By Mr. Risk - State Street Global Markets
Unleash Volatility Beast
Thanks for nothing, central banks!
- If central banks provided the prototypical inflection point, risk assets should get destroyed next week.
- Feast your eyes on a compendium of volatility charts. The beast wants out.
- Keys to watch: DXY, EURAUD, and 10-year yields. Move over ZEROHEDGE. There is a new BEAR in town,
* * *
Ahead of the BOJ and Fed meetings, volumes slowed to a trickle, traders got back to flat, and algos reached for the offswitch. Now that event risk is in the rear view mirror, it is time to vote. Buy-the-dip or ‘‘sell everything?’’ If classic market reflexes are in play, a market meltdown following the passing of event risks is by far the more likely outcome. That US equities launched higher is nothing, because it always does that on Fed day. The obligatory central bank forensic is a good place to begin.
Expectations as measured by overnight volatility ahead of the BOJ were the third highest in 3-years. Notably, 7 out of the 10 highest readings have occurred in 2016, which says something about the growing perception about policy failure. Expanding monetary base has not delivered higher inflation expectations or a weaker currency. Just about every 2016 meeting USDJPY sunk like the proverbial stone.
The ‘‘monetary assessment’’ conducted by the BOJ was an admission that QQE was unsustainable, and needed to be tweaked. Plan B is ‘‘QQE with yield curve control.’’ No, that is not a new shampoo. Here is the stripped down ghetto-economist version.
- Negative interest rate
- Stabilize 10-year yields at 0%
- Keep asset purchases at ¥80 tn/year
- Abandon monetary base target
- Aim to overshoot the 2.0% inflation target
- Rebalance ETF by buying less Nikkei 225 linked ETFs and more Topix, removing a well-flagged distortion.
On the day, Topix banks were big winners (6.97%) versus Topix (2.7%). Not going negative and signalling a steeper curve was reasons to celebrate. As for yen it was rinse, repeat. Ostensibly ease, watch the currency weaken for a nanosecond before a violent reversal. Collectively, it was along the lines of ‘‘hey, its BOJ day, aren’t we supposed to sell USDJPY? What the heck is it doing above 102? Sell it.’’ As for the boldness of the policy these are Mr Risk’s conclusions:
- Policymakers have not lost their appetite for untested monetary experimentation.
- Pure Krugman -- credibly promise to be irresponsible.’’
- It’s radical. The question is how credible.
- On the flipside: BOJ opens the door to ‘‘stealth tightening’’, as one commentator worries.
Inviting an inflation overshoot when not a single economist believes that the BOJ will achieve its 2.0% inflation target in FY 2017 sounds like a sick joke, but really it is a radical. Even more radical is the commitment to hold JGB 10-year yields at zero. If inflation is rising as the economy heats up, they are pledging to cap nominal 10-year yields and thus keep lowering real rates, adding juice to the inflation trend. Alternatively, what happens if the global factor driving all global bond yields goes even lower? Then BOJ has committed to selling JGBs, thereby tapering and draining liquidity. This could get interesting.
In the Q&A, Kuroda talked about the unwanted negative impacts on credit creation from yield curve flattening. It hurts banks NIM and threatens pension funds ability to deliver on promises. The BOJ wants to steepen the curve, but not by increasing longer yields because that is a monetary tightening. By deduction the market factors in a lower deposit rate going forward. FX traders don’t like it, but bank stocks might. Perhaps that links the two different outcomes.
Confused? Tim Graf says the BOJ embraces uncertainty. That nails the zeitgeist. The world just got a little crazier and a little more dangerous. Central banks need to learn that when you are in a hole, stop digging.
Mr Risk’s takeaway is in line with Greg Ip’s who said ‘‘central banks have shown the will to hit their growth and inflation targets but do they have the way?’’ Read his article. Central bank tools are losing their edge. The BOJ gets full marks for monetary experimentation, but investors are increasingly set to question why previous innovations have fallen short. This marks the most worrying thing possible, namely, the popping of the central bank bubble.
YELLEN: NOTHING TO SEE HERE
The headline is ‘‘open warfare’’ at the Fed with three Fed Presidents voting for a hike, the first time that three members have dissented in favour of tighter policy since September 2011 under previous Chairman Bernanke, before that it was 1990. Lee Ferridge pens the analysis with a cheeky title: We will hike in December; honest we will. In the most simplistic terms it appears as if the Brainard stock went up. Let the labour market run hot carried the day.
Forget the ‘‘dots.’’ Put no stock in the idea that the Fed makes the case for a year-end hike, as argued by Hilsenrath. Uncertainty ahead of the election is the real reason the Fed stood pat, fearing what might happen to financial markets and economic data if ‘‘the Donald’’ wins.
In the medium term, the issue with the ‘‘dots’’ boils down to a credibility problem. Michael Metcalfe writes that the ‘‘FOMC is caught in a potentially vicious circle. The market has had a run where it appears to be a better forecaster of the policy rate than the FOMC. This limits the ability of FOMC to guide market expectations because the market believes it knows better. If policy makers are then unwilling to surprise the market, as they have been historically, this reinforces the market’s better run at forecasting the policy rate and makes it even harder for the policy makers to guide expectations.’’
