For the first time in a long time, geopolitics actually will matter beyond one news cycle.
That's from former trader Richard Breslow, who writes a daily column for Bloomberg. Specifically, it's from his Friday missive.
I don't know whether he's right or wrong, but what I do know is that his rationale for making that prediction makes sense if you accept his premise which is this:
Way too much ink has been spilled on the subject of central bank puts. Even as I readily stipulate that it has been a guiding force for markets for years. But it has morphed over time from a realization that emergency liquidity will always be there in a pinch to an inexorable flood that you could set your watch by. Sadly enough, commentators are confusing gradualism with dovishness. That’s a mistake.
To be sure, Breslow has been making this argument (or some derivation thereof) for months. Since Sintra (and for the uninitiated, Sintra refers to the forum on central banking that took place in Portugal over the summer) when Mario Draghi kicked off what amounted to a hawkish procession and triggered a mini-rates tantrum by suggesting the ECB was prepared to look through "transitory" downward pressure on inflation, it's been clear that policymakers are keen on making a serious run at normalization. This has been most clearly manifested in the Fed sticking to its guns on the December hike despite still subdued inflation, the BoE hiking in November, and notably, the BoC surprising the market with two consecutive hikes in July and September.
Of course, the idea here is to effectively manage the risk of the exit not only by taking a gradualistic approach, but by preserving the implicit arrangement that effectively allows the market to vote "no" on further tightening, simply by selling off in response to this or that trial balloon floated by policymakers.
As I've discussed previously, the effect of this arrangement is the buildup of risk. Think of it as the snowfall that accumulates prior to an avalanche. On the surface things seem stable, but they are not. In the market context, the accumulation of risk takes the form of what JPMorgan's (JPM) Marko Kolanovic has called "quantitative exuberance" which he described recently as follows:
We think that for the next market crisis, irrational exuberance in the ‘tech bubble’ sense is not needed. The reason is the prevalence of quantitative and passive strategies that don’t decide based on emotions, but rather based on measures such as the level of interest rates, volatility, price momentum, or bond-equity correlation. Examples of these strategies include Volatility Targeting, Low Volatility strategies, Trend Following strategies, Risk Parity strategies, Dynamical hedging strategies, Volatility selling strategies, and others. In addition, there are relative value strategies that transmit risk premia compression across asset classes and strategies.
The question is what triggers a volatility spike (VXX) that is large enough and sustainable enough to cause an unwind. Put differently, where is the skier whose scream creates the avalanche? Where is the boy in the crowd from "The Emperor's New Clothes"?
Think about the excerpts from Breslow above in the context of Kolanovic's 2018 outlook for volatility. Here's the summary from JPMorgan's full year-ahead piece:
VIX to average ~13-14 in 2018. Higher volatility forecast based on rates cycle, G4 CB balance sheet reversal creating demand-supply imbalance, geopolitical risks, and increasing role of systematic strategies in markets.
That's what Breslow is hinting at in the piece excerpted here at the outset. A hike is a hike. A taper is a taper. Hikes and tapers are only "dovish" relative to expectations and those expectations are inherently subjective. When Breslow talks about mistaking gradualism for dovishness, he is referring to the tendency for markets to effectively pretend as though G4 CB balance sheet reversal and higher rates are somehow not what they are just because policymakers are not moving ahead too aggressively. The assumption is that the combination of still subdued inflation and the two-way communication loop with markets will ensure that policymakers are pre-emptive as opposed to reactionary. Here's Breslow again:
In the good old days something bad had to happen first before the rescue team was mobilized. Not so in the world of trickle down. But if there’s one thing we should have realized by now is, we are slowly, gradually, hesitatingly moving back to that earlier paradigm.
But here's the thing. That's only true to the extent the market believes it to be true. That is, the central bank "put" became self-fulfilling long ago. Breslow is describing the very dynamic that undercuts his thesis. He is asserting that the market can no longer differentiate between gradualism and outright dovishness, but if he's right, then his prediction cannot come to pass. Have a look at this chart:
Note the blue arrow and the annotation that accompanies it. Confidence in the policymaker "put" has become so deeply ingrained in the market psyche that it now runs on autopilot. In order to break that spell, central banks would need to fail to respond to a shock. But that's the paradox. Exogenous shocks can happen, but as long as the market is confident that it retains its role as a co-author of the policy narrative, those exogenous shocks will not translate to a sustained spike in volatility. Here's the bottom line: if you firmly believe that a selloff (SPY) would immediately engender a policy response (e.g. jawboning or in an extreme case, the postponing of a taper), why would you not go ahead and buy the dip or re-engage in vol. selling? Why wait around for a policy response you know is coming? That's how the central bank "put" became self-fulfilling.
Given that, there's a certain extent to which Breslow cannot be correct. It will take a policy shock not an exogenous geopolitical shock to break the spell. Markets must be given a reason to doubt central banks. Forward guidance and transparency on the future pace of asset purchases are designed specifically to foster trust. This is why rate hikes and taper decisions are almost always completely priced in by markets by the time they're announced.
This is why a sudden upturn in DM inflation is so dangerous. It would effectively force an endogenous shock (i.e., a policy shock) by compelling central banks to tighten without the market's "permission." That would amount to canceling the market's license to co-author the policy script which would in turn lead immediately to a spike in rates vol.
Another thing to consider is the extent to which the near constant barrage of minor political shocks has had the effect of dampening vol. by fostering dissensus. Here are the two charts everyone loves to hate:
So obviously that's economic policy uncertainty on the left and geopolitical risk on the right, both plotted against S&P 12-month vol. The disconnects we're seeing currently aren't entirely unprecedented, but what's becoming clear is that it will soon cease to make sense to plot these measures of uncertainty on the same chart as market-based measures of volatility.
Practically every week, there is a new issue that eclipses the previous one, and we lose interest in past issues, before there is any semblance of resolution. But shocks, if they are predictable, lose their spell and gradually become facts of life. Predictable political shocks feed back into their source. Due to their antagonistic character, they gradually erode the ability to make consensus.
What does one do when no consensus can be formed? Well, one waits. The selling of volatility (XIV) amounts to the monetization of that time spent waiting. As vol. sellers re-engage, dealers who take the other side of the trade hedge, thus reinforcing local stability. In the context of political shocks, we have thus moved into a dissensus-driven vol.-selling regime.
Ultimately, you cannot disentangle political outcomes from markets. That premise is part and parcel of the whole Heisenberg raison d'être. But the interplay between the two is much more complex than the fleeting knee-jerk reactions you get around this or that headline.
Coming full circle, is Breslow correct to say that geopolitics will matter beyond one news cycle? I doubt it. For all of the reasons spelled out above.
One final note: if a geopolitical risk important enough to destabilize markets irrespective of everything said above does come calling, Breslow's contention won't apply. After all, inherent in the idea of geopolitical headlines only mattering for "one news cycle" is the notion that something else comes along that's more critical.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.