According to Deutsche Bank's Aleksandar Kocic, we live in a reflexive world, one where "the Fed knows that the market knows and the market knows that the Fed knows that the market knows, so everyone knows, but pretends that nobody knows and the game goes on." That pretty much covers much of modern market analysis which, like some mutant version of the Heisenberg Uncertainty Principle, implies that it is impossible to know the value of assets without also taking into account what the Fed thinks about said value, and what it will do in response to the valuation manifesting itself in the form or asset prices.
There's more to it.
Following up on last week's note, in which the DB derivatives analyst looked at the market's current "metastable" state from the perspective of Minsky dynamics - a series of constantly shifting disequilibria which vary in leverage and volatility (the lower the vol, the higher the leverage until the system tips over and is forced to reset)...
... to analyze what may be the exogenous "circuit breaker" that finally snaps the fake calm of the past 9 years of central planning, overnight Kocic put it all together in his latest report which converges on most of the tropes he has been discussing over the past year, including the build up of negative convexity by way of continued state of exception, misallocation of capital, buildup of tail risk, and metastablity, and explains why markets are caught in a "Sachzwang – a factual constraint residing in the nature of things that leaves no choice but to perpetuate the existing conditions."
For those unfamiliar with Kocic's latest metaphysical allegory for capital markets - which would be everyone - this is how he explains it. As usual, a PhD in philosophy is recommended, and increasingly, required.
Continued pressure on vol is shaping to become the signature mode of this year. Its decline from its post-elections high at 95bp (in terms of 3M10Y) to its near all-time lows of 55bp in less than 12 months has been a function of general distribution of risks and persistent supply of convexity through complacency, transparency, liquidity, and predictable monetary policy. Politics no longer matters -- increasing negative newsflow has created political bottlenecks which have eroded the ability to produce consensus resulting in a noisy status quo. Yield enhancement strategies seems to be everywhere. Credit spreads have compressed to their post-2008 lows while risk premia and volatilities have collapsed across the board.
At the same time, this state of affairs is causing a buildup of negative convexity out-of-money by way of continued state of exception, misallocation of capital, buildup of tail risk, and metastablity. The market is vulnerable to bear steepening of the curve with Fed massively negatively convex to inflation risk. One would expect that vol would find support in the face of these risks. However, there does not seem to be any meaningful signs of resistance levels at this point. Investors are aware of the underlying risks, but are implicitly forced to ignore them in order to survive the short-term demand for return.
Unlike the chess "zugzwang", in which the player is forced to make a move, making their position significantly weaker, and would thus rather not move at all, in the Kocic world, the equilibrium market state is a suffocating paralysis under which the only option is making no move at all, thereby perpetuating the paralysis. The final outcome - as we are confident the metaphysical analyst will eventually unveil - is Cosmic Death... a state of 0 Kelvin in which central planning crushes one's will to exist, let alone trade, or some other similarly dramatic philosophical narrative.
Markets are caught in a Sachzwang – a factual constraint residing in the nature of things that leaves no choice but to perpetuate the existing conditions.
Short-dated volatility continues to probe new lows in tune with other measures of risk premia. There has been hardly any departure from the trend. As gamma collapsed, vol sellers have been moving along the surface and ironing out the calendars. This is causing collapse of horizons and general paralysis which further perpetuates status quo. Time is gradually coming to a stop – this is the real collateral damage of the existing dynamics.
Perhaps he is right: instead of a "VIX supernova", maybe the fate of the market is a singularity of ever-shrinking volatility and trading and infinite boredom, one in which everyone withers away as neither newsflow nor decisions matter. If so, it would certainly explain the next part: angry clients who know the final outcome, yet are reluctant to concede that they have become irrelevant pawns in a game which is no longer winnable.
These ominous vol lows are triggering unpleasant memories of the past episodes of complacency and their aftermaths. Every time we asked the question: “How much lower could vol go”, things would become unpleasant.
And yet, as the saying goes, maybe this time it is different, at least for rates traders. Here - according to Kocic - is why and how it is different.
To be blunt, when it comes to future rates volatility, there is very little to be learned from its history at this point. Most of the past market mechanisms, and by that we mean pre-2007, are no longer in place. Mortgage negative convexity is no longer transmitted from home owners to capital markets. Monetary policy shocks used to arrive from the front end of the curve, and active convexity hedging, and with it, bid for vol, went hand in hand with carry, steeper curve, and generally higher risk premia. In contrast, post-2008, the MBS convexity hedging has practically disappeared – while housing market continues to expand, hardly any of its negative convexity is being transmitted to the capital markets. Monetary policy seems to be largely administered through the back end of the curve – more stimulus during QE meantflatter curve, less carry, but also potentially higher volatility. Management of stimulus unwind has now become a major source of convexity supply -- Fed’s communication with the markets has been the key reason for compression of risk premia. On top of that, financial conditions have been as loose as ever. Tight fiscal policy, stricter regulations and positive supply oil shocks, together with global QE, have compressed long rates to the point that remaining playground for the Fed has been reduced to a mere 50-60bp range. On this restricted landscape, nothing is super exciting anymore. The Fed’s main concern is how to get unstuck without getting unglued.
To be sure that concern will become a trigger for wholesale market panic if the Fed raises rates by another 50-60bps while long rates fail to budge in parallel. In fact, it will be especially ironic if it is the Fed's rate hikes that unleash the yield curve inversion and thus, the next recession, something another DB analyst - Dominic Konstam - suggested would happen two months ago. And speaking of vol regime variances, Kocic also explains what he perceives to be the biggest disconnect between past and present vol regimes.
