Waking Up So We Can Continue To Sleep

Most traders and investors long ago came to accept (sometimes begrudgingly, sometimes quite happily) the reality of administered markets.

2022 marks 14 years since the financial crisis. The emergency measures adopted in its wake, ostensibly to avert a deflationary spiral, are mostly still in place. Ensuing crises (e.g., the eurozone debt debacle and the pandemic) served to entrench and extend the market equivalent of a state of exception — the forcible suspension of normal market functioning in the interest of restoring order.

“The intrinsic contradiction of this maneuver is resolved only by understanding that suspension is temporary. Stimulus will have to be unwound,” Deutsche Bank’s Aleksandar Kocic wrote, in 2017, on the way to delivering what still resonates as perhaps the most poignant description of central banks’ addiction liability in the post-Lehman world:

However, the accommodation has been in place for a very long time, during which traditional transmission mechanisms have atrophied and investors’ mindset has changed in a way that has altered irreversibly their behavior, the market functioning and its dynamics.

Engineering a state of exception comes with considerable risk. The Fed (and central banks in general) carries an implicit responsibility for orderly re-emancipation of the markets, which makes stimulus unwind especially tricky. This highlights the deep dichotomy of power: While a state of exception is an exercise of power, there is a clear tendency to disown that power. And the only way to avoid facing the underlying dilemma is to never give up the power. This creates a new status quo — a permanent state of exception.

Eventually, that manifested in the idea of administered markets. Prices are, for all intents and purposes, managed from the top down. There is no price discovery.

For years, the quintessential example of this has been periphery European government bonds. The poster children of Europe’s sovereign debt crisis now borrow for a song. In 2021, the benchmark of all benchmarks (the 10-year US Treasury) achieved its own autonomy from the underlying economic  fundamentals of the sovereign.

“There is nothing more predictable than the straight line and nothing more disturbing than the straight line that eludes predictions,” Deutsche’s Kocic wrote, describing the scatterplot (below) which shows 10-year US yields cutting the proverbial cord with inflation. “The robust one-sided divergence between inflation and rates goes beyond any recognized pattern between reality and known models,” Kocic said. The “disagreement” between market variables and fundamentals “can no longer be interpreted as a temporary dislocation that is likely to converge,” he added.

10-year Treasurys are the reference asset off which almost all other assets are, in one way or another, priced. Similarly, artificially suppressed yields across developed market sovereign bonds mean unprecedented disconnects between market variables (in this case risk-free rates) and fundamentals are embedded in virtually every asset class.

“It’s useful to remember that while we like to think we are in a free-market world, we are anything but,” Bloomberg’s Ven Ram wrote Friday, referencing the massive footprint of developed market central banks in their own bond markets. “In the guise of saving the economy on their mighty shoulders, monetary authorities around the world have arrogated to themselves far more than anyone entrusted them with,” he said. “Instead of being the referee watching over the action, they have become the star player in the game.” That’s just another way of describing the dilemma and risk associated with engineering a state of exception.

Over the past two months, fears of a policy error associated with rate hikes, tapering and other manifestations of monetary tightening in the face of a waning fiscal impulse, have proliferated. Or at least according to surveys of fund managers and headlines across financial media outlets.

We often point to flatter curves (and especially inversions) as evidence to support the contention that central banks are on the brink of a “mistake.” Flatter curves are the market’s way of “warning” policymakers of an imminent misstep. Or so goes conventional wisdom.

Deutsche’s Kocic offered a more nuanced take. Usually, tightening is an iterative process, and the Fed “tends to administer more hikes than necessary which could cause an excessive slowdown of the economy and possible recession,” Kocic wrote. Colloquially, the Fed hikes until it breaks something, as the saying goes.

But, Kocic noted that although the GREEN/ BLUE sector of the curve does typically anticipate a policy pivot (i.e., a return to easing) “even before all rate hikes have been administered,” never before has if forecasted such a pivot so far in advance. Specifically, markets are forecasting a policy pivot at least three months ahead of liftoff and perhaps as far ahead as six months.

In October, when developed market central banks pivoted abruptly hawkish, I suggested the communications loop between markets and policymakers was severed — that the market’s license to co-author the script had been revoked. That was a reference to another classic Kocic note, in which he described a collaborative relationship between markets and central banks. “Fed’s communication strategy, it is becoming clear, is an equivalent of what in theater context is referred to as Removing the fourth wall whereby the actors address the audience to disrupt the stage illusion – they can no longer have the illusion of being unseen,” he wrote, in September of 2015, when Janet Yellen delayed liftoff following market turmoil associated with an overnight devaluation of the Chinese yuan the previous month.

Two months ago, it looked as though central banks were rebuilding the wall in an attempt to reclaim sole discretion over policy in the interest of fighting inflation. Now, though, that interpretation appears mistaken.

Instead, Kocic said this week, the market’s willingness to forecast the end of the tightening cycle months in advance of its onset, coupled with the Fed’s rapid convergence with market pricing in light of inflation realities, suggests a “continued absence of the fourth wall in the Fed/market communication.”

“There is a script,” he continued. “The market has written it, the Fed has adjusted to it [and] both sides agree how it will start, for how long it will go, at what pace, and when and how it will end.” The two-way communication loop lives. Policy is still a collaborative affair. The previously unalterable spectators who Yellen transformed into alterable observers, retain their capacity to alter.

Kocic subsequently drove home the point as only he can. The following excerpt, from the same piece, dated December 21, is yet another testament to my long-standing contention that at least when it comes to wielding a pen, Kocic is peerless:

The often used term “policy mistake” in this context, becomes a misnomer — there is no mistake here, the inversion of the GREEN/BLUE is part of the script. There is an implicit agreement between the Fed and the market, ahead of time, that the monetary policy will be reversed after the expected hikes have been administered. The market recognizes the force of monetary policy, but the Fed also recognizes the importance of market’s consensus.

We wake up from a bad dream because we have encountered some repressed traumatic knowledge that announces itself in it. But, after we fully wake up and shake off the residues of the dream, we return back to sleep — we have woken up only to be able to continue to sleep.

What we are facing now is the possibility of a moment that interrupts the narratives of administered markets with an episode of “normal” or “real” markets, only to continue later with administered markets. The market realizes the necessity of rate hikes, but accepts it only as a temporary maneuver in order to save the idea of administered markets — the current acceptance of hawkish monetary policy is simultaneously priced with its subsequent reversal. This functions as a reversed state of exception (which has the same pattern as waking up from a bad dream): The suspension of normal markets functioning is temporarily interrupted by allowing normal market functioning to take place only so that it can be later suspended again to make room for administered markets to resume.