Two weeks ago, one of our favorite derivatives strategists, BofA Barnaby Martin wrote something we have said for years: "QE has been the most effective way for CBs to 'sell vol'", arguing that accommodative monetary policies across the globe amid QE have "clearly supported a strong rebound in fixed income markets." This should not be a surprise: as Martin calculated, there is now some $51 trillion at risk should rates vol spike, not to mention countless housing bubbles that have been created since the financial crisis where the bulk of middle class wealth has been parked, which in turn have trapped central banks, preventing them from undoing nearly a decade of unprecedented monetary largesse that has pumped over $15 trillion in central bank liquidity.
The BofA strategist showed that every time the Fed embarked on the different phases of its QE program, credit implied vols declined significantly, while during periods of no monetary easing or when the market started pricing the possibility of easing policy removal (tapering tantrum and the subsequent tapering phase) implied vols advanced.
It's not just the Fed that is stuck "selling vol" - the same happened in the case of the ECB: implied vols re-priced lower post the announcements of the PSPP and especially the CSPP.
Of course, with central banks selling vol, there is inherent risk that even one wrong word will instantly "short-circuit" the vol-selling process, such as observed when both the Fed and the ECB attempt to communicate that these policies will have an end-date, implied vols reprice significantly higher. A good example is the market reaction post the May 2013 Bernanke’s mention of the idea of gradually "tapering" the Fed’s monetary expansion. The same reaction was seen back in October last year, when tapering fears hit Europe: implied vols moved higher over the following couple of months.
This forced an immediate reversal as both the Fed and the ECB, despite formally announcing their intentions to reduce the pace of their QE programs, still had their announcements complemented with a significantly dovish tone.
Or take the ECB December meeting, when the central bank delivered a dovish taper. Despite ECB’s announcement of the reduction of the pace of the QE program from €80bn down to €60 billion per month, implied vols moved lower, as a hawkish action was coated with a dovish message. Draghi said on that day that "there is no question about tapering" as "Tapering has not been discussedtoday" also pledging that this will continue " until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim".
Or take the stunning drop lower in JGBs volatility in September last year when BoJ introduced the 10y yield targeting mechanism. Since then volatility remained at record low levels.
And while in recent months the drum beat of "policy normalization" has been all the rage central banks have, Martin concluded that "as global debt has been mounting to more than $150trillion (government, household and non-financials corporate debt), global GDP is just above $60trillion.....
... we think that the risk for credit spreads and volatility is only on the moderate side as central banks are becoming more cognisant that “uncertainty” and a volatility shock could be damaging for the world economy. Hawkish messages are followed by dovish ones to introduce a “low vol monetary policy normalisation”. This is keeping vols and spreads in check."
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Fast forward to today, when the topic of keeping vols and spreads in check was also the dominant theme of another notable derivatives strategist, this time BofA's Aleksandar Kocic, who three months ago was the latest to warn that the market's current phase of "metastability" will eventually lead to "cataclysmic events"...
... just not yet.
In his latest note, Kocic takes a roundabout view of how central banks effectively sell vol, and write that in his view, the "primary reason for persistent pressure on gamma is excessive liquidity on the exchanges and transparency of the Fed."
Post FOMC excitement has proven to be short lived. The market has reverted again to what appears to be a familiar pattern, whereby gamma becomes a way of event trading. It is difficult to see anything in the near term that can provide a sustained support for vol. As long as there is no structural shift – and it is becoming increasingly clear that such a shift is not on the horizon -- regardless of the content of the event, volatility is unlikely to sustain a bid.
While the narrative of excessive central bank liquidity is hardly new, and just a few days ago was postulated by Kocic' Deutsche Bank colleague Jim Reid as the most likely cause of the next financial crisis...
... the take on central bank transparency, or rather "transparency" is a novel spin on a familiar idea. As Kocic writes, with his characteristic stream-of-consciousness flair, "as much as transparency has been elevated as a tool intended to inspire trust, it inherently creates blind spots and residual risks that in the long run become difficult to manage. Transparency forces everything inward and numbs the awareness of anything that resides outside of the existing channels of informational exchange, making it difficult to have a non-consensus view against the background of total transparency. In this way, transparency becomes a method of control."
It is ironic that the Fed, which in Yellen's own words is now clueless about how to reassert control over "mysterious" inflation, is doing its best to claim it is at least being "transparent" about it. So much so, in fact, that it has become a form of paralysis for traders who are glued to every Fed soundbite, aware that the Fed has no clue what it is doing, but also aware that this clueless Fed has one mission only: to keep volatility low as Martin explained above.
