‘Yet Another Frame Of Reference’ Collapses Amid Fed Blitz

The rapidity (perhaps “ferocity” is more apt at this juncture) of Fed hikes has markets on high alert for collateral damage.

Everyone knows there are consequences when the Fed moves, but what’s underappreciated is the extent to which those consequences are likely to be magnified this cycle thanks to the market dynamics engendered by the Fed’s long period of relative inactivity.

Forward guidance was a powerful vol suppressant. “Through their communication with the markets, central banks, and the Fed in particular, have become ‘good listeners’ with their decisions and actions made with markets’ consent,” Deutsche Bank’s Aleksandar Kocic wrote, nearly a half-decade ago. “After years of this dialogue, markets gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting,” he said. “Not much of a choice, really.”

And, so, leverage was deployed into what, ultimately, became one, giant carry trade — a globalized hunt for yield that took investors out the risk curve in an almost monolithic bet on the persistence of subdued volatility, all underwritten by central bank forward guidance. The linchpin was low inflation and a generally staid macro environment.

In 2022, we’re working our way backwards. Inflation took off, shattering the macro calm and forcing central banks to raise rates rapidly and withdraw forward guidance. The consequences of a hyperactive Fed go beyond what would normally be associated with tightening, not just because the pace of rate hikes exceeds previous cycles, but also because the prolonged period of inactivity encouraged and facilitated behavior conducive to ruin in the event a macro shift forced a policy regime change.

Not only that, the market’s capacity to cope was (and is) severely impaired by the length of time price discovery was systematically suppressed. It went on for so long that at least some of today’s youngest traders don’t remember Lehman because they were in first or second grade in 2008, and can’t remember 9/11 because they were barely born. (Let that sink in for a moment.)

Long-time readers will recall that Kocic presaged this years ago, in a classic piece on the possibility that we may have slipped into what he called a “permanent state of exception,” a reference to martial law in the political context. The following passages (from a 2017 note) become more prescient and germane every year:

In its core, policy response to crises was an extension of what in a political context is known as the state of exception: Market laws had to be suspended to restore normal functioning of the markets. The intrinsic contradiction of this maneuver is resolved only by understanding that suspension is temporary. Stimulus will have to be unwound. 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 reemancipation 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.

In 2018, Jerome Powell attempted to lift the state of exception and reemancipate markets, but it didn’t go so well. Fortunately, inflation wasn’t a problem, and the Fed soon found an excuse in Donald Trump’s trade war to go back to rate cuts. The idea of deliberately and irrevocably withdrawing forward guidance (thereby cutting markets completely out of the loop) was never seriously considered.

Now, rather than a managed detox, the Fed is compelled to foist upon markets a cold turkey program, which includes draconian rate hikes, balance sheet rundown and the formal repudiation of forward guidance, unless the “guide” entails reiterating policymakers’ intention to keep raising rates.

The results have been predictable. Last month, they began to manifest in severe withdrawal symptoms, including multi-decade lows for the yen, record lows for the yuan and sterling and, of course, the near implosion of the UK pension complex on the back of an unprecedented VaR shock triggered by unthinkable volatility in gilts.

In a new note, Kocic highlighted yet another manifestation of the rates shock, pointing to a “prominent dichotomy between the curve and vol” engendered by “the sheer force of delivered rate hikes” and the accompanying “awareness of the possible consequences.”

Before 2008, the 10s/GOLDs spread (a proxy of curve risk premium) and 3M10Y vol were cointegrated, and while the relationship broken down a bit following the GFC, the trend remained generally intact. During the Taper Tantrum, Kocic wrote, risk premium responded to reflect the newly elevated risk of a volatile carry trade unwind, but “subsequent rate movements remain[ed] in a tight range, never violating the breakevens on a 3M10Y straddle.”

Eventually, after what Kocic called “lots of reassurance by the Fed,” the two converged, and moved together until 2021 (figure above).

After that, though, the two went their separate ways. “2021 mark[ed] the end of more than two decades of commonality between the curve and vol, the end of their logical interaction and a beginning of a new phase, in which they continue to move away from each other,” Kocic wrote.

This represents the loss of “yet another frame of reference and an RV metric that is likely to elevate the level of uncertainty and undermine market confidence,” he went on to say, adding that as vol “remains a function of near-term uncertainty associated with the pace of monetary policy, the curve continues to prepare for its long-term consequences,” none of which are conducive to lower volatility.

The title of Kocic’s missive: “Unwind of the state of exception.”