“These are administered markets”, Deutsche Bank’s Stuart Sparks begins, in his latest note.
It’s a familiar refrain. In fact, he used the same phrase earlier this month in the course of projecting the Fed will ultimately accommodate (i.e., monetize) the entirety of the virus relief packages delivered by Congress. And that includes an expected “phase four” bill.
Sparks is unequivocal and quite blunt in his assessment of the rates market. “Outcomes will be driven by the policy goals of the Fed and the tools it elects to deploy to achieve them”, he says, flatly. “The Fed must engineer and maintain financial conditions that are conducive to economic recovery such that it ultimately meets its employment and inflation policy objectives”.
There’s just one problem: Policy is still too tight.
For everything that’s been done – the trillions in congressionally-approved relief funds, the trillions in assets already purchased by the Fed over the past six weeks, and the myriad liquidity facilities rolled out to ensure that virtually any asset can be posted as collateral for cheap cash – it’s not enough.
There’s no mystery here. I talked, for instance, on Sunday about the extent to which a simple chart of breakevens, oil and the dollar, paints a perilous picture for the Fed, which habitually undershot its inflation goal prior to the pandemic. Now, they’re up against the largest demand shock since the Great Depression, oil has become (literally) worthless and the dollar is stubbornly resilient.
“The trade weighted dollar is stronger than it was before the COVID-19 shock, and is stronger than it was when effective funds were more than 225 bp higher last year”, Sparks writes, before noting that while oil has “nearly monopolized commodity-related headlines”, it’s only part of the story.
“Agricultural commodities and metals are significantly lower on the year” too, he notes, on the way to pointing at breakevens, where the bank’s model fair value “is roughly 1% and clearly no where near the context of Fed policy objectives”.
(Deutsche Bank)
For what it’s worth, Albert Edwards advanced a broadly similar argument last week, albeit in his own, signature parlance, which is quite a bit more colloquial than most analysts.
So, if policy is too tight now, how loose should it be? Well, as anyone steeped in this debate knows, that’s not an easy question to answer. It’s pretty clear from observable markets (e.g., inflation expectations and the dollar) that policy isn’t loose enough, but r* isn’t observable. Sparks leans on a model from Francis Yared (also a Deutsche Bank rates strategist) which uses equity/fixed income correlations to infer the r* “implicit in market behavior”. That level is -1%.
Narayana Kocherlakota’s best efforts aside, the Fed isn’t likely to take rates negative, so when it comes to easing policy to the equivalent of NIRP, asset purchases it is.
“The Fed’s empirical works suggests that $100 billion in asset purchases has roughly the same impact on growth as a 3 bp reduction in the funds rate”, Sparks goes on to say. The math then dictates that in order to engineer 100bps worth of additional easing (i.e., in order to drive the effective real short rate to a level that borders on stimulative), the Fed needs to buy some $3.3 trillion in assets.
Deutsche expects they will, and, like UBS, TD and others, expects yield curve control to be instituted later this year (over the summer). Ultimately, Fed purchases will surely outstrip coupon issuance by a hefty margin.
But the key macro takeaway from Sparks is again the lesson from March, which I discussed at length in the first linked post above. He summarizes it in one concise paragraph. To wit:
March presented a painful but instructive lesson on the potential risks of abrupt significant increases in real yields or the real term premium, such as might reasonably be expected if effective real short rates remained significantly higher than r*, the Fed tapered balance sheet growth prematurely, and the Treasury was left to fund fiscal stimulus absent Fed demand. At the outset of the oil price war, the meltdown in breakevens caused real yields to spike and the broad dollar to hit its strongest levels in 17 years. This dynamic illustrated local circularity, as falling commodities further pressured commodity prices and breakevens, driving real yields higher. We expect the Fed to continue to depress the real term premium to maximize incentives for capital to be allocated into funding for the non-financial corporate sector and to minimize further dollar appreciation which threatens already weak commodities and shaky inflation expectations.
