Posted by on May 22, 2017 12:35 am
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Categories: Business Congress Convexity Deutsche Bank donald trump Economy Federal Reserve System Finance Greenspan put Layering Market Crash Mathematical finance Monetary Policy money Options Technical Analysis Transparency US Federal Reserve VIX Volatility

It took the Fed several long years to discover just how reflexive and circular the relationship it had established with the stock market had become. The Fed’s Catch-22 was first observed back in September 2013, when as the Fed was still debating whether to taper or not caught in a vicious cycle where any hint it would ultimately end QE would be met with a prompt selloff, Deutsche Bank explained how it had found itself in such a reflexive mess:

Another theme arising from their decision to hold fire was their worry that financial conditions had tightened over the past few weeks. If this is the case then the path of tapering is going to be tough because every time the market thinks they are going to taper, yields will likely rise and conditions will tighten. However the Fed’s guidance is becoming confused enough now that you couldn’t rule out another change of emphasis, especially as the composition of the Fed will change notably over the next few months. So markets are underpinned by liquidity for now but it’s a fluid situation and it strikes me that the Fed do not have a clear direction at the moment which makes them difficult to second guess.

Three years later, the Fed found itself in the same bind, eager to hike rates but very much unwilling to suffer the risk asset consequences this would entail, i.e., worried about a market selloff. And, as we discussed last October, in the Fed’s Minutes, for the first time we observed a Fed that appeared to have become self-aware, and had grasped just how reflexive the nature of its “communication strategy” with the market has been all along. To wit:

Over half a year later, we again go back to Deutsche Bank in general, and its most whimsical and metaphysical of strategists, Aleksandar Kocic, who first highlighted the reflexive nature of the Fed four years ago (and who recently has been more vocal on political topics such as the failure of globalization as the culprit behind Trump’s victory, and the backlash against populism), and who over the weekend extended the familiar circular frame established between the Fed and the market by one key player, layering in the the US presidency as a critical participant in the “communication channel” the Fed had established with the market. In other words, the “Fed put”, which Yellen et al financed “option by selling an (out of the money) option on their credibility” was being supplanted by a “Trump put.”

There are several major problems associated with that.

As Kocic warns, the introduction of this particular “irrational” actor into a long-running, game-theoretical setup which has become quite familiar to both the market and the Fed  – as Kocic puts it “the Fed could tailor its exit in an optimal way, while the market could voice its view at each step of that process so that both sides are happy at the end. Because of that, it was not in the market’s interest to challenge Fed’s credibility” – would jeopardize the fluid equilibrium between the Fed and the stock market.

Furthermore, “in contrast with the Fed whose communications with the markets reduced volatility, the new political transparency, as communicated through presidential tweets and political discourse, has been generally volatility increasing.” Said simply, blame Trump if volatility explodes in the near future, at least according to Deutsche.

Finally, there is the issue of the market being shocked by a brutal “margin call”, as the pre-implied political “consensus”, similar to that between the Fed and markets, fractures resulting in a marketwide “margin call”, which would be most disruptive for equities while pushing VIX higher, creating a destructive feedback loop in which crashing confidence in the “Trump put” translates into a further market selloff, which in turn further impairs confidence in not only the Trump, but also Fed put, in the process potentially unwinding years and years of artificial market levels as not only Trump, but the Fed also lose their credibility.

For the sake of completeness and coherence – because nobody can do Kocic justice by expounding on his thoughts, and it is best to leave to Kocic to say what Kocic meant to say – here is his full essay from this weekend.

Approaching a margin call: Politics and policy behind the fourth wall

For a good part of the last 5-6 years, the Fed had made a point of establishing an open channel of communication with the markets. We have viewed this phase of market introspection as a maneuver equivalent to the removal of the fourth wall in the theatrical context: The audience (in this case the markets) is no longer a passive spectator, but assumes an active role in shaping the script (policy). In consulting the markets, the Fed has retained an option to be flexible and act in the market’s interest without disturbing it. They have financed that option by selling an (out of the money) option on their credibility. This is a tradeoff that worked for everyone. The Fed could tailor its exit in an optimal way, while the market could voice its view at each step of that process so that both sides are happy at the end. Because of that, it was not in the market’s interest to challenge Fed’s credibility.

With the arrival of the new President, there appears to be some coordination between politics and monetary policy in their communication channels. The Fed communications with the markets gave way to presidential tweets, press briefings and general media appearances, which took center stage as another form of shaping the narrative jointly with a wider audience. So, while the Fed’s fourth wall had to be reinstated, another fourth wall came down. It makes perfect sense for the two communication channels not to coexist at the same time — removing two walls at the same time would have produced two parallel narratives resulting in a significant “cognitive draft” and potential loss of coherence of the resulting script.

The two communication modes of removal of the fourth wall, while on the surface similar, have (at least) one notable difference. When expressed in options language, the Trump put has the same decomposition as the Bernanke put during the QE period. Effectively, this is a supply of equity vol to the market financed by “selling puts” on President’s credibility. However, in contrast with the Fed whose communications with the markets reduced volatility, the new political transparency, as communicated through presidential tweets and political discourse, has been generally volatility increasing. This communication caused volatility is the main difference between politics and policy. Originally, the market has been willing to accept this volatility because the promises at the end look attractive (tax cuts, deregulation, fiscal spending,…). But, this volatility presents the key risk for the President’s brand. The collateral asset behind president’s “credibility put” is his ability to pass the promised reforms, which is conditioned on his ability to form consensus within the party, the House and the Congress. Excessive volatility erodes the value of this collateral and increases the risk of a “margin call”.

This was highlighted by the last week’s events: The latest political developments outlined the lines of fractures in the political consensus and the market’s reassessing of the probability of a “margin call”. As a consequence, volatility sellers were caught off guard as gamma rebounded. The awareness of this possibility alone is likely to provide a lower bound for vol – as long as political uncertainty prevails, vol is  unlikely to be pushed to new lows. As the Trump trade took the center stage by the end of the last year, the highest level of uncertainty was perceived to be in the FX channel and the lowest in the risk assets, with rates market somewhere between the two. In itself, the political “margin call” would be unwind of this mode and, as such, most disruptive for equities pushing VIX significantly higher, as it means withdrawal of convexity from that market, and somewhat less supportive for rates and FX vol.

To all this we can only add, that it would be doubly (if not triply) ironic that Trump – who less than a year ago accused Yellen of blowing a “huge market bubble” – then a few months ago changed his tune, and started grading his presidency by every uptick in the S&P while praising Yellen and low rates, were to be left holding the bag as the president who unleashed the biggest market crash of all time, in the process wiping out the Fed, whose “market put” is now all in, as is its reserve currency-defining credibility.

Actually scratch that, the correct word we are looking for is not “ironic”… it is “planned.”

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