"The Unwind Of The Consensus Trade" In One Flow Chart

The mechanism behind the market’s recent volatility has been the result of inflationary concerns triggering an unfavorable rise in interest rates which in turn has triggered higher volatility, an violent unwind of short-vol instruments, and panic selling in equities.

Deutsche Bank shows this in the flow chart below, which the German bank summarizes simply as "the unwinding of the consensus trade that was premised on the continuity of low inflation and the market’s “three low” environment of low interest rates, low spreads, and low volatility."

The focus points going forward are:

  • (A) How long will the higher volatility, and the accompanying panic selling of equities, continue? And
  • (B) How long will the unfavorable rise in interest rates continue on inflationary concerns?

Regarding “A,” Deutsche believes that the abnormal rise in volatility (futures) on 5 February has already served as a sort of relief of pent-up pressure. However, unless “B” is dealt with, volatility will remain elevated and the instability in share prices (risk asset prices) will continue.

As (B) inflationary concerns continue to simmer, the unfavorable rise in interest rates continues.

And yet looking at the schizophrenic divergence between the USD and rates today, suggests that while one market, bonds, sees many rate hikes, at the same time USD traders are convinced there is no risk of further rate hikes and is tumbling.

Addressing this divergence, Deutsche says that "with no major changes in inflationary indices, inflationary concerns may end as just that – concerns." To be sure, last year, many market participants were receptive to the idea of structurally low inflation, and believed inflation and interest rates would remain low for a long time. But as is always the case with consensus trades, changes in market themes are abrupt.

In this context, the recently hot inflation and wage print, the basis for the structurally low inflation argument remains intact: economic globalization, technology-wrought changes to the industrial structure, and population ageing (and longer lives).

Deutsche Bank's conclusion is somewhat sanguine, despite its forecast for a "large once-a-decade change in the credit and risk asset cycle" set to take place by 2019:

Our global financial research team believes that a large once-a-decade change in the credit and risk asset cycle will occur by 2019 (and US to enter recession by 2020). However, the credit markets are currently stable, and have not passed the “point of no return.” As long as the risk scenarios including advancing inflation do not materialize, we see a possibility that asset prices will return to an uptrend this year

Meanwhile, vol-sellers continue to do what the Fed has programmed them to do so well over the past decade: sell vol.