Back in July, Deutsche Bank’s derivative strategist Aleksandar Kocic believed he had found the moment the market broke, which he defined as a terminal dislocation between market and economic policy uncertainty: as he wrote 4 months ago, it was some time in 2012 that markets “lost their capacity to deal with uncertainty.”
It was also some time in 2012 that traders and market participants realized central banks have not only taken over the market, but have no intention of ever leaving as the alternative is a crash that wipes out 8 years of artificial “wealth effect” creation and puts the very concept of fractional reserve and central banking in jeopardy.
This intention was confirmed last week when as Kocic again wrote overnight, it became clear – once again – that Central Banks’ main agenda “is management of the risk of policy unwind” which has two different aspects, especially for those who still believe there is such as a thing as a “market.” Kocic explains:
- On one hand, it is reassuring that Central Banks are cognizant of severity of the risk and are showing appropriate flexibility in adjusting their reaction functions to incorporate these realities.
- On the other hand, this is less good because it does not allow the market to reposition and, thus, normalize. By soliciting feedback from the markets, Central Banks are further encouraging bad behavior making things potentially worse by postponing the resolution further into the future.
This is also the “nightmare scenario” envisioned by Eric Peters: a world in which central banks inject more and more liquidity and “stimulus”, and yet inflation does not rise, resulting in greater and greater financial inflation, i.e., asset bubbles, and a Fed chair who is confused about the “mystery” of inflation.
Yet while the Fed is mystified by the lack of “real economic” inflation – just because it is unwilling to admit it has blown yet another bubble – investors are mystified by something else entirely. As Kocic explains, the common theme constraint in this world in which central banks are focused on “risk policy unwind”, the same risk they created, is that investors, and people in general, are facing fixed long-term liabilities. In such a world, “with continued political pressure to reduce taxes and avoid more deficit spending, welfare programs and safety nets are being further dismantled and, through continued privatization, those costs are being passed onto consumers. This means that long-term liabilities are not going down any time soon; if anything, they are most likely to continue to grow”
In this environment, in which demographics + debt + disruption = deflation, “investors are looking for higher returns and money managers are pressured to deliver in an increasingly challenging environment as risk premia continue to compress across the board. The dilemma money managers are facing is either to engage in short term risky strategies or face redemptions.“
This is another way of saying “you will either become part of the crowd or your career is over.” And since most financial professionals have conceded, and are indeed part of the crowd, “anything that would disturb this mechanism is likely to make markets unhappy and cause “tantrums” which could escalate and potentially trigger unwind of the existing positions creating a situation that would be difficult, if not impossible, to manage.”
Since this forces current flawed monetary policy to persist and remain “transparent, predictable and overly accommodative”, it further reinforces “bad behavior and focus on short term strategies with disregard to their long-term consequences.” Which is Kocic’s traditionally verbose way of saying all traders care about is the year end bonus; as for what happens after, to paraphrase Louis VX, “Apres moi, le deluge.”
In practical terms, this means that while markets appear to be locally stable, they “are effectively dancing on the edge of metastablity whereby practically any non-trivial shock can be destabilizing” as “people had abandoned any long-term agenda and have concentrated all the efforts on extracting as much as possible in the near term.” This goes back to what Kocic said back in June when he first defined the market’s “metastable” (dys)equilibrium, and predicted that eventually it would lead to “cataclysmic events.”
Picking up where he left off, Kocic explains that investor confusion, or rather schizophrenia, is the result of an “overhang of almost a decade of unprecedented stimulus and one-sided positioning” which has made “the market is vulnerable to violent selloffs.”
This is a consequence of Central Banks’ complicity and shrinking of the horizons – the future is degrading into an optimized present. At this point, there is an implicit symbolic pact between Central Banks and the markets.
This brings the old trope created by Kocic when he looks at the interplay between the Fed and markets as manifestations of second, third and higher level intentionality, or as the DB analyst puts it, “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.”
Which, of course, is the $64 trillion question, “what happens if there is an exogenous
circuit breaker and we can no longer pretend?” Or, what happens when the Fed can no longer fake that things are normal…
Which brings us to the question of crisis catalysts – what is the “non-trivial” shock that will break the current cycle of metastability and unleash the next “cataclysm.”
To answer, Kocic looks at the interplay of volatility and leverage in history, one “which defines the dynamics of the economy. Generally, reduced uncertainty engenders higher levels of 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.“
And since it has become the Fed’s sole purpose to prevent this mean reversion from taking place, perhaps ever, ultimately the tension in markets boils down to this simple question: how long can the Fed prevent the “Minsky moment” from asserting itself, sending volatility soaring and ending the current unstable state, ironically by injecting ever more of the one catalyst that unleash the next crisis: debt.
