You don’t have to be particularly bullish on the US economy (or on the outlook for the rest of the world, for that matter) to tentatively suggest that risk asset dips should be bought and that vol. spikes should be sold.
All you need to know is that when it comes to the potential for central bank asset purchases to suppress volatility, both the “flow” and the “stock” impulses are back in play.
Let’s briefly review.
Generally speaking, the “stock” effect refers to the notion that the sequestration of assets on G4 balance sheets supports markets by ensuring the supply/demand picture in government and investment grade bonds is skewed towards scarcity. That effectively preserves the “hunt for yield” dynamic that keeps a bid under risk assets like high yield credit. It is, the argument goes, the size of central bank balance sheets that’s important.
The “flow” argument revolves around the notion that while “size matters” (so to speak), it’s the marginal bid inherent in monthly asset purchases that is critical when it comes to ensuring that asset prices remain buoyant and that financial conditions remain accommodative.
Well, on the flow side, the ECB has restarted net asset purchases (on top of reinvestments, of course) and the Fed is buying T-bills for reserve management purposes (on top of their own reinvestments). Without getting into the specifics, many believe the Fed will need to pivot to coupon purchases (i.e., “real” QE) sooner or later in order to address and otherwise mitigate the factors plaguing short-term funding markets.
As to the “stock” effect, assets will be sequestered away on central bank balance sheets for the foreseeable future. Peak QT is behind us. Runoff is over. The idea of en masse, outright asset divestiture (i.e., central banks becoming big, active sellers) is unthinkable, although it’s at least possible the ECB could run into problems with its corporate bond book in the event of fallen angels.
The bottom line is that although central banks’ ability to suppress volatility may be fading, it’s still there, and the primary transmission channel between asset purchases/forward guidance and market outcomes is rates vol. “No other measure best captures the cumulative effect of QE and the effect of forward guidance [as] the former accumulates assets and the latter anchors uncertainty about the future path of funding costs and the potential risk of re-pricing across the fixed income world”, BofA wrote back in February, in a note documenting the disconnect between policy uncertainty as quantified by news-based measures and market-based measures of implied vol.
Heading into 2020, both the stock and flow effects of QE are in place, and policymakers are carefully calibrating forward guidance to ensure there are no surprises. At the same time, there are structural factors weighing both on growth and inflation. Naturally, that favors a lower neutral rate.
What does this mean for asset allocations in the first half of 2020? Well, if you’re BNP, the read-through is a carry-friendly environment characterized by a kind of low-vol., muddle through.
You’ll recall that, like SocGen, BNP expects below-consensus growth for the US and sees the Fed cutting rates in the first half of the new year.
“Ongoing weakness in US growth is likely to pressure the Fed to cut rates [and] this remains a positive backdrop for carry trades”, the bank says, in an asset allocation piece for 2020.
Next, they bring in the points above regarding rates vol. and central banks’ efforts to tamp down tumult.
“We expect the impact of the stock of central bank balance sheets to continue to dampen global interest rate volatility and hence broader asset class volatility”, the bank remarks, on the way to noting that “this is likely to fuel the search for yield, keeping the term premium low”.
You can begin to see how this becomes a self-feeding loop. BNP drives the point home as follows:
Trade tensions will continue to dominate, in our view, despite a phase-1 deal being agreed between the US and China. We expect this ongoing uncertainty to continue to weigh on global trade and limit any rebound. Lack of confidence is likely to continue to drag down global capex, skewing down potential growth. Structurally, we expect this to keep neutral rates low, with long-term rates staying low for an extended period.
Meanwhile, the broken price Phillips curve and generalized sluggishness of inflation against a backdrop of rising wages will crimp corporate margins, pushing down profits and eroding free cash flow. In other words, corporate fundamentals will deteriorate, dovish central banks or no.
And now for the punchline, which finds BNP explaining that despite this somewhat dreary outlook, the implication is actually that dips should be bought and vol. spikes sold. To wit:
In sum, we see an environment of low returns, slowly deteriorating corporate fundamentals and structurally low volatility. Overall this is a carry environment for global markets, in our view, despite the trade uncertainty and weaker growth backdrop. Volatility may rise in Q1, which we would use as an opportunity to put on short volatility strategies. We would view any risky market weakness as a buying opportunity.
Implicit in all of this is the notion that perhaps growth outcomes will not rebound as expected by consensus. But, again, that just means a return to the environment that’s dominated for years – subdued inflation, the reassessing lower of neutral rates, central bank volatility suppression in recognition of the sluggish macro environment and a market that’s conducive to carry as the hunt for yield proliferates.
The only difference between now and previous, similar backdrops, is that this time, the cycle is even longer in the proverbial tooth, ostensibly raising the odds that, the best efforts of the benefactors with the printing presses notwithstanding, the cycle will finally turn.
This view is clearly inconsistent with the prevailing reflation euphoria, but it speaks to something we’ve suggested on numerous occasions of late – namely that it’s possible to make a constructive case for risk assets irrespective of how you expect growth outcomes to develop.
The only unequivocally bearish case is a scenario where the outlook deteriorates so much, that worries about the proximate cause of central bank dovishness (i.e., slowing growth and rising recession risk) overwhelm the temptation to take risk occasioned by the notion that policymakers will make sure the bottom doesn’t fall out.
Finally, do note that if a massive, global, coordinated fiscal stimulus push ever comes calling, you can throw all of the above out the window, because nobody knows how to trade honest-to-God reflation anymore.