Lots has changed relative to pre-2008. Vol is still a carry game, but the market is effectively less negatively convex then before. Monetary policy now dampens volatility instead of generating it, and economic volatility is lower. During the period of active convexity hedging, carry was an opportunity to buy vol – existence of carry allowed mortgage hedgers to spend some of that carry to hedge their convexity exposure. That supported an extra premium for rates volatility, on top of general uncertainty reflected by other markets. The Figure shows a history of 3M10Y rates gamma overlaid with the FX vol index (CVIX). We note the spread between the two in the first half of the first decade. With disappearance of convexity transmission mechanisms, carry is now seen as signal to sell vol.
Having establishing the disconnect between present and the past volatility regimes, how does Deutsche Bank see its future? Before answering that, Kocic revists the Minsky Dynamics aspect of historical crisis formation he discussed last week:
In our view, interplay between volatility and leverage is the framework that gives the most straightforward tool for understanding the future path of volatility. We have discussed this relationship in our recent publication. Here, we extend this interaction to a broader context of buildup of leverage and management of subsequent crises across multiple cycles. To recap, we argued that there is a logical relationship between leverage and volatility. Low uncertainty engenders higher leverage which in turn leads to additional compression of risk premia and a buildup of risks. Ultimately the system becomes unstable and results in a crisis, which in turn forces the system to deleverage in a highly volatile manner. In a way, continued prosperity and stability in itself is destabilizing leading to riskier lending as the asset prices of collateral decline. This is the essence of Minsky's take on financial markets.
However, what is most interesting for Kocic, is the question of "what comes after each crisis, namely how is the recovery engineered and economy brought back on track." His answer:
To be specific, let’s choose as the starting oint 1999, the beginning of the internet bubble and follow (in the clockwise direction) the subsequent economic trajectory in the vol-leverage plane in the Figure. As the economy is heating up, volatility declines and leverage increases until the bubble bursts sometime in the late 2000. There is a volatile deleveraging for the next 2-3 years when low rates and expansion of the real estate market created conditions for the turnaround and beginning of another cycle. The only difference is that, this time around, the bubble was bigger and the limits were more extreme. Instead of being a periodic object (e.g. ellipse), the trajectory now becomes an outward spiral – in the second sweep, the leverage is higher and risk premia compression more extreme leading, naturally, to a deeper crisis and a need for an even more extreme measures of recovery.
Of course, one could (far simply) say that it takes more and more debt to kick the can, and keep the world's biggest asset bubble ever created - the explicit backing of central banks - inflated. This is precisely what Bank of America's Barnaby Martin did in far less words yesterday:
"the irony in today's world is that central banks are maintaining loose monetary policies to generate inflation…in order to ease the pain of a debt "supercycle"…that itself was partly a result of too easy (and predictable) monetary policies in prior times."
Alas, sounding philosophical has emerged as a calling card for quite a few financial pundits, as saying the same thing over and over (for 9 years) has lost much if not all impact and has to be spiced up in any possible way. Like, for example, using Finnegans' Wake or Ulysses as one's stylesheet. In any case, when charted, Kocic's argument looks as follows:
Where Kocic is concise, and accurate, is in what he says next, namely that "spiraling leverage cannot continue indefinitely. At some point, the bubble becomes too big and cannot be subsumed by a bigger bubble – the damage of its burst would become irreparable. Therefore, when that moment comes -- and we believe that moment is now – the market is facing a following dilemma."
- Permanent state of exception: We continue to operate in a regulated environment. Leverage is limited, but care is taken not to overconfine the system so we avoid the Japanese scenario. While this appears as a prudent approach to reality, it implies giving up all the ideas of unlimited growth, something that made US economy look better than the rest of the world. Compared to what we have seen before, this means settling for much less than this country is used to aspiring. Although a reasonable proposition, it is emotionally a difficult choice that is and will remain subject to substantial political manipulation. It is unlikely that populist narrative will not continue to challenge this choice [ZH: hey, one can just blame the Russians, right?]
- Flirting with high tail risk : Deregulation and deficit spending could result exactly due to abandoning the first path, as its direct challenge, under political pressure that American economy can restore its old status and resume its pace of the previous decades. This is a serious tail risk as it is playing against the backdrop of considerable overhang of the post-2008 one-side positioning. Central banks are massively short convexity in this scenario. Any inflationary maneuver, or anything that would be a bear steepener of the curve, could force disorderly unwind of the bond trade and reinforce the trend thus creating another crisis from which there could be no way out.
- Forced deleveraging: An overly hawkish Fed forces rates higher and triggers a disorderly unwind of the bond trade, thus forcing the system to deleverage. This is the policy mistake.
Deutsche Bank's conclusion:
"The tension created by these three choices is in the center of both economic and political discourse. It will shape the market dynamics in the future, beyond the near term. Taper tantrum and the US presidential elections were the two most recent episodes that have highlighted the risk distribution opened by these choices. Policy mistake appears less likely at this point. The financial conditions are as loose as they have ever been. Fed hikes are only going to tone this down, but it is very difficult to see how they can create overly tight financial conditions and cause economic slowdown. Nevertheless, negative convexity of the central banks in the bear steepening or generally high rates scenarios are making risk of volatile deleveraging alive."
Ironically, it was yesterday's sharp bear steepening that was largely cheered by markets:
If they only knew.