Six days after the VIX prints a multi-decade low, it then spikes up to the month’s highs in the course of just a day. The one day move was the 8th largest in its history. This then prompted much gnashing of teeth about market mayhem, as Brazil’s stock market and currency lost the best part of 10%, words such as ‘impeachment’ were bandied around, and the 10yr US rate came within a whisker of hitting the year’s lows.
So now what? What’s the driver? Well, there’s a few candidates…
Carry on carrying has been the motivation of markets ever since central banks forced it upon them. Never-ending cheap money was deliberately designed to pump up risky assets. It was designed to subdue volatility. It was designed to keep everyone in a safe space until the world was well enough to withdraw the methadone. That was all fine until….
Yes, The People intervened. It turned out this massive rally in risky assets benefited the asset rich, just as those most reliant on the state were told that they needed to pay the price for massive debts and bank bailouts. Years of austerity may have been designed to hurt everyone similarly, but the pain felt unequal. The rage exploded into unexpected political outcomes. That saw some big market moves, but then it all became fine when politics became too shouty and confusing to bother with…
- The Economy
Ah but it’s OK, because the global economy is back in action. Reflation is afoot, with China producer prices emerging from 5 years of deflation last September. The deflation demon has been slayed. So that’s all fine too then…?
We don’t know, do we, which of these we really are fine with. It’s tricky. We are now entering a volatile period as these themes fight it out for dominance.
The central banks are rowing back, aren’t they? Two Fed hikes in 4 months; the BOJ won’t let 10yr yields fall below zero; and the ECB are actively discussing when to discuss ending QE. Previously this caused a tantrum from the methadone-fuelled market, but now, as long as they take it easy, we don’t seem to care. This is because economies are improving, and also that their easy-does-it stance seems to have lulled everyone into not caring. Furthermore, the ongoing rally in the stock market, plus tighter credit spreads, keeps financial conditions accommodative. So, the tightening hasn’t really happened yet. Here’s US financial conditions – they’ve been getting easier ever since the Fed actually started hiking:
So the carry motivation remains strong. As long as the world isn’t volatile, right?
This has thrown a spanner in the predictability works for the last 12 months. But it’s Ok now, because all those pesky binary referendum/election events are over with aren’t they? Just the German election to get through, but the choice is Mutti Merkel versus the former President of the European Parliament, so no populism risks there eh? And in any case all these elections haven’t killed the markets or harmed their economies yet have they… so let’s just forget all about it.
Then the risk of the US President becoming embroiled in criminal proceedings springs up. Just as he could rip up or sign up to a trade deal in a heartbeat. Or trip up in diplomacy with China or North Korea. Those risks can’t be ignored. Meaning that future volatility is definite, but unpredictable. Even Bernanke (remember him?) commented earlier this week, ‘It puzzles me that markets are very blasé about political risk until the last minute’. It shouldn’t puzzle him. He more than anyone knows that the market is obsessed with quantifying risk and then parcelling it away. But political risk is not quantifiable. This leaves the Carry trade in a Schrodinger’s Cat of a quandary. If we can’t measure the political risk, does that mean it’s not there?
- The Economy
Even if we can’t get a handle on the conditions for the carry trade, can we at least agree on the underlying growth of the economy? For this, it’s worth checking out the US economic surprise index – which has been plunging in the past few weeks:
This leads to a debate over whether the Fed can really keep raising rates. Which leads to a question of whether carry can work. Which leads to a question of whether volatility can remain low. Which leads to a question of whether unquantifiable risks can be taken into account. Which leads to a question of whether the central banks can keep withdrawing stimulus…. And so on.
So for now, pick your poison:
- The economy is faltering – sell stocks, buy Tsys, risk neutral
- Politics is imploding – sell stocks, buy Tsys, risk off
- Volatility is low – buy stocks, sell Tsys, risk on
- Politics is irrelevant – buy stocks, sell Tsys, risk on
We are likely to try out all of these scenarios over the next few weeks as we break into a new framework for what is driving the market. Unfortunately that means the market will be fragile. Just as Cable suffered a big figure flash crash at random yesterday, we also saw the Dollar rally on a misinterpretation of a Comey video, and today the Taiwanese dollar gained over a percent on a simple restatement of the central bank’s currency policy.
In this world, don’t get wedded to anything.