decision, more cuts in growth and inflation forecasts would raise the chance that the bank’s first post crisis rate hike, now seen next year, is delayed even longer.

“Japanification”? Maybe. Indefinite vol. suppression? Almost definitely.

None of this is to say that volatility can’t suddenly shoot higher. Indeed, as we saw late last month when rates vol. suddenly woke up, the current “metastable” configuration is defined by periods of tranquility and placidity shattered by episodic vol. spikes, which expose the inherent underlying fragility of what is, at heart, a tenuous equilibrium.

But simply warning that vol. spikes are “inevitable” (e.g., “How to Prepare for Inevitable Moment When Volatility Explodes“, from Bloomberg) isn’t really saying much. That is, of course they’re “inevitable”, in the same way that you will “inevitably” have a really bad day at some point when a series of factors conspire to throw you for a personal loop (maybe you spill hot coffee in your lap causing you to rear-end someone on the way to work and your subsequent lateness elicits a rebuke from your boss, which puts you in an even worse mood, eventually culminating in a senseless argument with your significant other over something silly like the dry cleaning –  à la the famous Will Ferrell “family dinner” sketch). And yes, an acute lack of market depth and Marko Kolanovic’s “liquidity-volatility-flows” feedback loop have the potential to make episodic vol. spikes worse when they do occur.

At the end of the day, though, policymakers’ vol.-suppression efforts can only truly “fail” in the event of a deep downturn and/or if enough people decide to challenge the capacity/willingness of central banks to control markets. The problem with any one person taking it upon themselves to figuratively issue that challenge is that it’s meaningless if nobody else is along for the ride.

So, yes, there’s a sense in which vol. spikes are “gray rhinos”, but thanks to the “smart power” dynamic, they manifest more as “black swans”.

Oh, and in case the “gray rhino”/”black swan” fans are wondering, I am (proudly) blocked by NNT…