Flying Blind: What’s Behind 2022’s Market Volatility

One of the most underappreciated contributors to recent market volatility is the apparent demise of central bank forward guidance, both implicit and explicit.

“Data dependence” in the post-financial crisis environment entailed predictable, market-friendly policy because it was exceedingly difficult to imagine a scenario where inflation moved sustainably above target in advanced economies.

The idea of a rapid jump in realized inflation to levels high enough to impact consumer psychology was seen as a virtual impossibility. “We should be so lucky,” BoJ officials might’ve said.

Between a restrained fiscal impulse (which in some cases meant the institution of outright austerity measures) and the perpetual overhang from a familiar list of powerful disinflationary trends (e.g., globalization, debt and demographics), central banks in developed economies were pursuing an elusive goal.

“In the period of disinflation during which core PCE spent more than 70% of the time below the 2% target, crowd control was not that complicated,” Macro Risk Advisors’ Dean Curnutt said, in a recent note. ‘”More policy’ was always at the ready in light of the air-cover provided from persistently trying to reach an inflation objective from below.”

This was all very pro-risk. Post-GFC, growth never accelerated meaningfully enough to chance an overheat, and the specter of Japan-style disinflation was ever-present. At no point were central banks forced to reckon with the idea of a dangerous inflation overshoot, let alone an inflationary impulse large enough and persistent enough to affect consumer expectations.

Indeed, accommodation sometimes worked at cross purposes with policy’s stated intent. Remember “zombie” dynamics? The figure (below) shows how engineering a hunt for yield contributed to the very same disinflation policymakers were ostensibly trying to stave off.

Thanks to subdued inflation, the messaging was always the same. Monetary policy would continue along a predictably accommodative path in pursuit of inflation targets no one seriously believed would ever be achieved — or in any case certainly not fast enough to compel abrupt pivots of the hawkish variety.

Bottom line: The worst case was never surging inflation and the withdrawal of forward guidance. Rather, the worst case was recession, in which case policy would be even more accommodative.

The pandemic changed things, albeit on a delay. Initially, markets assumed the virus would be yet another deflationary supernova. After all, the immediate impact of COVID was demand destruction on an epic scale accompanied by an equally epic debt binge, both among corporates and governments. At the same time, the world was plunged into a fleeting Depression (with a capital “D”) which in turn prompted the most aggressively accommodative response in the history of modern monetary policy.

But the macro outlook quickly shifted. The disinflationary impulse gave way to rapidly rising inflation. Between the forced severing of globalized supply chains, interminable disruptions tied to rolling virus flareups, a fiscal bonanza aimed at delivering a defibrillator shock to demand and, in the US, acute labor scarcity, it became apparent that the world’s once-in-a-century public health crisis would be highly inflationary, at least in the near-term.

The transition from “Great Moderation” / post-GFC disinflation to the new, inflationary post-pandemic reality is illustrated in the figure on the right (below), which shows market-based probabilities for US CPI over five years.

Recall that the Fed hasn’t been in its current predicament in well over three decades (figure on left, above). For the first time in a generation, rate hikes are commencing with inflation at alarming levels.

One way or another, everything comes back to the dynamics outlined above. The notion that forward guidance and optionality are being withdrawn in the face of rising macro volatility is a break with at least a dozen years of precedent, and more than that depending on how literal your interpretation of the “Fed put” is. This is what’s roiling markets in 2022.

The excerpted passages (below) were penned late last month by the above-cited Dean Curnutt. They help contextualize and otherwise illuminate our (and the Fed’s) predicament:

Today’s setup is new and, where the handshake between the Fed and markets is concerned, altogether more complicated. Undoing promises is never easy, especially when they are so baked into the foundations of global asset prices. Low rates — and the Fed’s near explicit promises that they would remain low — have been the metric against which everything else, from tech stocks to SPACs to NFTs to art to cryptocurrencies, have been judged. Low rate volatility has been evidence that the market was convicted that the lowest rates in 100 years would remain so. Inflation that is so far above target is an unwelcome interloper in the Fed / market love fest. [There are] similarities between equity volatility and inflation. When the VIX spikes, the conditional probability that it could accelerate much further in a hurry becomes real. In a similar fashion, the level of inflation and the level of inflation volatility are highly connected. 24-month realized volatility on core PCE is currently running 3-4 times its pre-pandemic level.

What are the implications of higher inflation vol? We can look to risk managing an equity portfolio. The demand for insurance often accelerates at very high levels of volatility. When a market becomes sufficiently destabilized, a de-risking process can feed on itself. A risk manager is forced to contemplate an increasingly wide set of outcomes in such a scenario, sometimes forcing the decision to buy a deep tail hedge like a 100 strike call on the VIX. In light of the connection between the level of inflation and inflation vol, the Fed’s risk management duties require it consider a much wider distribution of what is possible on the inflation front. The result? The Fed is forced to buy insurance against unforeseen outcomes even if it finds those outcomes improbable. The damage from waiting too long is already real. The risk of not sufficiently protecting inflation tails could be catastrophic.

[This] frame[s] the wholesale shift in how the Fed and markets interact with respect to optionality. Over the longer period of trying to reach inflation from below target, risk management (against deflation) was pro-market. Because market and economic downdrafts often occur together, investors are the fortunate beneficiaries of monetary policy efforts to revive the economy with a very “finance centric” tool kit. When market vol gets too high, the Fed allows investors to cover below true mark to market replacement cost. The Fed was a provider of vol to the market in this regime. Today’s Central Bank objective, hedging against inflation that is well above target, requires the Fed to be long optionality. This is expressed in meeting-by-meeting decision making, a speeding up of the taper and then vague language around the balance sheet, all data dependent. And because we are so far above target and Powell is clearly nervous, events may have to unfold at a pace that perhaps is not yet appreciated by markets.