Two weeks ago, in his must-read 2018 credit outlook report (which we urge everyone to read) Citi's credit strategist Hans Lorenzen made three striking observations.
The first had to do with explicit central banker fears that they have now lost control of a market which, no matter what the Fed does or says, no longer believes that tighter financial conditions are possible - after all even a 5% correction gets hints of QE4 from the Bullards of the world - and as a result keeps bidding up risk and selling vol to new daily records:
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.
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.
The above hardly needs a clarification, as "a growing fear among central bankers" who are baffled by a market that no longer responds to negative headlines is self explanatory. As is how it all ends.
The second observations was Lorenzen's conclusion, in which the credit strategist compared the modern market to its closest comp: fairy tales, especially those in which the emperor is naked.
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?
Hans Christian Andersen had naked emperors; we have central bankers. And according to Citi, there no longer is a difference. Citi is right.
The second observation directly leads to the third and final one, because in this world of record high valuations and record low volatility, in which the market no longer responds to news, shocks or risks, and in which nobody dares to point out the obvious - that this is the biggest asset bubble in history - there is just one trade:
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.
Luckily, this is no longer the real world: after all as Citi admits it is a fairy tale, one which will last until it ends "suddenly and unexpectedly" and "everything that has long been taken for granted is suddenly in pieces."
For now, however, it continues. So for those curious what this low-vol equilibrium looks like, and would much rather settle for a simple chart instead of one of Aleksandar Kocic's abstract, post-impressionist piece of "chart art", today Lorenzen has published a follow chart pack to his outlook report, which while largely recapping most things we already discussed, has the following diagram which explains quickly and painlessly what the self-reinforcing, low-vol "market" equilibrium created by the infinite central bank backstop looks like. The answer is shown below:
And while Lorenzen had nothing additional to add to what he already said at the end of November, he did reiterate his previously warning about the state of the market in which central bank liquidity is now being withdrawn: he says that the "biggest vulnerability lies in assumption of the status quo" and concludes that "Markets have not reflected change in paradigm."