Citi's Shocking Admission: "There Is A Growing Fear Among Central Bankers They've Lost Control"

Earlier we showed a variation on a VIX chart from Citi's Hans Lorenzen which, if it doesn't impress, or scare you, then nothing probably will.

However, leaving readers unimpressed - and unscared - will not satisfy Lorenzen, which is why the credit strategist who works together with the godfather of rational doom, Matt King, and has been warning for weeks that now is the time to sell credit, unloads in one of the more effusive missives of dripping negativity to hit during this holiday week when one after another equity sellside analyst has been desperate to outgun each other with their ridiculous 2018 year end S&P forecasts.

And while Lorenzen touches on many things, at its core, his warning is straight out of Shumpeter: the longer nothing changes, the greater the crash will ultimately be, a topic which DB's Aleksandar Kocic dissected over the summer, even defining an entirely new term in the process: metastability.

 

So without further ado, here is Lorenzen explaining why "embellishing the status quo will be the market’s undoing.

Ultimately, extreme valuations, the lack of risk premia, and a lack of responsiveness to tail risks are merely symptoms. The real question is what the skewed incentive structure resulting from that backstop has done to the fabric of markets after so many years. To our minds the answer is that trades and strategies which explicitly or implicitly rely on the low-vol environment continuing, are becoming more and more ubiquitous.

 

Realised historic vol is de facto an exogenous input to much of the risk management framework that underpins modern finance. With lookbacks extending a few years, an extended period of market stability reduces VaR measures and improves Sharpe ratios. Both allow / encourage investors to take more risk – driving valuations higher and vol lower still, creating a self-reinforcing dynamic. Intuitively, returns should follow flows – money is deployed and the asset price goes up. But in the real world the causation works the other way.

What this means in real-world terms:

Long periods of one-way markets breed survivor biases. The fund manager with lots of beta outperforms, the cautious fund manager underperforms. Either the latter gets on the bandwagon or soon enough outflows from the fund will ensue. Over time, fewer and fewer “critics of the regime” are left standing.

 

In an asset class where the upside is constrained, like in credit, that dynamic is further reinforced by the fact that a fund manager has to take more and more beta relative to benchmark in order to sustain the level of excess carry that will merely cover costs. The lack of volatility and the super high correlations between credits and the index (Figure 24), leave precious little scope for alpha (Figure 25).

Here we can add another piece to the short vol conundrum, because the closer spreads get to the lower bound, the more explicitly being long credit in itself becomes a short-vol position. With less and less upside remaining, owning credit risk become a question of generating a small amount of carry (or premium) for taking future downside risk – essentially, akin to selling a put option.

Meanwhile, as spreads collapse, as dol implied and realized vol, we are all “happily” ignoring that more risk is being issued into the market than ever before (Figure 26) and that the credit quality of the market keeps slipping – for the first time ever the market cap of the BBBs is about to overtake the rest of the € IG index (Figure 27).

What happens next should be familiar from the last financial crisis: the infamous step up in risk:

When the conventional asset class of choice no longer offers a “decent” return potential, money looks to the next one on the quality spectrum for a pickup. IG funds holding BBs and AT1. DM funds buying EM debt. European and Asian funds holding more and more $ fixed income. Corporates moving their liquidity from money markets to short-dated IG credit funds. Mandate creep in the investment criteria. Even synthetic structured credit is making something of a comeback. The list of tourist trades goes on and on. Most of these too are predicated on the status quo - if volatility and risk premia were to rise, retrenchment back towards the original / natural asset allocation would be swift and uncompromising.

And then, one day, the market will finally discount that the central banks are no longer set to injection trillions in liquidity: that's the moment the public finally begins to admit the emperor is not wearing any clothes.

You could rightly argue that many of these factors are generic to every bull market. The fact that volatility clusters is exactly because of these (and other) selfreinforcing dynamics. But the implicit ceiling on vol / cap on downside from the central bank backstops has, in our view, allowed them to run for much, much longer than would have been possible in a market operating on its own devices.

 

You could argue that there is nothing to worry about as long as fundamentals remain strong. But those looking at the economic data, corporate earnings or leverage trends to indicate the next turn in markets are looking in the wrong place, if you ask us. Over the last 50 years, only 2 out of 19 corrections in US credit were led by a recession. 12 had no overlap with a  recession at all. In half the corrections, there wasn’t even a discernible turn in the leading economic indicator beforehand. Plainly, there is a long history of market corrections being triggered by other factors than fundamentals – Black Monday in 1987 and the correlation crisis in 2005 are two obvious examples.

