There is a reason why those calling for a crash, or even a market correction in the past decade, have been carted out feet first: central banks, and noweher was this more obvious than the shocking aftermath of Brexit. The UK’s Brexit vote (Jun-16) marked the point when the buy-the-dip trade became a self-fulfilling put, according to a new analysis by Bank of America.
However the buying did not develop on its own: "From the taper tantrum in 2013 through the Aug-15 China devaluation shock when Yellen decided not to raise rates due to “weak equities” (which were only down just over 10% from life-highs) the Fed consistently (even if only verbally) supported markets during stress."
At that point the "buy the dip" Pavolovian reflex was so strong, central banks could dit back and watch: sure enough, when in early 2016 Yellen suggested the Fed may need to move more “cautiously” because of the risk of Brexit, once Brexit happened, the market rebounded so quickly (3 days) it did not need to step in. From that point forward, dips have only become shallower as investors compete for “dip alpha”.
Or as BofA summarizes, "In every major market shock since the 2013 Taper Tantrum, central banks have stepped in (even if verbally) to protect markets. Following the Brexitvote, markets no longer needed to hear from CBs as they rebounded so quickly that CBs didn’t need to respond. Buy-the-dip has a become a self-fulfilling put"
This brings up two interesting observations: i) the Fed put is falling with rising rates, and ii) paradoxically the market needs a shock to discover what the new "strike price" is, yet this is impossible due to BTDers stepping in assuming the Fed backstop. BofA explains:
The Fed put strike is falling with rising rates even if markets don’t realize it. As our Head of Global Economics, Ethan Harris, has pointed out, sitting at the lower bound in rates put the Fed in risk-management mode, meaning they had to be ultrasensitive to the risk of making a policy mistake as they had no traditional ammunition to fight a potential downturn. But as the Fed gradually increases rates, and with markets seemingly unconcerned, they will inherently become less sensitive to risk. In other words, the Fed put strike is falling both because the Fed is rebuilding ammunition, and because it recognizes that markets can better stand on their own. Of course surprise inflation remains the real killer as it would effectively handcuff the Fed from providing a high strike put, and will require much higher stress before they can step in.
However, we still need to see a shock to know where the Fed put strike is. Just because the Fed put strike is falling with rising rates doesn’t mean markets will recognize it until there is a shock of sufficient magnitude to test it. And while Powell is believed to have a largely similar policy stance as Yellen, until we see how he (and his new committee) react to financial stress, it’s hard to know exactly where the Fed put strike sits. This fact, along with the uncertainty of when we see a sufficient shock to test the Fed, makes calling an end to this environment difficult. For example, in 2017 the strong buy-the-dip mentality, and arguably solid fundamentals, prevented the Fed from being tested.
Meanwhile, in a world without market shocks, vol continues to decline, forcing even more vol-selling in a self-reinforcing feedback loop as Citi showed yesterday.
Bank of America has a slightly different representation of the various low-vol feedback loops currently active in the market:
So does this mean that the status quo continues? BofA believes the answer is yes, and "there is a clear risk that the 2017 low vol environment carries on through 2018, which is more likely if inflation were to fail to rise, prolonging the current goldilocks period. The Fed could continue to slowly plod along with hikes, and absent a sufficient exogenous shock, the market may maintain full faith that they could pause (or cut) if needed. In this case equities would again generate exceptional Sharpe ratios, beating almost any other asset, as we saw this year. As US equities recorded nearly their highest Sharpe in history this year (the Dow Jones Industrials recorded a Sharpe of 4, 99th %-ile since 1935), the chance of this repeating yet again may be lower than some expect."
Aside from inflation, however, there is one other risk to breaking the goldilocks regime: other central banks, and the extensively discussed inflection point in mid-late 2018/early 2019 when liquidity injections by all central banks fade out, and eventually become a drain of liquidity.
While the Fed is closest to normalizing policy and has been among the largest contributors to the moral hazard injected into markets, the ECB and BOJ still matter. We project G4 balance sheets will finally peak and begin to decline in Q1 ‘18 (Chart 8), another key inflection point in the global QE story. However, the more important question is whether QE remains effective at suppressing volatility. While it’s a slow moving risk, we have noted that since 2016 more QE in Japan and Europe have not dampened vol as they had previously but in some cases (e.g. when Kuroda went to negative rates in Jan-16) actually resulted in higher volatility. This is a key reason we continue to like owning Japanese vol, as you can own QE failure risk with positive carry.