‘Blue Sky’, ‘Ugly’ Or ‘Armageddon’: 3 Paths For The Emancipation Trade

Jerome Powell has become something of a whipping boy for market participants and especially for Donald Trump, who on Monday renewed his attacks on the Fed a little more than a week ahead of the December FOMC meeting.

To us, it was always clear that Powell’s self-described “plain English” approach to communicating combined with his decision to hold press conferences after each meeting was a recipe for problems, especially in an environment where the Fed was set to keep raising rates.

Initially, pundits (and some analysts) cheered Powell’s “plain speaking”. But by the time the curtain mercifully closed on 2018, Trump’s incessant public maligning of Fed policy and Powell’s lack of finesse during press conferences, ended up tanking markets.

Paradoxically, the kind of academic doublespeak employed by Janet Yellen (and eschewed by Powell) created more transparency by fostering a two-way communication loop that allowed market participants not just to read whatever they wanted to read into the Fed chair’s remarks, but to actually help write the script. Powell’s “plain English”, by contrast, left little room for interpretation. Even once the Fed pivoted back to easing mode in 2019, he still struggled to pacify markets on FOMC decision days, in part because his inability (or unwillingness) to obfuscate and theorize continually left a bad taste in the mouths of traders.

“It’s becoming blatantly obvious that peak central bank power has passed”, BofA’s equity derivatives team writes, in their 2020 outlook, adding that “the pinnacle occurred under Yellen’s tenure, when repeated efforts to protect markets at very low levels of stress resulted in a market that competed for ‘dip alpha’ to the point that the S&P went for the longest period in history (since 1928) without a 5% dip (405 trading days ending in Feb-18)”.

(BofA)

2018, you’re reminded, was the first year in more than a decade that one version of a simple “buy the dip” strategy stopped working. Recall the following, from Morgan Stanley’s Mike Wilson (writing a year ago last month):

[This market] trades like a bear market [as] a buy-the-dip strategy has not worked this year, the first time since 2002. What’s notable about Exhibit 1 is the fact that the only years the Buy the Dip hasn’t worked was during bear markets, or the beginning of one (1982, 1990, 2000, 2002). In the cases of 1982, 1990, and 2002 it was also accompanied by a recession. In the case of 2000, it was the year preceding a bear market and recession and the topping of the TMT bubble. In other words, while 2018 is clearly not a year of recession, the market is speaking loudly that bad news is coming. 

Bad news didn’t come, or actually, it did, but it didn’t really matter because central banks all pivoted back towards accommodation in 2019, lifting some 92% of global assets to positive returns in the process.

And yet, as the first visual above clearly shows, the halcyon days of 2017 are gone – and so is Janet Yellen. And now, so is Mario Draghi.

It’s worth taking a moment to remember how “BTFD” was legitimized. That is, how did it come to be that “BTFD” went from being a standing joke (a derisive meme about retail investors’ penchant for being bag holders) to a real thing? We’ve been over this before, so if some of it sounds familiar, it’s because this is familiar territory.

The vaunted “Goldilocks” narrative of synchronous global growth and still-subdued inflation underpinned the low vol. regime by allowing traders to point to upbeat economic indicators while citing well-anchored inflation as a reason to expect central banks to remain accommodative for the foreseeable future.

And when it came to central banks, the two-way communication loop (mentioned above) between policymakers and markets became a self-fulfilling prophecy. Markets became so conditioned to policymaker intervention and dovish forward guidance that no one saw any utility in waiting around for it anymore. After all, if you know it’s coming, why wait on it? Why not buy the dip now?

Once that mentality took hold, it obviated the need for further dovishness. Markets reacted to the expectation of dovishness and in doing so, ensured that the policymaker “put” ran on autopilot. As BofAML put it last year, “competition to buy the dip becomes so strong, CBs no longer need to react”.

But things are different now, something BofA underscores in the same derivatives outlook piece cited above.

“Another indication that central banks’ ability to suppress volatility is fading is the fact that in recent years, across all major central banks (the Fed, ECB, and the BOJ), we have begun to see volatility rise post CB meetings, whereas previously it had declined”, the bank observes, on the way to noting the obvious, which is that “in the US, this stark change came with Powell taking over the Fed”.

(BofA)

Where things go from here is an open question and, indeed, it may be the only question that really matters if fiscal policy never steps up to the plate in a meaningful way.

Ideally, central banks would like to disown the power they have over markets, but as Deutsche Bank’s Aleksandar Kocic has eloquently detailed, that is proving to be quite difficult. “The Fed (and central banks in general) carries an implicit responsibility for orderly reemancipation of the markets, which makes stimulus unwind especially tricky”, Kocic wrote in 2017, effectively previewing what was in store a year hence. “The only way to avoid facing the underlying dilemma is to never give up the power”, he went on to say, in the course of suggesting that emancipating markets may not be possible.

BofA adopts a similar tone in a note dated November 26. “A necessary condition to escape this environment of artificially low volatility, alpha starvation, and high fragility is for central banks to step back and allow markets to run on their own [but] at this point, most paths towards this end seem quite disorderly and would certainly result in higher volatility and risk-asset losses”, the bank says.

They then list the three paths to market emancipation.

The first is labeled the “blue sky” scenario, and it finds the global economy rebounding enough to buoy sentiment and convince market participants that the training wheels are no longer necessary and that things can return to normal. Suffice to say the Japanification of Europe and the threat that the US will succumb to the same fate makes the “blue sky” scenario seem far-fetched indeed.

The second path is labeled the “ugly” and it essentially involves inflation showing up, stripping policymakers of their ability to maintain plausible deniability while persisting in accommodation. Not only that, it would mean massive losses for anyone sitting on trillions in duration – “anyone” like central banks.

“We have long argued that inflation remains the Kryptonite for the low-vol bubble, as it would unwind nearly all of the supporting factors allowing central banks to maintain control”, BofA says, describing the “ugly” inflation scenario, and noting that “it would not only drive higher fundamental volatility, but would handcuff central banks from being able to proactively protect markets, except in the most dire of cases, and would impair central bank balance sheets”.

But that’s not the biggest danger. No, the biggest danger comes from the “policy impotence” trade, which BofA’s derivatives team describes as “Armageddon” (and that’s a quote).

Because we feel like we’d be doing the original a disservice to paraphrase this short passage (the full note is 40 pages long), we’ll just leave you with the actual quote from Benjamin Bowler and co. To wit:

CB policy impotence (Armageddon): Clearly the biggest visible tail risk would be the loss of central bank credibility, given nearly everything we know about financial markets in the last 10 years has been defined by their credibility and support. While this risk is elusive and hard to price, it’s not one to ignore, given evidence of policy already pushing on a string. Importantly, so much of this support is a function of the collective belief in central bank power, and collective beliefs are fickle. A sudden shift in mentality from “Great, the Fed is panicking and they still have 150bps of traditional ammunition” to “Oh no, the Fed only has 150bps of ammunition” seems a real risk.

(BofA)

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