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As ‘Large Local Risk’ Realized, Fed May Be Forced To Finance Political ‘Rationality Deficit’

"In the absence of conviction about the existence of political circuit breakers"...

If Donald Trump was looking to stoke enough uncertainty to make Fed chair Jerome Powell think twice about the notion that a “mid-cycle adjustment” will be enough to offset the psychological drag from the ongoing trade conflict, the president likely succeeded on Thursday.

Trump’s abrupt announcement of new tariffs on the remainder of Chinese imports took markets by surprise, just when US equities were in the middle of staging an impressive rebound off Wednesday’s post-FOMC selloff.

To be sure, it was clear that Trump wasn’t happy with China, but the announcement of new duties was still enough to send stocks careening lower in afternoon trading on Thursday.

Read more: ‘Tariff Man’ Returns: Trump Announces New China Tariffs, Stocks Crash

It’s worth noting that one of the local risks for equities has now seemingly been realized.

Although Nomura’s CTA model still has spot SPX and NDX well above levels that would trigger de-leveraging from trend followers, it looks like we may be through levels where dealers’ gamma profile flips. “The larger local risk is Dealer Gamma flipping —SPX and SPY combined Gamma vs Spot is lined-up at 2983 (2979 ex 8/2/19 expiry) — so an accelerated move lower from there will see Dealers ‘Short Gamma’ and forced to sell more delta the lower the market goes”, the bank’s Charlie McElligott wrote Thursday.


If the afternoon losses hold, Thursday would mark the first time since December that the S&P has fallen 1% or more in consecutive sessions and the largest one-day spike in the VIX since mid-May.

Markets may ultimately regain their composure once everyone realizes Trump’s latest escalation is likely an effort to compel Beijing to make concessions over the next several weeks.

It’s also possible investors will take comfort in the notion that the more perceived irrationality emanating from the White House, the more likely the Fed will be to step in. After all, it was the assumption that the Mexico tariff threat cemented the case for a July cut that ultimately catalyzed the rebound in equities off the May lows.

In that context, and with the July Fed meeting in mind, we’ll leave you with a few excerpts from a June note by Deutsche Bank’s Alexandar Kocic, which seem particularly germane right now.

At the moment, there are three main agents that define the backbone of the underlying configuration with distinct economic profiles and attributes: Fed (fully rational), markets (conditionally rational), and politics which, from the economic view, can be characterized as conditionally irrational. 

In the absence of conviction about the existence of political circuit breakers, the market is coopting the Fed to complete the market and offset any rationality gaps and “finance” potential deficits of economic rationality. The dilemma that defines the current structural instability is the tension between the desire to co-opt monetary policy to complete the markets and the Fed’s resistance towards its exaptation –the effort to drag the Fed into the policy mix and change or augment its role to subsidize the markets subjected to the side-effects of politics. Effectively, the Fed is expected to finance a potential supply of short-term protection (e.g. a lower deductibility S&P put) with long dated (OTM) put on its credibility; this is a position of increasing liability for them and is logical to expect some kind of contestation.



3 comments on “As ‘Large Local Risk’ Realized, Fed May Be Forced To Finance Political ‘Rationality Deficit’

  1. Anonymous

    The idea that investors should not worry about tariffs because the fed will step in and that is also the reason trumpolini is doing all this is just idiotic. It is equivalent to burning the village to save it. In other words he is just destroying global trade and global order so the fed can cut so markets can rally. Another idiotic idea courtesy of Goldman i think is that tariffs even if they end up hurting will only hurt the manufacturing side of the economy, leaving other sectors unscathed. Never mind the interdependencies between sectors just slice them put them aside and pretend they don’t exist. Markets in the US have mistaken Chinese goodwill towards accommodating american irrational behaviour in order so they can find some common ground and continue trading, as inability from the Chinese side to respond to whatever the US does, it is a mistaken belief.

  2. And don’t forget: trade wars are easy to win. LOL.

  3. jamaican

    so much winning…
    @ Anon: agreed, to mistake chinese goodwill/accomodation for ineptitude is a grave mistake.
    But do not expect the stable genius to understand any of this.
    The way he talks about GeeDeePee you can tell he has the economic understanding of a five-year old.

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