“The unwind of financial repression is qualitatively different from traditional recoveries,” Deutsche Bank’s Aleksandar Kocic wrote, in a new note revisiting a number of key concepts he’s animated brilliantly in the past.
One of those concepts is what he calls “the agony of the off-diagonal,” which juxtaposes the path along which markets travel during traditional recessions and recoveries with that traversed in the post-Lehman years.
This is a way of visualizing the problem of re-emancipating markets — the pain associated with lifting martial law and allowing for the return of price discovery.
Normally, everything takes place in the first and third quadrants on a standard graph, where yields and equity prices are the x- and y-axes. “We start at point 1: Recession typically begins with a steep decline in risk assets and overweight in bonds,” Kocic wrote, narrating the journey. “Monetary policy intervenes with rate cuts which slows down the selloff in risk, with easing continuing until the economy stabilizes and the market turns around (2).”
After that, the recovery mirrors the recession. The recession trade (short stocks, long bonds) is unwound and rebalanced (3), the market conjuncture moves into the third quadrant and risk allocations get more aggressive as do underweights in bonds, until rate hikes are implemented to cool things down.
They key point is that, as Kocic wrote, “The unwind of the recession trade in conventional settings goes along the grain of the market trade — its inertia leads naturally into recovery [and] because of this, past recoveries have been generally accompanied by lower volatility.”
Compare (and contrast) that to (and with) the trajectory seen since the financial crisis. At first, the path is familiar. Stocks sell off and bond yields decline (points 1 and 2) as recession approaches. But then, with rates at the lower bound and the crisis untamed, QE is introduced, which catapults markets into the second quadrant (3).
“We note an almost vertical rise in equities,” Kocic wrote. “The unwind of QE now essentially becomes a de-risking move — it goes against the grain of recovery. The trajectory moves along the off-diagonal.”
Below is Kocic’s concise description of the quandary facing both policymakers and market participants (it’s familiar to regular readers):
The essence of the problem resides in its path dependency. When central bank actions and the market environment create optimal conditions where, for an extended period, every asset class makes money at the same time, the natural question one has to ask is: What to expect after that? If unwind of the stimulus is its mirror image, what is one to do when everything sells off?
As rate hikes commence and QE is tapered (eventually becoming QT through passive runoff), stocks fall and we reach a critical juncture. That’s where we are now. At point 4 in the second chart.
“There are three possible directions,” Kocic said. Point 5 represents a soft landing or a mild recession. Equities meander and bonds rally modestly. Point 6 represents a descent into outright recession, which results in a sharp rates rally and a steep selloff in stocks. Point 7 is the real nightmare, though — that’s where the stagflation lives, and it’s accompanied by stubbornly tight monetary policy and ongoing pain both for stocks and bonds. Kocic calls that the “fear of the fourth quadrant.”
Notably, the unconventional trajectory is the only one many market participants know. “The last time we saw a recovery from a conventional recession was about 18 years ago and for many, this is longer than their entire professional career,” Kocic, a veteran of CERN and Lehman, remarked, adding that, “the current unwind of stimulus is fundamentally different from those times not only because of the changes in the underlying market psychology, but because the unwind of financial repression, by its very nature and inner logic, creates obstacles to normal market recovery.”
Everyone (including the “Wizard”, it seems) has their head inside the monetary-bucket and are missing the fiscal impulse, which is creation of money. QE does not create new money. It only swaps forms of money. Only deficit spending creates new money (bank credit does too, but it is only temporary money). Since money is the fuel for both the economy and the stock market, it is foolhardy to only look at monetary issues.
What “wizard” are you talking about? I think you might be confusing analysts. Also, no, nobody is “ignoring” the fiscal side. Kocic has discussed fiscal policy on so many occasions over the past five years that I doubt even he could catalogue them all, as has every other Wall Street rates strategist of any kind. Please try to remember when you make sweeping assessments that you haven’t actually read these notes. A lot of this stuff is dozens of pages long, and in some cases much longer than that. Above, I used a few very short, properly-cited quotes, presented in a journalistically/academically responsible way, from 18 full pages, for example. I realize there’s no way for you folks to know that, but at the same time, I like to offer this friendly reminder occasionally: CliffsNotes aren’t the full book, by design.
I’ll accept your explanation and your criticism. I certainly did not read everything Kocic (the “Wizard” in my eyes) has written, but my point was that, in general, what one mostly hears about from the analysts is concern over monetary policy and very little about the fiscal. That is all I meant by my comment. Not sure why you reacted so sensitively.
Yes, I understand, and I agree with you and appreciate your assessment. I just have to ensure that comments don’t exhibit a snowball effect. Unfortunately, the internet is a place where one person’s totally innocuous remark about, say, the perceived absence of fiscal considerations in analyst commentary can quickly become a string of such comments, which becomes problematic for someone like me, because then I have to decide between removing well-meaning comments from readers or leaving comments up which together might paint an accidentally inaccurate picture of an entire group of people, some of whom take a lot of pride in what they do. I realize that might seem like an especially pedantic bent on my part and admittedly, it’s somewhat incongruous with the critical tone I sometimes adopt towards a (very small) handful of analysts whose macro economic musings I occasionally find fault with, but at the end of the day, I try to err very, very strongly on the side of protective generosity when it comes to the research I cover. It’s served me well over the years and more than that, it’s just the nice thing to do. Obviously, your comment was fine which, by the way, is why it’s still there. 🙂
I commend artificially intelligent and therealheisenberg for the maturity and civility of their interaction around the wizard comment. I find the comments section of this website to be informative in and of itself. An added bonus to the lucidity of the articles themselves.
Pandemic money creation, and the lack of a meaningful increase in the velocity of money leads me to option five.
Interest rates will hold in the five area and the QE/QT may be used in a way we are not quite knowledgeable of.
This piece right here, worth the price of the entire annual subscription. It is the best contextualization I’ve seen of what has happened and the possible paths from here.
It’s probably an oversimplification but I view the unwinding of QE as unwinding of where the QE funding went. Yes, it did reach lower class folks in non-inconsequential sums, but it largely went to fund business through lending which transferred to investors through equities and bonds and housing through MBS. So the Fed raises rates, de-incentivizing the use of new debt to fund operations and refinancing. It’s selling debt, clogging up the bond market for investors leaving the only levers to improve operating expenses creating more shares of stock or cutting operational expenses. This will undoubtedly lead to lower revenues, job losses, and less valuable equity. Rates are higher so investors are now left to ponder the risk assets vs. now much more appetizing safe assets like inflation adjusted bonds and CD’s. The unwind won’t finish until the value QE added to the markets largely unwinds at which point the safe money now becomes available to invest in belabored markets who are starved for investors. Just wrapping up the Intelligent Investor and it’s hard not to see parallels to Benjamin Graham’s observations in the modern day economy. By the way, I read on another blog that the Fed has made mention of getting out of the MBS game altogether. Anyone have any more solid information on that? Because that seems pretty catastrophic for the housing market if so.
quick aside, H … I think you mean “marshall” law…lol…