Below is Kocic’ explanation of what the Minsky dynamics for the “new, centrally-planned, normal” market look like, how the interplay of vol and leverage could spark the next crisis, and what catalysts could send the world spiraling into a state of currency, and unconstrained, crisis.
The forgotten horizon: Where the wild things are
Excess liquidity can cause asset bubbles and market crises. However, excess liquidity cannot do it alone; it must be helped by deregulation and an asset that can convert liquidity into inflation. So far, both of these factors have been under control post 2008 – the financial sectors have been regulated and an asset class capable of forming a bubble is not on the horizon. However, and this is where the risk lies, as there is political pressure to deregulate the markets and inject additional fiscal stimulus, the door is being open for unprecedented liquidity injection to backfire in the long run.
What should we do if we really have to worry beyond the short-term horizon? In our view, the experience of the past eight years could hold a key to understanding the response of the markets to potential normalization in rates and volatility. Since the early days of the crisis, we have had four episodes of violent selloff with repricing of similar intensity: QE1, QE2, Taper tantrum, and 2016 US Presidential elections. However, each time, that the market was addressing different kind of risk with a distinct pattern of repricing of the volatility surface.
In order to establish cognitive coordinates of the problem which allow us to generalize the past experience, we discuss the general framework of volatility evolution in the context of leverage. There is a relationship between leverage and vol which defines the dynamics of the economy. Generally, reduced uncertainty engenders higher levels of 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.
During the conundrum years of the mid-zero-zero decade, there were several factors that led to subsequent instabilities and the 2008 crisis. In addition to low rates catalyzing the growth of the housing market, we had an increasingly predictable monetary policy on the back of further reduction of economic uncertainty and transfer of convexity risk to the banks’ balance sheets without a clear transmission mechanism to the capital markets. This led to continued decline in volatility and compression of risk premia as investors sought higher levels of risk in order to insure stable returns. This is the period of lowest volatility and highest leverage. In order to capture these dynamics, we describe the market behavior in terms of leverage and volatility (or risk premia), see the figure below. In this space, there are four quadrants corresponding to different regimes and the market trends with quasi-cyclical trajectories capturing the evolution of financial markets as they transition through different operating modes.
The low-vol/high-leverage state is intuitively easy to understand — we have already seen its full realization during the conundrum years, about a decade ago, and are currently getting a taste of its modified version. High-vol/high-leverage would correspond to the period of unsustainable public or private debt, such as the ones observed in certain emerging market economies, with typically high inflation and currency problems. High-volatility/low -everage would correspond to forced and disorderly deleveraging. Low-volatility/low-leverage is a regime we are trying to avoid.
The figure captures generalized trajectories of volatility and leverage as seen in the last 10-15 years. This approach is a conceptual relative to the Minsky’s idea of endogeneity of financial crises. To illustrate the market evolution in this context, we start our journey somewhere in the lower left quadrant and follow the trajectory along the ellipse in the clockwise direction. We can think of this starting point as being some time around the middle of the last decade. As the risk premia compress, leverage increases leading to higher levels of risk taking, which results in a crisis. The volatility spikes up while the system begins to deleverage. At some point the government steps in and for awhile there is an uncertainty about whether it would be able to contain the crisis without causing serious long-term side effects.
Volatility continues to grow despite the decline in leverage until there are first signs of relaxation and market stabilization. As vol goes through a turnaround the system continues to deleverage, we are leaving the upper half of the plane. The success of policy response up to that point brings in some optimism about future economic growth and risk premia begin to compress.
We are currently in the lower half plane. As we transition from the lower right to the lower left quadrants, the policy unwind begins. During taper tantrum, the system faces a dilemma between forced deleveraging (e.g. unwind of the Fed balance sheet and disorderly bear steepener) or gradual deleveraging with uneventful exit and transition deeper into the lower left quadrant (this is denoted as the “Base case”). This path requires some fine tuning as efforts are made not to overregulate the system and slip into a deflationary trap.
At around the same vol levels, during the 2016 presidential elections, new risk is resurfacing. With protectionist rhetoric and promises of additional fiscal spending, the risks of opening corridor to high inflation and currency crisis is back on the table, but this time, due to massive growth of retail balance sheet this becomes entangled with uncertainty about the long-term monetary policy response in this context.
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