Still, judging by the current state of the market, Citi writes that traders "evidently don’t expect a sharp market correction to happen tomorrow."

While the probability of a next-day loss still feels quite low there is an obvious temptation to stay invested a little bit longer for professional investors, tasked not with delivering a return of money, but a return on money and with high frequency. The process of judging that near-term probability manifests itself in the frenzied search for “triggers”. Surely, if one could just get a slightly better call on the next trigger, then it’d be possible to get out just in time before everyone else jams the exit? We don’t dismiss the importance of triggers. Indeed,  when you look back at the last fifty years, nearly every major correction in credit can be associated with a triggering event (Figure 28). With hindsight everything is easy.

Here Citi has some advice: don't look for triggers; instead focus on the big picture.

We are sceptical that hunting for the next trigger is worth the effort. If a trigger seems obvious, then it’s probably obvious to everyone and chances are it will be too late. Triggers are often latent – the long-term problem is obvious, but it is ignored until suddenly it explodes without much warning (think the Greek sovereign debt crisis). Multiple factors often have to  combine to create a triggering event – the GFC wasn’t just about sub-prime, it was about excessive leverage, inadequate regulation, unchecked financial innovation, misaligned rating methodologies, inadequate backstops and a host of other things. The last couple of years have seen several widely peddled “triggering events” crystallise with remarkably little shake out.

So what about the big picture? Here one can argue that in recent years the market simply wasn’t vulnerable with so much central bank money behind it. However, Lorenzen believes that "2018 is different." As we see it, it is now increasingly vulnerable to a mid-cycle, “technical” correction, based on what we have discussed above:

  • Central bank asset purchases are set to be the smallest in a decade (Figure 29). A $1tn of incremental demand versus 2017 is needed from private sources.
  • At least in the US, the opportunity cost of not being invested in credit (i.e. the yield differential to 3m LIBOR) is likely to be the smallest since 2007.
  • The perception of a backstop has facilitated a multitude of trades and strategies that are contingent on a low level of volatility in an increasingly crowded space. Now that backstop is moving “out the money”.
  • Vol is near historic lows and has been so for longer than ever before. More risk than ever before is being issued into a credit market where spreads, on a like-forlike basis, are close to the 2007 tights and where breakevens are wafer thin.

Lorenzen then branches into some chaos theory for good measure:

In the context of a self-reinforcing, herding market, the pivot point where the marginal investor is indifferent between putting more money back into risk assets and holding cash instead is fluid. But when the herd suddenly changes direction, the result is a sharp non-linear shift in asset prices. That is a problem not only for us  trying to call the market, but also for central bankers trying to remove policy accommodation at the right pace without setting off a chain reaction – especially because the longer current market dynamics run, the more energy will eventually be released.

And while not intended to be a conclusion, or even a punchline, the next line from the Citi strategist should scare the living daylights out of anyone: it is a direct admission that central bankers have now lost control.

That seems to be a growing fear among a number of central bankers that we have spoken to recently. In our experience, they too are somewhat baffled by the lack of volatility and concerned about the lack of response to negative headlines.... Our guess is that sooner or later in the process of retrenchment they will end up going too far – though that will only be obvious with hindsight.

Frankly, that's about the scariest admission from one of the world's biggest banks that we have read in a long time.

* * *

As for how this period of cataclysmic metastability ends, here is Lorenzen's dire conclusion:

In a fairy tale, turning points come suddenly and unexpectedly. Everything that has long been taken for granted is suddenly in pieces. In that sense markets are not all that different. People have gotten used to the paradigm that has been built up since the Great Financial Crisis. It has been tested on several occasions – 2011, 2012 and 2015 – and on each occasion central banks have overcome the challenge, thus ultimately reinforcing the regime.

 

The emperor in Andersen’s story was only able to parade around naked because the social norms, customs, conventions and vested interests that had built up over time were so strong that even the blatantly obvious was better left unspoken.

 

Similarly, the low risk premia, the low level of volatility, the lack of responsiveness to tail risk and spillover of systemic events, the reluctance to sell etc. to us are all indications that the market now has an almost Pavlovian response to central bank liquidity. The mere thought of it is enough to still leave us salivating, even when it is patently in the process of being turned off. Yes, excess liquidity will remain in the system even after central bank net asset purchases fall to zero, but as we have argued, if that money has chosen to stay out of the securities  market now, then why should it seamlessly come flowing in at these valuations when the backstop is moving out the money?