This is also why investing - as a long-term bet on future asset values - by definition no longer exists, and every market interaction become a short-term trade until the next Fed soundbite, or as Kocic puts it, "in the environment of abundant information, everything becomes short term." Kocic explains:
A long term vision becomes progressively more difficult to construct and things that take more time to mature receive less and less attention. Given the magnitude and severity of policy response during the financial crisis, Fed has been running significant addiction liability in the context of stimulus unwind. The communication loop between the Fed and the markets has become a way of controlling the residual risks associated with their exit. Excessive transparency has been perceived as the most effective way to stabilize the system. When used in this context, it confirms and optimizes only what already exists. The markets remain blind to what lies outside of the context of informational exchange. However, without a rigid reference point, like well specified reaction function, objectives, and triggers, policy risks to deteriorate into a matter of referendum."
As a result, a fundamental flaw emerges with the Fed's overarching embrace of "excessive transparency": "More information or more communication does not eliminate fundamental absence of clarity and does not necessarily lead to better decision. Most often, it only heightens confusion."
Worse, while confusion - about the Fed's reaction function, about asset prices, about everything - is rampant and daytraders are no longer able to discount the future but merely react to flashing red headlines, something another credit giant, Citi's Matt King asserted three months ago, the Fed's "transparency" as a way of stabilizing the markets "has become a tool of suboptimal control, one that reinforces the future risk in order to diffuse it", Kocic claims: "it is a tactics of delaying, rather than reducing risk."
As a result of post-2008 regulatory changes and eight years of accommodation, there is currently more than $2tr of duration parked in mutual funds, not all of it very liquid. This is happening at the same time as regulatory restrictions are limiting dealers’ ability to extend liquidity in a way they used to.
Echoing what Martin said at the start of the month, Kocic then points out that "anything that would force a disorderly unwind of this trade presents the biggest tail risk" and the challenge of its managing requires creation and maintenance of the environment which ensures that:
- probability of unwind remains infinitesimal, and
- even if triggered, unwind cannot be realized.
Managing these two barriers is likely to remain one of the main objectives of any policy making, and is why despite the Fed's hawkish rhetoric, and the overall mode of global policy tightening, the moment even a mire risk flaring hiccup emerges, central banks will scramble back to square one to undo the threat that their artificial house of cards falls apart.
In this context of increasing fragility, how does central bank policy play out?
Predictable monetary policy and tightly controlled Fed exit, in general, defines the background against which everything else will play out. Fed is long an option to hike (or not to hike), depending on the market conditions and assessment of market’s reaction – they can expand their reaction function/mandate in such a way that it keeps smooth operation without raising the fear of tail risk. At the same time, Fed is running a risk of upsetting the markets and/or creating a perception of eroding confidence. Fed is short a “credibility” option – their actions have to be credible and the market must not challenge them. This “credibility” short has been the major source of volatility supply to the markets – the reason why, despite all the risk associated with policy unwind, carry trade and volatility selling remain dominant across a range of market sectors.
Ah yes, in spite of all its best intentions to dominate and "centrally-planned" the market, the insidious persistence of private players means that unless the Fed nationalizes the capital markets, something Japan is well on its way to do, vol risk will remain like a coiled spring, and the further away from value and vol equilibrium the Fed's "excessive transparency" pushes, the greater the fear - and threat - of an unprecedented snapback - think the market reaction of August 24, 2015, when ETFs failed to operate as designed for the first time and the VIX shut down as the market failed to make sense for a good 30 minutes... only on steroids. Also think, universal and indefinite market closures the moment the Fed's "credibility" option bluff is called. After all, nobody is getting out of this particular Hotel California alive.
It also means that the Fed is no longer capable of stepping away and letting risk clear on its own, as the outcome would be devastating. But what if the Fed - as some have suggested - no longer cares as much about the market?
Withdrawing that option, i.e. being less transparent, and less concerned about the market reaction, could raise the stakes and push vol levels higher. It would restore risk premia as it would represent an implicit withdrawal of convexity supply to the market. However, Fed’s transparency is the key factor for managing risk of their exit. It is unlikely that they would willingly give it up.
Finally, if the Fed won't step back voluntarily, what can force it to do so? According to Kocic, just two things:
We see inflation and deficit spending (releveraging) – anything that would cause a substantial bear steepening of the curve – as the only factors that could force Fed’s hand. Either one could create conditions where unwind of the Fed’s “credibility” short becomes inevitable. That would represent a withdrawal of convexity from the market and, as such, would be bullish for vol. Without either deficit spending or inflation, the market will be reluctant to take a longer view on the Fed. The most we can expect is repricing of the Fed path, rather than the long end. In the absence of indication that the range of long rates is likely to be violated, we do not expect to see anything but short rate adjustments. We see this as another side of Fed’s transparency.
And while there is much confusion about what the fate of inflation is, ironically within the Fed itself where as we reported yesterday in the context of chronically low core CPI, the NY Fed just "found" that inflation may in fact be the hottest since 2007, one thing that is certain is that deficit spending - with or without Trump - is coming, and it will make your head spin.
The only question is when will the market price it in. Then again, if the market is truly broken and can no longer discount the future, the unpleasant answer may be "never."