In his latest weekend note, One River CIO Eric Peters discussed, among other topics, what he thought would be the nightmare scenario if not for the current, then certainly next Fed chairman: a world in which despite the Fed’s best intentions (and we use the term loosely), the Fed continued to hike rates without any perceptible increase in wages and thus, long-term inflation expectations. The result would be a failure to raise bond yields, which would provide further ammo for stocks to keep rising ever higher into what even the Fed tacitly admits is increasingly an asset bubble. This is how Peters described the ominous dynamic that would lead to major headaches for the next (and perhaps current, if Yellen remains in her spot) dynamic:
“Global profits are rising, unemployment is falling, growth is up” said the strategist. “Yet bond yields seem unable to jump.” US 10yr bond yields are 2.27%, Germany 0.40%, Japan 0.05%. “The cyclical surprise is that the Phillips curve finally kicks in, just as everyone gives in.” US unemployment is 4.2%, a 17yr low. Germany 3.6%, a 37yr low. Japan 2.8%, a 23yr low. “And the biggest structural surprise is that technology has rendered wage inflation a phenomenon for the history books.” “But if we don’t see a sustained cyclical jump in wages, then yields won’t go up. And if yields don’t go up, then the asset price ascent will accelerate,” continued the strategist. “Which will lead us into a 2018 that looks like what we had expected out of 2017; a war against inequality, a battle for Main Street at the expense of Wall Street, an Occupy Silicon Valley movement.” He paused, flipping through his calendar. “Then you’ll have this nightmare for the next Federal Reserve chief, because they’ll have to pop a bubble.”
Today, picking up on this divergence between rising short-term rates, and an inability – and unwillingness – of the long-end to reprice higher which continues to manifest itself in a flattening of the yield curve, where today the 2s10s pancaked to the lowest since the financial crisis…
… a move which continues to be ignored by markets…
… was Deutsche Bank’s derivatives strategist Aleksandar Kocic who confirms what Peters said, and argues that “for anything to happen, long rate has to move higher.” Taking a slightly different angle than Peters however, who focused on the structural deflationary forces which prevent the curve from steepening, Kocic frames a move higher in longer yields as one which underscores the trap the current (or future) Fed chairman is in: any notable steepening would be an indication of the Fed potentially losing control, or as Kocic puts it “possible missteps in monetary policy unwind” and a “disorderly unwind of the bond trade”, with the end result being an explosion in pent up volatility: “this is the risk that would be probably impossible to control, its trigger being either excessive deficit spending or inflation. “
As a result, Kocic writes that the Fed “has an uncomfortable (and complicated) task in this context: Fed needs to raise rates in order to prevent rates rise. What must not be, cannot be: Inflation cannot be allowed to develop because it would be no way of avoiding dramatic rise in rates. If the Fed embarks on aggressive hikes in order to fight inflation, rates would rise. If the Fed stays behind the curve, the market would bear steepen the curve. Either way, the long rates go up.”
Which, ironically, as Peters explained, is precisely what needs to happen to avoid the continued blowing of a massive equity bubble,or to summarize: the market finds itself in an increasingly unstable dysequilibrium in which on one hand the stock bubble grows ever bigger, while on the other, a normalization in equities is intimately linked to the Fed losing control of the yield curve. And, as Kocic has claimed on prior occasions, the ultimate catalyst that can trigger an end to this “metastable” market state is inflation. The outcome, in either case, would be explosive.
Here is Kocic:
With abundant liquidity, Fed transparency, and “predictable” political shocks, we have entered a regime of noisy status quo whereby the only temporary source of transient bid for gamma could be triggered by possible missteps in monetary policy unwind. However, even that seems to be relatively unlikely and, even if it happens, episodic at best. The largest, and possibly, the only risk capable of resetting the vol higher is the tail risk associated with bear steepening of the curve and disorderly unwind of the bond trade. This is the risk that would be probably impossible to control, its trigger being either excessive deficit spending or inflation.
It is precisely the severity of this problem that prevents return of volatility. Current monetary policy is focused on the management of the underlying tail risk and the Fed transparency and gradual hikes are all about the reduced maneuvering space that has remained after almost a decade of stimulus. Fed has an uncomfortable (and complicated) task in this context: Fed needs to raise rates in order to prevent rates rise. What must not be, cannot be: Inflation cannot be allowed to develop because it would be no way of avoiding dramatic rise in rates. If the Fed embarks on aggressive hikes in order to fight inflation, rates would rise. If the Fed stays behind the curve, the market would bear steepen the curve. Either way, the long rates go up.
Going back to the increasingly flatter curve, this is what Kocic defines as the “maneuvering space” left for the Fed. One look at the chart above confirms that said space is getting increasingly smaller. A flat, or worse – inverted – yield curve would imply game over. Here is Kocic again, who points out that the steepness of the curve is the “market’s playground”, in which “everything that can happen, has to happen inside this space”… a space which is curently a paltry 60 bps and shrinking every day:
The gap between the Short term rate expectations and the Long rate represents the remaining maneuvering space that the Fed has left. This gap defines the playground for the markets — everything that can happen, has to happen inside that space. This gap is narrow, currently at 60bp .
Mechanistically, this is logical, as the longer the current business cycle continues without a recession – and some immaculate increase in productivity and r-star – the flatter the curve become:
If the Fed has a long way to go into the cycle, the back end remains steep. However, as the hikes approach the final destination (the Long rate), the curve will continue to flatten reflecting the declining inflation expectations. These are pure mechanics of the Fed cycle. These stylized facts are illustrated in the Figure 14.
This is also a problem, because all else equal, the Fed has at most two more rate hikes before it loses control. In the interim, it somehow has to reprice both risk premia and vol higher… but without crashing equities, forcing a new easing cycle, which may include not only more QE but also NIRP:
“Given where long rates are, Fed appears as overly hawkish – it has only two more hikes to go and, for volatility and risk premia to reprice higher, the gap has to widen. As is appears unlikely that the Fed will be cutting rates any time soon, the gap could widen only if the Long rates sell off.”
And, as noted above, “for anything to happen, 5Y5Y sector has to move higher”, however the $6.4 trillion question is whether this sell off in long rates will be violent or controlled. As Kocic concludes, “This is the catalyst for everything.”