 

While our conviction in the exact timing and magnitude of the paradigm shift is admittedly low – hence the deliberately very wide range in the scenario forecasts – it is unwavering  when it comes to the broader point that central bank asset purchases will remain the key driver of markets. Exactly because trades and strategies have been built up around an assumption of the status quo, we fear that the inflection point, if / when it comes will be anything but smooth and linear. Indeed, the longer we remain in the current paradigm, the greater the chance that it  ends up being both sharp and painful.

 

One of our favourite quotes pertains as much to markets as it does to economics:

 

“In economics, things take longer to happen than you think they will, and then they  happen faster than you thought they could.”

    ? Rudiger Dornbusch

 

Surely, that is a sentiment which the emperor who had his vanity and pride shattered so abruptly from the least likely angle would recognise all too well?

We end with one of our favorite pictures: the one we call Yellen's moment of epiphany haw it all ends.

No wonder the Fed chair can't wait to get the hell out...

Comments

El Oregonian InsaneBane Sat, 11/25/2017 - 20:19 Permalink

It is obvious that the delusion of mass monetary illusion runs deep in people's psyche, to the point of denial, even when the facts present themselves as truth..."and with every wicked deception directed against those who are perishing, because they refused the love of the truth that would have saved them. For this reason, God will send them a powerful delusion so that they will believe the lie," -2 Thessalonians 2:11

In reply to by InsaneBane

shitshitshit DownWithYogaPants Sun, 11/26/2017 - 06:40 Permalink

I wonder why would they not do the simplest and most obvious action to fix heir crooked system: namely changing accounting rules to keep the dollar afloat...After non gaap earnings, why not non gaap CB balance sheets?The goal would still be the same: buying out everything out of everyone's hands by means of outbidding.Do you still believe they lost control? really? -To me it looks like they're still very good at shaking everyone's hands and they own more and more companies -the heart of the economy- while imbeciles fight over all the way up during this bitcoin bubble, which does not produce anything tangible. In the end they will possess the assets, whereas the rest of us will be into whatever stupid illusion. You know what happens next...  

In reply to by DownWithYogaPants

Endgame Napoleon max2205 Sun, 11/26/2017 - 08:58 Permalink

Okay, so these math brains take a lot of risk just to move to the next musical chair in the circle of possible investments, while the conservative fund managers get scolded for not taking on more risk.

My question is why do we have a society where there is an incentive for traders to take on so much risk that is measured in such small units, but the investors who have capital often choose the “safe” route, taking jobs out of the economy and putting their extra money in this apparently [risky] stock market, as opposed to [risking] their money to start businesses that employ underemployed Americans?

Maybe, it is due to this illusion of safety in the markets. Most people do not understand any of the details of this. Only math / finance experts and big-time investors really understand the dynamics here. Why don’t they try to educate their customers about these issues so that the pressures and incentives will shift for fund managers due to different client expectations?

That is what you do in a luxury business, where you want to sell a better-quality item. You find ways to show skeptical clients the difference.

They should read ZH, actually. It is more interesting than most of the drier financial writing.

In reply to by max2205

MonetaryApostate overbet Sat, 11/25/2017 - 17:03 Permalink

It's all engineered to destruct so that they can force cashless societies & digital totalitarianism globally, eg digital money so you can't evade gov theft & control.  It's obvious they put everyone else at risk of the systemic collapse.  Like I said, long food, water, iodine, ammo, & guns.If you can't figure out why the immigrants are invading, you are clearly ignorant of the war at our doorsteps to cause chaos!Just look at Venezuela & Greece, this is the future.

In reply to by overbet

Escrava Isaura hedgeless_horseman Sat, 11/25/2017 - 16:59 Permalink

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hedgeless_horseman: So hard to tell if the serious money printing is coming to an end, now, or just getting started……..It is really a coin flipper. Of course money printing is not going to end. Just like asking people back in the 60’s just to have one baby. I had none, but I was an exception. There’s no need to flip a coin. Central banks know exactly how this will end. They will print money. When money fails, they will take by force. It’s that simple……….But no one wants to contemplate this scenario. “How did you go bankrupt?" Two ways. Gradually, then suddenly.” - Ernest Hemingway  

In reply to by hedgeless_horseman

hedgeless_horseman Escrava Isaura Sat, 11/25/2017 - 17:41 Permalink

 

They will print money.

