Napalm

One bond market recap featured the word “bloody.”

I suppose the hyperbole was apt. Last week was, in fact, dramatic for rates, and particularly the short-end.

There’s now a sense of alarm among markets that they’ve been cut out of the loop.

Market pricing for rate hikes wasn’t completely aligned with forward guidance in some locales, but the assumption was that any disagreements would be resolved gradually and amicably in accordance with post-financial crisis decorum.

Central banks and markets would come to some consensus on how to interpret the incoming data and that consensus would be incorporated into forward guidance. Any policy changes would, in effect, be agreed ahead of time — a product of the usual consultation process which limits disruption associated with any shifts.

Last week cast considerable doubt on that assumption. The rolling plebiscite mode, where policy is the result of a referendum or a consultation between central banks and markets, was called into question. “In a span of a few days, the view that some major central banks will be slow to raise rates shattered into pieces,” Bloomberg’s Liz McCormick wrote.

“Shattered into pieces,” indeed.

The genesis of this can be traced to September 23, the day after the September FOMC, when the Norges Bank became the first central bank to raise rates in the pandemic era among countries with the 10 most-traded currencies. Just hours later, a hawkish BoE statement set in motion the dynamics that brought us to where we are today.

Things escalated materially on October 18, after comments from Andrew Bailey triggered a dramatic bout of bear flattening in gilts on the same day a red-hot inflation print out of New Zealand set the stage for another RBNZ hike.

Then the situation spiraled.

The BoC’s hawkish statement and abrupt end to QE sparked a statistically impossible move at the Canadian front-end and the RBA abandoned yield-curve control, sending yields on the YCC note to eight times the target. Finally, Christine Lagarde’s remark that it’s “not for me to say” whether markets are or aren’t correct in pricing ECB hikes, was yet another tacit break with convention.

“Between the BoE, BoC, RBA, and to a lesser extent the ECB, the transition away from the extremely accommodative monetary policy environment will continue to contribute to upward pressure on front-end yields globally and leave investors on watch for a bearish period in risk assets,” BMO’s Ian Lyngen and Ben Jeffery said.

Goldman on Friday brought forward their forecast for Fed liftoff to July. Or, in other words, immediately after the projected end of the taper, which, by all accounts, will be announced next week. A second hike will come in November of next year, the bank now says. Inflation, Goldman reckoned, might not be entirely “transitory” after all. That means “a seamless move from tapering to rate hikes” will be “the path of least resistance” for the Fed. “Seamless” could prove to be a misnomer.

Data out Friday showed headline and core PCE were largely in line with expectations for September. But both are still running a mile above target (figure below) and separate data showed employment costs rose the most on record during the third quarter.

“Central banks are unlikely to hike as much as expected right now, but we won’t have the support or evidence for that view until we are well into 2022,” TD’s Rich Kelly said, calling this “the eye of the storm when it comes to inflation fears.”

Central banks’ “resolve will continue to be tested and the risks remain biased to the upside for much of what is driving fear in the market,” Kelly went on to write, in the same cited note, adding that it’s “difficult to trade around the increasingly itchy trigger fingers of some central bankers.”

That really gets to the heart of the issue. The idea of central bankers with “itchy trigger fingers” is completely inconsistent with the behavioral patterns markets have been accustomed to for the last decade.

As discussed here last weekend in “Underestimating The Biggest Risk Of All” and “The System Has Become Over-Optimized”, preemptive rate hikes to manage risk haven’t been “a thing” (so to speak) for the entirety of many market participants’ professional careers.

In the wake of the BoC shocker, Bloomberg’s Cameron Crise called this “a brave new world for STIR traders.” “If you’re a STIR trader younger than your mid-30s, you’ve never seen anything like this in Canada,” he wrote. “Even older traders rarely saw one day moves like this before and during the GFC.” The front-end of the curve delivered a 15-sigma move that day. The Dec21 BA contract sold off by 30bps after 12 months of sub-2bp per day delivered moves.

Following the chaos in Aussie rates on Thursday, Nomura’s Charlie McElligott described “wafts of VaR-napalm emanating from Macro HF pods [as] the fresh rates calamity… add[ed] more fuel to the ‘hawkish global CB pivot’ fire.”

He continued, calling the situation an ongoing “disaster with trapped / bad positioning from clients, and dealers largely unable to provide liquidity in light of event-risk and VaR constraints, further exacerbating” stop-outs in the upper left corner and in steepeners.

Meanwhile, the long-end continues to fret over the implications for growth. Expect “policy mistake” to become the top tail risk for market participants going forward.