Since the Fed failed to taper, the market has taken another hit of the “lower for longer” drug that has been its comfort over the last 5 years. Volatility has fallen, stocks have rallied, yields are lower. The difference now is that we’ve seen what happens when it’s revealed the Emperor has no clothes, courtesy of the June taper-inspired wobble. So how does a market trade when it knows the cold turkey is coming? When it knows that the pain of that snap back-to-reality has just been made worse by another hit of the drug?
It ignores it.
Sure, there are lots of possible bad situations that could eventuate, but why worry until you need to? In fact, the Govt shutdown gave the perfect excuse to bury your head in the sand. “The Fed says it’s data-dependent? Well, the data for at least the next two months is unreliable, ergo irrelevant, so I don’t care”. And so, shut your eyes, do the “risk-on” thing, and push any concerns from your mind.
Except… last week the alleged risk-loving AUD and NZD were the worst performing major currencies while the low-yielding Euro went from strength to strength. It’s hardly a simple case of “Carry as King”. The trouble is that different parts of the market are prey to different kinds of flows, because overall conviction is low. One-off position adjustments dominate. CTAs can quickly run one way then the other in AUD/JPY, just as real money puts cash to work in Korea, and global asset allocation shifts money out of US equities into European ones.
What can we pick out of this jigsaw puzzle?
If there is any theme, it’s one that ML’s Michael Hartnett recently flagged: “The Fear of Liquidity”. Ride the free money wave – but with care. It’s not just that we know now what happens when the plug is pulled, but that its negative impact has been exacerbated by the Fed blinking. They have effectively mandated themselves to get behind the curve. So we feel uncomfortable with holding “risk-on” positions because the fat tail risk has in fact increased.
The trouble is, as ever, timing. Even buying options won’t save you, with implied vols cratering. The JPMG7 fx vol index is on the year’s lows at 7.6 (it hit 12 in June and was around 6 in 2007). The Vix is at 13.3 (vs. 10 pre-crisis). Even the potential threat of a US default, however small, couldn’t keep vols up for more than 24 hours. Investors have discovered that insurance is expensive, after trying to bet on Euro armageddon.
Wouldn’t it be ironic, after years of panicking about the ghost of Lehman past, that the moment the market became too tired to care was exactly when disaster struck?