Meanwhile (and apropos of nothing, really, other than that we’re still talking about rates), JPMorgan notes that “historic” or otherwise anomalous events are popping up in fixed income all the time these days.
“If it feels like 100-year flood type events are happening all too frequently across markets, that’s because they are”, the bank says, in a note out late last week.
(JPMorgan)
“The incidence of ‘historic’ events has been rising for years”, the bank continues, adding that “even adjusting for the usual heteroskedasticity of financial asset returns, the rate of 3-sigma and larger events is not only many times what one would expect from a normal distribution, but that has nearly doubled since 2010.”
“The incidence of ‘historic’ events has been rising for years…even adjusting for the usual heteroskedasticity of financial asset returns, the rate of 3-sigma and larger events is not only many times what one would expect from a normal distribution, but that has nearly doubled since 2010.” Methinks a visual representation of the phenomenon described would look a lot like “Gallopin’ Gertie” — the Tacoma Narrows Bridge on opening day: https://www.youtube.com/watch?v=j-zczJXSxnw
Big surprise, it’s not a bell curve! Try a power curve obviously
100 year floods happen much more frequently. I believe it is more than just “fat tails”. Returns are not normally distributed. Time to throw that assumption in the trash can along with capm and the emh.
I thought these assumptions were thrown in the trash about 20 years ago… clearly Bachilier’s work was useful BUT wrong. Markets are complex, dynamic systems, with power curves.
Perhaps the occurrence of heteroskedasticity is because markets are not “normally distributed”. Benoit Mandelbrot proved 60 years ago security prices are distributed via a power law. Mean and variance DO NOT settle to a single value and therefore standard deviation is undefined. (Cauchy, Pareto) Wall Street chose to ignore his research even though markets, and JP Morgans analyst in the analysis above, have proven him correct.
heteroskedasticity–even dictionary.com does not have a definition for this word….
Technical term in statistics https://www.investopedia.com/terms/h/heteroskedasticity.asp
That term I believe describes error terms that are correlated rather than random in a regression. Fat tails refers to skewness or kurtosis meaning each side of a normal looking distribution have a higher probability than a standard normal distribution. In practical terms this means seemingly unlikely events at each end are more likely…… so the hundred year flood is more like a 5 year event. Or a 5 standard deviation event is more like a 1 or 2 standard deviation event.
It’s enough to make a liberal arts major want to study statistics. Poetry.
The question begged is whether the Fed has enough ammunition to backstop not only the domestic economy, but also the global order. Or perhaps i is more a question of how long can they keep up and whether it will be long enough. I’ve never considered gold as a viable “investment” until this pandemic, but it seems to me that the rules have changed yet no one has the new rule book…
heteroskedasticity: In statistics, a collection of random variables is heteroscedastic (or heteroskedastic; from Ancient Greek hetero “different” and skedasis “dispersion”) if there are sub-populations that have different variabilities from others.
That might be a nice way to think about antigenic drift and virus mutation and a reason as to why a vaccine is sorta tuff to invent, e.g. one reason the common cold has never been cured. .
One can never assume a full gaussian distribution but of course lately and in the future I would expect tails to be fatter simply because actions by the federal reserve in the past 2 and a half decades have had the major effects of making debt cheaper and ever increasingly pushing capital further out the risk curve. Simply put with every major fed intervention in bond markets eventually, longer term, risk increases as money is pushed further and further out reaching for yield
All the answers wind up being questions in the end or as my father always referred to these issues “mental Gymnastics”…. Good post…H…!!
The implications of some of these comments is that the bond market is now more of a “greater fool” market than I could ever imagine, especially on the long end. I just dumped a large 7.5% stripped treasury that was selling near par with more than six years to run. Put the cash in an insured CD which will pay me triple what the UST would. Also, turned a huge pending OID liability into a smaller capital gain with less than a quarter of the tax liability. This s**t is crazy.