Now something interesting that many may not know. While a dissent from Fed Presidents happens quite a lot, only three times have Fed Governors dissented. Even more interesting is the power to change rates rests with the 5 Governors -- Yellen, Fischer, Tarullo, Powell and Brainard. That is not a typo. Yes just these five. The Financial Services Regulatory Relief Act of 2006 amended the 1913 Federal Reserve Act to give the Fed the authority to pay interest on reserves beginning Oct 1, 2011. Did you know that it is only these 5 Fed Governors who have the power to set the rate of interest of excess reserves? Now that is interesting right?
After a press conference with plenty of the usual waffle, financial markets do what they always do on Fed day; they rallied. So far it’s carrying on today, giving the buy-the-dip crowd something to crow about.
DXY is setting up for a monster move. It can go either way, but there is an excellent chance this launches higher. It’s not like the Fed can do anything more on the policy front to crush it. Moreover, the a-b-c-d-e triangle may resolve higher in an explosion of volatility. Mr Risk is in wait mode. Let market forces tell us which way it breaks.
While trolling Twitter, Mr Risk came across the following from Anil@anilvohra69. You just have to laugh at fitting the facts to the story or is it the story to the facts, Mr Risk forgets.
• High yields signal stronger growth
• Low yields make stocks more attractive via a lower-discount rate.
• Either way, buy stocks
• Low volatility is good -- it reflects confidence
• High volatility is good -- as it declines stocks rally
• Either way, buy stocks
• Low oil is a tax cut for consumers
• Higher oil boosts investment
• Either way, buy stocks
DISTURBING FUN FACTS
• Factset reports S&P500 quarterly buybacks declined 6.8% y-o-y% in Q2 to $125 billion. This is uber-positive for volatility as buybacks are one of the key variables suppressing it.
• The last day of summer (21 Sept, or if a weekend, the previous trading day) has only 4 previous times since 1994 been an up day. Yesterday made it 5.
• The week after September options expiration has only been higher 4 times in the last 26 years or (15% of the time). It is down 1.1% on average. That does not bode well for Friday.
• What does 2016 have in common with 1986, 1990, 2001, and 2008? Bloomberg story says: falling profit margins, LMCI negative 12-month change, Capex negative, and Speculative grade defaults above 5.5%. Only 1986 escaped recession, but remember that energy consumption share was larger and we did not have shale production.
• The $400bn risk parity is in the crosshairs. It is estimated that there could be ‘‘$50bn of bond selling from risk parity type investors.’’ Read this: is the latest risk-parity blow up just starting and is a VaR shock just starting: here is the checklist. Honestly, this is one of the hottest topics right now.
UNLEASH THE VOLATILITY BEAST
If central bank bubble is popping then all of these following charts might actually mean something. If not, they are just a bunch of charts that look incredible but mean nothing. Let the reader decide.
Let’s begin with the 1-year average of the VIX which catches the long cycle. It shows the two phases. Below 16, is benign, above 16 is disturbing. It has popped above the threshold and if history repeats is in the beginning of the high volatility phase which can last for the next year.
The 3-month change in S&P 12-month forward earnings peaked in July (2.76%), turning down in August (2.20%). ISM points to a further decline. This is pointing to a higher VIX reading.
Profit margins have declined 8 quarters on the trot. Consequently, the corporate financing gap has turned south which means increased dependence on external sources of liquidity, aka, debt. In the past such moves in the financing gap signal a downturn as well as boost the VIX.
What is absolutely critical for unleashing volatility is a US or global recession. Expansions are not supposed to die of old age, but nonetheless the current expansion is the 4th longest based on NBER dating. There is a plethora of economic and financial series pointing towards recession. A full piece on that is on the ‘‘to-do’’ list.
The yield curve slope adjusted for the level of yields warns of recession. Keen followers of demographics like Mr Risk’s pal Michael Green (Ice Farm Advisors) argue that the incentives are set to disappear to work past 70.5 years from a Social Security benefits standpoint. This is critical. The baby boom began in 1946. Do the math. Add 70.5 to 1946 and you get 2016.5. What do retirees not do? They don’t work. They don’t spend. Still not convinced? Consider the Social Security Act was passed August 14, 1935. While not the primary reason for the 1937-38 recession, payroll taxes were first collected in 1937. These things matter.
The flattening yield curve slope (3m-10y) is another useful indicator when advanced 2-years against the VIX.
The Fed’s Senior Loan Survey percent of banks tightening lending standards points to the beginnings of a credit crunch. Wait, are you saying that we should worried about not just energy loans, but car loans and commercial property loans? Oh, this is starting to get interesting.
If that chart did not get the visceral juices flowing, wait for this next one. C&I delinquency rates deviation from its 12- month average not only is ripping higher but in fact hit the worst readings of all time. When will the VIX wake up?
Markets are interconnected. Positive SPY/TLT says there is little diversification value, which adds to pressure to deleverage positions.
SEXY SEPTEMBER SEASONAL
2016 Dow price action is tracking the 1900-2012 Presidential-cycle September returns like a glove. Note that the real serious waterfall style declines are historically next week, which by the way coincides with the Trump-Clinton first debate. Also note that the incredible fit to the historical trend so far this month.
USDJPY -- GET A GRIP
Normally, we expect USDJPY to behave in line with US 10-year yields, the Nikkei and volatility. For one of the longest stretches in a while, this currency pair has misbehaved. Mr Risk is sending it to its room with no dinner, no Facebook, and taking away its stash of Cohibas. More seriously, this persistence dislocation speaks to positioning, top side export sellers, and ultimately a lack of faith in the BOJ to deliver a weaker currency. Hope springs eternal for this USDJPY bull!