“All paths lead to lower rates”, Deutsche Bank’s Aleksandar Kocic writes, in a brilliant new note that finds him deftly navigating the intersection between a left-field macro shock (the coronavirus) and the Fed’s decision calculus, at a time when reality seems to be painting US monetary policy into a corner with regard to inflation.
Equities and high grade credit have managed to rally off the virus-scare lows and wides, respectively. Although various explanations have been floated to explain the resilience of risk assets (and particularly new record highs on US equity benchmarks) in the face of pandemic worries, one way to view things is that expectations of ongoing US economic outperformance (as well as favorable yield differentials and the haven appeal of the US long end) continues to catalyze flows into USD assets, which in turn flattens the curve.
Of course, that’s a problem for the Fed, because it entails more dollar strength, which in turn points to the importation of the world’s disinflationary impulse.
To the extent rate cuts aimed at alleviating the problem end up juicing the domestic economy, thereby exacerbating the economic divergence at a time when the rest of the world is still trying to recover from the trade war and coping with the fallout from the coronavirus epidemic, a lower policy rate in the US could paradoxically lead to lower inflation stateside.
And yet, the market increasingly expects more Fed cuts, because, colloquially speaking, what else are they going to do? Although there’s a good case to be made that more cuts could be counterproductive (in the fashion just described and detailed here), it’s too nuanced a narrative for the market (let alone the public) to full buy into. Besides, the only effective way to punctuate the conclusion of the policy review may be with a rate cut. That is, when the Fed announces a reinvigorated plan to bring inflation sustainably to target after a year-long review process, a simultaneous rate cut would, at the least, convey conviction.
“The novelty introduced in the last weeks has been the resurgence of the debate about the rate cuts, manifested by the rise of volatility risk premia in the upper left corner of the surface, which comes after almost six months of persistent calm in this sector”, Deutsche’s Kocic writes, adding that “while realized volatility remains roughly unchanged along the curve, the spike in the upper left corner signals return of uncertainty regarding the monetary policy response”.
Kocic then takes a look at vol. risk premia across assets. The rates space, he notes, remains something of an outlier.
Stocks and FX have had a “smooth ride” recently thanks to low short rates (i.e., accommodative monetary policy) and relatively stable differentials in those rates, respectively. And yet, as Kocic writes, the prospective vulnerability in equities and FX “commands elevated premia associated with corresponding insurance trades” while, in rates, markets “seem to be pricing relatively low levels of anxiety, despite comparatively high levels of realized vol.”. That’s what you see in the chart.
(Note: The reason IG sticks out should be obvious. Markets are concerned about the BBB “apocalypse” story or, stripped of the hyperbole, there are concerns about “fallen angel” risk. Those concerns are likely to be heightened by the Kraft Heinz debacle.)
The key point in Kocic’s latest comes when he observes that vol. risk premia for risk assets and rates decoupled markedly beginning in the second half of last year.
What accounts for that? Well, if you’ve been following along over the past several months, you can probably offer up one explanation – namely that inflation has become the central narrative, instead of growth.
“Lower inflation expectation is driving rates to the territory of little excitement, which could be supportive for risk assets, while keeping them at the same time vulnerable”, Kocic says, before driving home the point by showing how this logic manifests itself in relatively wide calendar spreads for FX and risk assets versus rates. To wit:
Because of the steady short rate differentials across different economies, there has not been much realized volatility in FX causing a virtual collapse of gamma. However, lingering future risks remain priced in and the corresponding calendars wide. Similar pattern is observed in risk assets. This is in sharp contrast with rates market where gamma is supported by high delivered vol, while long-term uncertainties remains low and calendars flat as all rates paths leads to truncated rates probability and low vol environment.
For Kocic, we’re approaching a kind of fork in the road, where the Fed’s level of resoluteness will determine the path for risk assets and, to a perhaps lesser degree, for FX.
If the committee is resolute (i.e., cuts rates in the face of continual dollar strength and/or the re-inversion of, for example, the 2s10s), risk assets will react positively. Any foot-dragging by the Fed, on the other hand, could see risk assets react less favorably, despite the inevitably of an eventual dovish policy response.
“The least ambiguous trade emerges from the view that all roads lead to lower rates”, Kocic says. “While there can be more than one path, the destination is the same in all of those cases”.