One of the peculiarities of the prevailing market environment is that when political shocks become predictable (e.g. when the news cycle becomes so manic that everyone accepts it as likely that what was “news” on Friday, won’t be “news” on Monday thanks to some new “bombshell” which will almost invariably come calling), ostensibly destabilizing events lose their ability to destabilize due to the rapidity with which they occur. “#Shitholegate” only matters until we find out that Trump tried to fire Robert Mueller. And that only matters until we find out that Trump wants Rod Rosenstein gone. And on, and on.
Ultimately, this results in gridlock. It’s a rolling political crisis. At best, it means legislation will be an uphill battle and will proceed only at a snail’s pace. At worst, it means paralysis that finds expression in perpetual can-kicking like we saw in the U.S. last week. Impasses are never resolved. The best we can hope for is that everyone agrees to disagree until next month. That’s what a continuing resolution is.
For market participants, this has to be viewed in the context of central bank policy. To the extent the unwind of monetary accommodation is possible at all, that effort is complicated by political gridlock. Central banks do not want to risk abandoning markets (i.e. withdrawing transparency or otherwise severing the reflexive relationship that effectively allows market participants to have a say in the evolution of policy) at a time when political uncertainty is high.
Thus, rolling political crises paradoxically become a reason to sell vol. As Deutsche Bank’s Aleksandar Kocic put it last year, this is a “dissensus-driven vol. selling regime.”
Think about the events that transpired last week in the context of that framework. Donald Trump’s efforts to make good on his promise to protect domestic industries and the accompanying weak dollar rhetoric from Steve Mnuchin created still more uncertainty on the geopolitical front.
Thanks to the direct FX link, the feedback into monetary policy operated differently than it normally does. Over the last two years, political uncertainty was blunted by the implicit policymaker “put”. Markets have been conditioned to believe that aggressively dovish forward guidance is but one sustained vol. spike away. So why bother selling risk assets in the first place? In that respect, the policymaker “put” was operating on autopilot.
Last Wednesday, this was turned on its head. When the policymaker “put” is operating on autopilot, it essentially means that by virtue of the transparency with which they operate, central banks are perpetually ahead of the curve in terms of heading off risk-off episodes. The relationship with markets is reflexive, but rarely do central banks find themselves having to respond precisely because markets have learned to expect that response. That expectation means markets can ignore adverse events.
Last week, markets (FX in this case) had no choice but to react because this time around, political uncertainty manifested itself in an explicit attempt to move the dollar. By virtue of coming in the same week as the ECB press conference (and also just a day after the BoJ meeting), we got to watch in real time as the dynamic was reversed. Draghi was forced to respond to events in markets and generally speaking, he failed. His rhetoric on euro strength amounted to bringing a knife to a gunfight considering the gravity of the U.S. Treasury Secretary saying the words “weak”, “dollar”, and “trade” out loud, in front of people with working ears.
Effectively, Mnuchin’s comments sent the ECB and the BoJ back to the proverbial drawing board when it comes to policy normalization. They were already staring down unpalatable euro and yen strength (respectively) and it was already the case that any perceived hawkish lean was likely to exacerbate the situation. As my friend Kevin Muir detailed in his Monday note, the policymaker paradox in a world where everyone is sitting on bloated balance sheets and ultra-low rates is as follows: any attempt to capitalize off the “success” of those policies (where “success” means a sustained upturn in growth and signs of progress on the inflation front) by moving to normalize will immediately result in FX appreciation as the market tries to price in your tightening relative to everyone else persisting in accommodation. That FX strength imperils your progress on growth and inflation. If the currency appreciation that invariably accompanies policy normalization starts showing up in slower growth and, more importantly, disinflation, well then you’ve got to go back to easing.
This is an inescapable loop in a world full of bloated central bank balance sheets. It’s far easier to coordinate a plunge into accommodative policies across disparate economies than it is to coordinate the exit.
So, what you saw last week was very interesting. It was a twist on a familiar dynamic. Political uncertainty created dissensus which, under “normal” (where “normal” actually means the “new normal” or, “the post-crisis world”) circumstances, would be ignored on the assumption that dovish forward guidance to allay market fears was a foregone conclusion. But in this case, the ECB and the BoJ have seemingly been forced into a situation where the pace of normalization will have to slow if the U.S. pushes the envelope on a weaker dollar.
Of course to the extent a weaker dollar does indeed force Draghi and Kuroda to rethink their normalization plans, it entails persisting in accommodation for longer and thus represents the very same dynamic described here at the outset: a political shock making it impossible for anyone to make consensus, thus perpetuating the prevailing dynamic characterized as it is by a seemingly endless exercise in moving the goalposts when it comes to deciding when to normalize policy.
That, in turn, greenlights vol. selling, yield seeking, and carry trades. Unless…
Unless the only thing that can break this spell and force central banks to withdraw transparency comes calling. That “thing” is inflation. This morning, 10Y yields in the U.S. hit their highest since April of 2014.