Two weeks after Aleksandar Kocic highlighted the moment in 2012 when the market stopped caring about newsflow and reality, and, in a word “broke” with pervasive complacency setting in regardless of macro uncertainty…
… Deutsche Bank’s post modernist master of stream-of-consciousness narrative is back with a new essay dissecting his favorite topic, the interplay between the Fed and markets, the so-called “umbilical limbo” that connects the two in the form of ultraeasy monetary policy and QE in general, and more importantly, the narrative that the Fed has spun over the past ten years, which while supportive of risk assets, has concurrently resulted in what Kocic calls a “permanent state of exception” from normalcy as a result of the Fed decision to defer the financial crisis indefinitely.
It is the unwind of this exceptional state, created symbiotically between the Federal Reserve and the markets, that is the source of consternation for markets, and manifests itself in the upcoming “tricky” renormalization of both the global rate structure, and the unwind of central banks’ balance sheets and trillions in monetary stimulus. And, quick to revert to his favorite philosophical abstraction, Kocic notes that more than anything the Fed is hardly eager to “disown” the power it has been exercising for years in its attempt to avoid, or at least delay the next crisis:
The Fed (and central banks in general) carries an implicit responsibility for orderly re-emancipation of the markets, which makes stimulus unwind especially tricky. This highlights the deep dichotomy of power: While a state of exception is an exercise of power, there is a clear tendency to disown that power. And the only way to avoid facing the underlying dilemma is to never give up the power. This creates a new status quo — a permanent state of exception.
In practical terms, this confirms what we have been warning about for years, namely that the Fed is increasingly “acting as a non-economic actor” – and a price-indescriminate one at that – whose “communications with the markets (“removal of the fourth wall”), excessive accommodation, unconditional support for risk, convexity supply to the market, etc. in place, its role is aimed more and more at achieving “social” and not necessarily financial goals.”
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In some ways, this was to be expected at a time when the traditional defender of social goal, key among them stability – the government – is increasingly unable to perform its duties due to a record and growing ideological chasm between the left and right, which has forced the Fed to resort to preserving the social order through the only “monetary channel” under its control: pushing asset prices to ever higher nosebleed levels, in hopes of boosting the confidence of the general public that “all is well, just look at the S&P“, a trope most recently adopted by none other than Donald Trump.
At its simplest, this boils down to merely perpetuating the capital markets’ status quo, or as Kocic calls it “Monetary policy continues to be supportive for stocks, bonds and USD at the same time.”
This has been a radical departure from traditional relationships across different assets (in the long run, the two can only rally if the third one sells off). These correlations are the gift to the market. In the past years, owners of US risk assets and bonds (as a “hedge”) have been enjoying persistent positive externalities allowing them to make money on both stocks (the underlying) and bonds (the “hedge”).
To market participants who observe the lack of solid economic growth coupled with a global market cap that just hit a new all time high, this divergence creates a sense of deep confusion, yet one which few are willing, or able, to challenge in keeping with the mantra of “don’t fight the Fed.”
Still, problems are increasingly emerging, most recently from Bank of America, which in a note yesterday urged the Fed to finally “take that punch bowl away”…
… and warning that the longer the Fed’s status quo persists, the greater the risk of a violent renormalization, i.e., crash.
If we are wrong and central banks do not take away the punch bowl, things will get much messier eventually. “Bubbles” may form that will eventually burst, leading to much higher volatility than necessary. Keeping rates low in response to persistent positive supply shocks that keep inflation low could lead to imbalances, with a painful eventual correction. Central banks did this mistake before the global crisis and kept monetary policies too loose as inflation was low, ignoring very easy financial conditions, excessive and sometimes irresponsible credit expansion and a housing price bubble. We do not believe, or at least we hope, they will not repeat the same mistake twice.
Amusingly, BofA was hopeful that central banks had learned their lesson from “making this mistake before the global crisis” adding that “we do not believe, or at least we hope, they will not repeat the same mistake twice.” And yet, last week’s events cast significant doubt on this “hope.”
There are other problems with perpetuating a “permanent state of exception”,not least among them the fact that the market will remain broken via an “indefinite suspension of traditional market exchange” which also means that the Fed must reinforce its control over risk prices every day through a “continuous uninterrupted exercise of power.”
In essence, it is all about diluting the possible downside of stimulus unwind — an attempt to have an option to obfuscate without losing one’s credibility. With traditional market rules and relationships breaking down, central banks appear to be chasing the illusive target, which means that victory and the final goal are not well defined, which in turn insures the persistence of the “battle” and indefinite continuation of the state of exception. This implies indefinite suspension of traditional market exchange, which means continuous uninterrupted exercise of power that must be won every day.
Kocic previously touched on this topic, calling it a state of market “metastability“, in which the “persistence of low volatility causes misallocation of capital. This is how complacency leads to buildup of risk – it is the avalanche waiting to happen.”