We kicked off the year with the warning to get imaginative. Volatility was going to rise, ranges would be broken, and we would see things we never thought we would see. The 10% drop in EUR/USD, violent removal of various currency regimes, and more flash crashes than you can shake a stick at would indicate that imagination has certainly been the quality to be in possession of this year.
And yet. How quickly we forget. The flash crashes can burn both ways: if you pile into the panic, its abrupt disappearance just hours later leaves you nursing a confusing loss. Volatility has shrunk just as fast as it has propagated. The disaster that was supposed to accompany China’s wobbles in the summer has thus far been averted. Much fewer headlines are being written in the current environment about how the Shanghai Composite is up 20% from its lows. Bear markets sell newspapers; bull markets not so much.
The frustration with this Bobby’s Dream world is bubbling over into central banks. They don’t know how worried they should be either. Mario Draghi looks like a superhero communicator compared to the Fed, but maybe that’s because he only has one mandate (price stability) whereas the Fed have two, plus now an explicit financial stability mandate to boot. Hence the flip flop from September to October, where a rate rise moved off the table only to come screaming back onto it. No wonder we are all confused. Take the speech last night from Stan Fischer on ‘The Transmission of Exchange Rate Changes to Output and Inflation‘. For a 10% appreciation in the US dollar:
‘The staff’s model indicates that the direct effects on GDP through net exports are large, with GDP falling over 1-1/2 percent below baseline after three years. Moreover, the effects materialize quite gradually, with over half of the adverse effects on GDP occurring at a horizon of more than a year.’
Here’s the impact on net exports:
Doesn’t look good, does it? Most of the impact comes after that first year. So we’re only just getting into the business end of the impact of the dollar’s strength on the US economy. And the Fed are about to hike?
Check out his conclusion:
“To wrap up, while the dollar’s appreciation and foreign weakness have been a sizable shock, the U.S. economy appears to be weathering them reasonably well, notwithstanding their large effects on certain sectors of the economy heavily exposed to international trade. Monetary policy has played a key role in achieving these outcomes through deferring liftoff relative to what was expected a little over a year ago”
So his argument now is that they’ve been dovish enough because they have already postponed their first hike, even as now it’s just around the corner. This is Tardis monetary policy. They’ll tell you about the easing after it’s happened!!
Blondemoney has attended a few roundtables recently, and the mood is certainly exhausted by this kind of confusion. The central banks don’t make sense; while the volatility of volatility is so high that markets don’t seem to make much sense. Perhaps unsurprisingly, as a consequence, positions are light. Yet not beaten. The mood appears to be that there will be a chance to get back into risk-positive trades on any kind of pullback. People still quite like many emerging markets, not least as they are cheap. People want to use the Euro as a funding currency. People think commodities remain stable, but both equities and bonds look expensive. People are not without views, just without conviction.
Yesterday saw the biggest downmove in the S&P for 7 weeks. That statistic looks quite frightening, until you find that the loss was -1.4%, which should make us all less afraid. It’s as if we are frightened of our own shadow.
Blondemoney is an optimist and would usually wholeheartedly debunk this lack of cojones. But the risks of an accident in such a febrile environment are increasing, particularly as we enter the less liquid period of the year. Bloomberg ran a story this morning about the reduction of liquidity on FX markets, the most liquid markets in the world, which contains this useful little chart about spreads widening:
Your imagination should now be spent on what might happen if the fundamentals fall out of the picture, due to being so uncertain, and liquidity becomes the dominant theme.