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.

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10 thoughts on “Waking Up So We Can Continue To Sleep

  1. good article. it is not surprising that the markets and the fed cooperate with each other since they both want the same thing. a slowly growing economy with low inflation and high employment. it is not a bad thing that the market help the fed forecast when they are making a mistake. i know iread an article and i thonk it was on this site during the fall 2018 selloff that the combination of tapering and rate hikes was the equivalent of 400 basis points of tightening and that we were heading for a big slowdown in 2019. the market threw a fit to warn the fed and it reversed course. the problem is that no one has figured out how to restrain the greed of the market.

  2. The US government spent about $7T in 2021. $4T came from taxes and the remaining $3T was borrowed or printed by the Fed. The Fed’s balance sheet stands at $8T (US GDP is about $23T).

    The 5 largest spending categories in 2021 were:
    Income security $1.6T
    Social security $1.1T
    Health $800B
    National Defense $800B
    Medicare $700B

    Interest, debt service was the 6th largest category at $350B.

    I won’t repeat the stats of European Union, China, Japan or UK- however, US is better positioned with our currency borrowing/printing than others.

    I just don’t see an imminent tipping point that throws all of this into chaos.

    Yes, Virginia, there is a Santa Claus.

  3. A couple sentences (“The Federal Reserve’s foray into similar territory around the Second World War suggests that combining yield-curve control with quantitative easing when government borrowing needs are substantial can create constraints on monetary policy that are not easily removed” and “Moreover, a central bank’s heavy involvement in a market can distort the behavior of private market participants to the detriment of market efficiency”) from the November 29, 2016 article “The Fed’s Yield-Curve-Control Policy” by the Cleveland Fed seem to encapsulate some of the content above.
    As Burton Malkiel says: “In principle, for the buyer who holds his or her stocks forever, a share of common stock is worth the ‘present’ or ‘discounted’ value of its stream of future dividends.” Buy & hold “retail” investors and those who don’t care about quarterly reports like Simons and Buffett can ignore this “two-way communication loop” and search for Graham’s “margin of safety,” Buffett’s “economic moat” or Simons “market inefficiencies.”

  4. Rates are where they are in my view because of the tremendous amount of debt in the system. The reaction function of the economy has changed due to this leverage. Small increases in rates now have an outsized effect on economic activity. To unwind this situation will require some sort of adjustment- inflate out of debt, default, or gradually grow into the debt. In any of those scenarios, central banks will have to hold interest rates somewhat below what was previously believed to be the “neutral or natural rate”. The new normal is going to be lower rates versus nominal growth. If we choose to grow out of our problem, it will take some time before the economy overcomes the large amount of debt outstanding (by the way this is not just a take on government debt- private credit is still elevated in most sectors as well). A combination of the 3 options, growth, default and inflation is probably the kindest to most participants. This phenomena took many years to take off. It is going to take some time to wind down. Anyone looking for a big bang and a quick reset is likely to be disappointed.

    1. Good points.
      The US can tolerate some inflation if Congress offsets the impact of inflation by providing “income security” to those in the US most harmed by inflation. The holders of US debt are the ones who are harmed the most- being repaid with less valuable USD and earning(I mean paying) a negative interest rate.

    2. Well said. I agree that sensitivity to the interest burden of the current total debt load of 400% of GDP trumps (sorry) all other considerations Each basis point of rise in “i” adds billions to the debt service load. Keeping rates down is now, as the Bard let Hamlet speak, ” … a consummation devoutly to be wished.”

      1. Everywhere?

        MMT is a simple description of the reality that the US can print as much as it wants/do whatever it wants… till it hits the physical limitations of our fallen world.

        … which, we noticed with COVID support morphing into inflation, was probably closer than expected.

  5. Just seems to me like “twas ever thus”. The market is what people believe it is; the feedback loop between the market and the fed is real but is still what people are trying to “game”/guess. Which is just a new way of saying we know the market will change, but we’re not sure when or which direction or how much.

NEWSROOM crewneck & prints