In “Napalm,” I contextualized recent front-end rates fireworks by reference to a possible shift in the interplay between markets and policymakers.
In the pandemic era of elevated inflation, there’s been some disagreement between markets and central banks around the timeline on rate hikes. But — and I’m going to quickly recap using verbatim language from the linked article above — 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.
Recent events 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.
That characterization of the policymaker-market nexus owes quite a bit to Deutsche Bank’s Aleksandar Kocic, and his “Fourth wall” analogy, which I was quick to employ on Wednesday afternoon amid unfolding drama engendered by the Bank of Canada’s hawkish pivot and the RBA’s apparent abandonment of yield-curve control.
In his latest, Kocic revisited the consultation process mentioned above as well as a variety of other, related dynamics that have featured heavily in his work over the years, including the Fed’s role as convexity manager and the pitfalls of re-emancipating markets after a dozen years of what amounts to martial law and administered asset prices.
Lifting martial law — the “state of exception” — is complicated by the entrenched nature of the market modes it engendered, facilitated and encouraged. The longer it persists, the fewer professional traders who remember what things were like before. And the greater the addiction liability. For some assets, we simply have no idea what the market clearing price is. It isn’t possible to know where, for example, some periphery EGBs would trade absent the ECB.
“Although unprecedented policy stimulus post-2008 was conceived as a temporary solution, it turned out to be anything but — it defined new realities of the market and set new templates of market behavior,” Kocic wrote, in a note dated October 29. “As such, thanks to its seductiveness and the comfort it had provided, the whole initial maneuver of monetary policy became the major obstacle to its own unwind, which required a different kind of exit strategy for central banks,” he continued, noting that “forward guidance, and excess transparency in general, has been the tool of supplying convexity to the market intended to smooth out the market functioning on the way out.”
Although policymakers have attempted to employ forward guidance in the pandemic era, the effort is complicated immeasurably by the persistence of inflation, ambiguities around its causes and risks associated both with staying behind the curve (e.g., exacerbating price pressures) or getting ahead of it (e.g., choking off growth and triggering a mild version of stagflation).
No one truly knows how long price pressures will persist in advanced economies. Consumer uncertainty around inflation, as measured by the University of Michigan, is the highest it’s ever been outside of recession.
Although the market may agree that rate hikes ultimately need to be pulled forward, there are two points worth noting.
First, the violent front-end repricing seen across economies (figure below, from Kocic) suggests markets were caught flat-footed or, at best, are having a difficult time calmly negotiating the likely pace and trajectory of rate hikes. Second, rallies at the long-end are suggestive of the market’s displeasure — compression conveys a warning to policymakers.
Kocic pointed to recurring curve twists as a manifestation of the absence of consensus.
“Every time the front end sells off in response to hawkish Fed rhetoric, the back end ‘rebels’ and rallies,” he said, noting that “these twists are generally followed by subsequent counter-twists as the market fades the initial shocks and both sectors of the curve retrace their previous trajectories.”
The figures (below) illustrate the point.
“Correlations between the front and the back end of the curve have reflected the rising frequency of the twists,” Kocic wrote, calling the decline in correlation “an articulation of the fractured consensus between the Fed and the markets.”
How this gets resolved is anyone’s guess. As noted above, ambiguity around inflation and growth makes policymakers’ task virtually impossible.
Threading the needle entails correctly calibrating preemptive tightening so that it helps mitigate inflationary pressures without weighing too heavily on growth, which is already decelerating. The absence of clarity around fiscal policy complicates the issue, as does the distinct possibility that rate hikes simply won’t do much to mitigate cost-push inflation absent a deliberate attempt to engineer demand destruction via recession.
Coming full circle, Kocic wrote that,
There is a deeper problem of market’s behavior and central banks’ “addiction liability” as a consequence of the comfort of administered markets associated with Fed’s enhanced mandate and extended reaction function of the last 13 years. Markets have gotten used to being consulted and listened to and any deviation from that script has already proven capable of creating considerable market disruptions. The VaR shock caused by the last week’s move of the global front ends is just the last reminder of the level of markets’ excessive reliance on central bank’s convexity supply either as an injection of stimulus or their forward guidance.
Over the last several weeks, at least, “the markets were not consulted,” he said.
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