Multiplying Crises Now ‘Exceed Our Capacity For Statistical Prediction’

One of the defining features of markets in the post-pandemic era is the inability to form consensus around the long-term.

I’ve written on this extensively. Traders, lacking visibility on inflation and thereby bereft when it comes to long run macro forecasting, have instead focused exclusively on the Fed and short-term monetary policy “as if it were the only thing that matters,” as Deutsche Bank’s Aleksandar Kocic put it in November.

That’s contributed to a variety of aberrations in rates, leading to a kind of false optic that suggests the tightening cycle is over before it started. In equities, the combination of manic intraday swings and the same forced myopia is making day-traders of institutional investors.

Simply put, it’s impossible to assign probabilities to anything other than the next FOMC meeting, and thanks to the war in eastern Europe, that’s become an exercise in abject futility too.

Recall that just a few weeks ago, Jim Bullard’s panicked exhortations for rapid tightening compelled traders to price a (roughly) one in three chance of an emergency, inter-meeting Fed hike. Fast forward a few weeks and markets went from pricing high odds of a 50bps move to pricing less than one regular 25bps hike for this month’s meeting. As Nomura’s Charlie McElligott put it amid this week’s front-end VaR shock, “the debate has turned from ’25 or 50?’ to now ‘0 or 25?’,” a remarkable turn.

In a new note, Deutsche’s Kocic brought all of the above together. “Last week’s developments added another dimension to uncertainty, which now has the potential to further deepen the fragmentation across both different horizons and different market sectors,” he wrote, adding that,

Even without the most recent additions, the long-term already looked so long and complex that it exceeded our capacity for statistical prediction. Things have only become worse now. The market has already abdicated on its attempts to wrestle with the future and has concentrated its attention on short-term Fed actions. This part is not new. However, the newly developing uncertainties around commodity prices now complicate even the short-term and introduce additional unknowns into the Fed reaction function through contamination of both the space of short-term unsecured credit and the pattern of immediate rate hikes. In that context, the yield curve (and with it the vol surface), when used in the traditional context, continues to send confusing and seemingly inconsistent signals about its interpretation of the economy. In our view, this suggests caution in taking the signals from the shape of the curve at face value and brings new urgency for developing new interpretative frameworks of its dynamics.

The conflict in Ukraine has rendered the short-term just as ambiguous as the long-term, and the commodity connection makes things more complicated still.

In a separate note, Deutsche’s Tim Wessel noted that although Jerome Powell’s remarks to Congress (see here and here) perhaps provided a bit of clarity on the March meeting, what happens beyond that is anyone’s guess.

Powell, you’ll recall, effectively ruled out 50bps for liftoff, but explicitly opened the door to larger increments down the road. “While the Fed’s reaction function for March is clearer after the Chair’s testimony this week, the path beyond perhaps grew more uncertain with the broader environment, as 50bps hikes remain on the table as does a course reversal due to a geopolitical conflagration,” Wessel remarked, on the way to reiterating the gist of Zoltan Pozsar’s warnings about potential funding market shocks from measures adopted to sever Russia’s access to capital markets.

“Meanwhile, the imposed sanctions add yet more risk that credit exposures are lurking,” Wessel cautioned. “After all, effectively removing a country from the global financial system is bound to have unforeseen impacts.”

In another instant classic note covered here early Saturday, Pozsar posed a number of provocative questions, one of which entailed suggesting there may be other reasons why the West is reluctant to impose an explicit, total embargo on Russian energy and raw materials.

“We have bases creeping in and commodities, like collateral in 2008, are becoming bifurcated,” Pozsar wrote, before delivering the following rather poignant passage:

Is the reason why we’ve cocooned energy and other commodity flows and related payments and institutions from sanctions to protect the consumer at the pump, or to protect the commodity derivatives ecosystem? Clearly, the West does not want to turn off the flow of energy, but there are growing risks — more sanctions, more self-policing and the Russian leadership can act as well. There is so much more. There are links between all this and headline inflation and interest rate hikes, and links between the seizure of Russia’s FX reserves and the dollar and demand for long-term Treasurys.

As Kocic wrote, we have indeed exceeded our capacity for statistical prediction.