Tuesday, February 2, 2016


"The Fed Suspended The Laws Of The Market In Order To Save It" - What Happens Next

That the Fed has been boxed in by unleashing destructive monetary policies to "fix" decades of prior policy mistakes, is starting to be understood very clearly by most. With each passing day the Fed and its central bank peers pile up error upon error  to offset prior mistakes, the day is fast approaching when this latest bubble, which some have dubbed the "central banks all-in" bubble, will burst as well: Friday's shocking announcement of NIRP by the BOJ just brought the world one step closer to the next monetary induced catastrophe.

However, the one saving grace for the central banks was that as long as none of the market participants who benefited from these flawed policies dared to open their mouths and point out that the emperor is naked, nobody really cared: after all, why spoil the party, especially since virtually nobody outside of finance knows, let alone cares, about monetary policy or why the Fed is the most important institution in the world. Quickly headed towards being the most impotent institution.

All of that has changed in recent weeks, when just one week ago in the aftermath of the Fed's dovish quasi-relent, the billionaires in Davos were quite clear that in light of the upcoming bursting of the latest "policy error" bubble by the central banks, "The Only Winning Move Is Not To Play The Game." As the WSJ summarized the Davos participants' mood so well, "their mood here was irritated, bordering on affronted, with what they say has been central-bank intervention that has gone on for far too long."

There is just one problem: in a world addicted and supported by central bank intervention, 
central bank intervention simply can not go away. Exhibit A: NIRP in Japan.

To be sure, it has become the consensus view that central banks are trapped, with further intervention no longer beneficial and yet unable to relent; over this past weekend, this perspective was best summarized by Deutsche Bank's credit derivatives strategist, Aleksandar Kocic, who writes that the Fed had to "suspend the laws of the market in order to save it." He also adds that the market was not saved, and all the risk that piled up and was swept under the carpet courtesy of the Fed, is merely waiting for the outlet to be released in one risk explosion.

Here is the full note previewing what the Fed hath wrought.

Beyond the fourth wall

It has been our contention for some time that when it comes to interaction between the Fed and the markets, the rules of the game have changed. There are two dimensions of this problem. One is the Fed/market communication and dynamic have been both transformed to resemble the Brechtian theatre where the fourth wall has been removed. The market is observing the Fed and the Fed is observing the market -- the "audience" is actively involved in shaping the play. The actors look for clues from the audience and shape the script according to audience's reaction. They are not merely passive spectator, but involved observers able to influence the play. The most explicit recognition of this has been the September FOMC. This type of circular reaction has been a consequence of the Fed assuming the role of a market stabilizer post-2008. However, as the stimulus is unwound, this type of interactive play will continue (this time in reverse) and stability of the markets could be compromised.

The other dimension concerns the particulars of stimulus implementation. Policy response to the crisis consisted of unprecedented injection of liquidity, transfer of risk from private to public balance sheet, and reduction of volatility from its toxic levels. The net result was near-zero rate levels and collapse of volatility across the board, while different market sectors developed high degree of coordination. But, risk cannot disappear; it can only be transferred or postponed by temporarily suspending the existing transmission mechanisms and the rules of the markets.

During QE days, the Fed has acted as a non-economic actor. Its presence in the market was aimed at achieving "social" and not necessarily financial goals – bond purchasing was conducted in order to lower the yields rather than to make profit over any given time horizon. Markets laws had to be suspended in order to restore normal functioning of the markets. This was the intrinsic logic of QE.

As such, policy response in its core is an extension of what in political context is known as the state of exception. The intrinsic contradiction of policy response to the crisis – suspend the laws of the market in order to save it – is resolved only by understanding that suspension is temporary. Stimulus will have to be unwound. But, and here lies the problem, accommodation has been in place for a very long time and this has had a profound impact on investors behavior, market functioning and its dynamics.

At the moment, consensus is shaping around the view that the market is driving the "play" by demanding relent, suggesting the implication that stimulus withdrawal has been premature. Lack of relent, without improvements in Asia and global economy is a policy mistake. The Fed is hiking, while it is importing disinflation. The curve would continue to flatten while persistence of rate hikes supports USD and pushes the short end of the curve higher. This is unlikely to be supportive for risk and should cause higher risk asset vol. Continued decoupling and EM dilemma regarding the tradeoff between weaker currency and growth is likely to keep FX vol at elevated levels as well.

Relent is supportive for risk and would mean return to carry trade in rates, while decoupling is no longer an issue and tensions in currency space and EM are no longer acute. This means lower vol across the board.

As a consequence of this landscape, three themes would dominate the near term: Policy mistake, negative rates and risk assets range.

In the background of all this looms the risk of massive, one time, devaluation by China and possibly the entire region which could cause a significant repricing across the board and further destabilize global markets in the near term. THIS IS A VERY REAL AND GROWING THREAT! 

Which brings us to the supreme irony: only a Fed which admits it has lost all credibility can "save" financial markets. However, since by definition its credibility would be henceforth lost, this would also be the final intervention that the Fed could engage in without proceeding to the next and final state of play: paradropping money in hopes of unleashing (hyper)inflation, as the opportunity cost to preserving credibility will, at that point, be zero.   WE ARE VERY NEAR THE END OF THIS ERA, IT WILL NOT BE LONG UNTIL THE MARKET FORCES THE HAND OF CENTRAL BANKS.

And since important market participants now have the courage to admit that "the Fed emperor is naked", it is only a matter of time before the Fed has to decide: either welcome the crash, or relent and do everything in its power through policy to unleash the animal spirits one final time. AS I SAID ABOVE, 

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