They do like to stop the presses, from time to time, to knock the air out of the nouveau riche, and pick up hard assets for cents on the dollar.  This is when true generational wealth is made by the patrons of those that attend the monthly dinners at the B.I.S. in Switzerland, shown in the photo above.  The blood in the streets is never their's, so it is easy for them to calmly buy THE fucking dip.

In reply to by Escrava Isaura

BlueGreen Escrava Isaura Sat, 11/25/2017 - 18:58 Permalink

"There’s no need to flip a coin. Central banks know exactly how this will end."OFFSso they got what...quantum communication or a crystal ball? These are guessing 'most likely ' $tyle answers.  I'm going to say go with what fulfills a brain stem tainted answer that meets greater attainment of greed, laziness, and sex....the three pillars of the lizard brain

In reply to by Escrava Isaura

Escrava Isaura BlueGreen Sun, 11/26/2017 - 03:56 Permalink

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Crystal ball? No. Few drinks. Here’s how it works. It works a little easier for women but clever men can do it. Come to DC and go to bars that bankers hang around. After a few drinks you get to learn all kinds of things. Basically, bankers care about collateral. If/when there’s no collateral, they will create schemes. Bankers, again, oversimplified, for the most part are neoliberals, meaning they lean left. They are the doves. They don’t use guns, tanks, or violence. They use financial strangulation. The hawks are neocons, meaning they lean right. They use confrontation. As long as the neoliberals’ solutions are working the neocons are happy, because the neocons are well paid.    

In reply to by BlueGreen

JRobby americanreality Sun, 11/26/2017 - 14:48 Permalink

I did not know that you were the authority on all intelligence levels around here?I would need to be watching the insane movie playing inside your head to access such insights though? I'll pass.PS, on an internet forum, you might not want it to appear that you are posting with multiple IDs regardless of how many personalities you have running your head. Nor would you want observers to think you are some kind of lap dog.   

In reply to by americanreality

Escrava Isaura Endgame Napoleon Sun, 11/26/2017 - 09:37 Permalink

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People take great joy in having kids. Religion gives them cover as well. Having kids are find to be a very selfish act. In the neighborhood that I was raised, only I and another didn’t have kids. Well, she ends up being a lesbian. Anyway, most had 3. Some up to 6 kids. I guess most will always remain a goy. It’s a gene thing. There’s not much government can do. Candidates that speak up about population overshoot and religion would have no chance in getting elected.  

In reply to by Endgame Napoleon

Putrid_Scum Francis Marx Sun, 11/26/2017 - 00:12 Permalink

"You cant loose control of something you never had control of to begin with."Oh don't kid yourself, the powers that be have had a total lock on the population since 1914. They killed, through brute force, tens of millions in two World Wars which was really just one big war. And the masses took it up the ass. Some resisted, via communism and other mass movements, but they eventually were beaten down. The powers that be are shitting their pants right now, because they don't have a fucking clue where to go going forward. They'd do the World War Three thing but that would get them killed too, so ... it's the Reset.Our System, Capitalism, has been collapsing since 1914. Its beginnings were extremely harsh which was a sign of where humanity and the System was headed. So why the surprise at where we've arrived to?And after 300 years of Capitalism anyone at the Top is completely fucked in the head. The plan is the Reset, it will be extremely unstable and will have unpredictable results. How bad is the System state presently? It's completely fucked up. There's no moral reform of a System which is ani-human. So forget about reform. Protect yourself, Putridwww.beforethecollapse.com/2017/05/23/the-reset/

In reply to by Francis Marx

Deep Snorkeler Sat, 11/25/2017 - 16:40 Permalink

America is in a state of political-economic depravity -everywhere there is strenuous retailing of deliberate lies.No organization is neutral.The hole in economic activity grows larger each day.Meaningful GDP growth is dead and new technologies cannot save us.

Wait What Deep Snorkeler Sat, 11/25/2017 - 21:54 Permalink

the author's point about metastability is nothing new. Mathematics came up with catastrophe theory as it applied to human systems way back in the 1960s. The brits used it to predict prison riots at one point. The manifold in the bimodal equilibrium is going to look more like the one in this video than simplistic image from Kocic et al.https://www.youtube.com/watch?v=FHgQUjqg-AI

In reply to by Deep Snorkeler