Over and over, again and again, the same characterization of DM central banks gets recycled and presented by the folks with their finger on the pulse of markets.
Central banks, through asset purchases and, more recently, through forward guidance, are the “largest sellers of volatility in the market” – that’s the blunt version from BofAML’s Barnaby Martin, but there are more nuanced versions.
The two-way communication loop between central banks and markets represents the use of total transparency in the service of keeping things stable as policy unwind moves ahead, albeit at a snail’s pace and, critically, with the market’s implicit consent.
As Deutsche Bank’s Aleksandar Kocic wrote back in January, “after years of this dialogue, the markets have gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting.”
The short vol. trade, in all its various forms both explicit and implicit, is a manifestation of that binary option or, more to the point, of market participants making the only choice possible when the short-termism implicit in total transparency renders a long-term view well nigh impossible to take (even if you decide to adopt a longer-term view, that view entails foregone carry and worse, the burning of premium until your AUM evaporates).
Clearly, managing this situation is a delicate task for central banks. The normalization effort is a tightrope walk that entails ensuring the market doesn’t get the idea that it’s been cut out of the loop. Data dependency, in its strongest form, represents the breaking of the communication channel between central banks and market participants – the withdrawal of transparency.
On Monday morning for instance, the ECB’s Villeroy suggested that rate hikes will come “at least some quarters, but not years” following the official end of APP. He qualified that by attempting to ensure that the market would effectively be “consulted” as described above. To wit, from an interview with Bloomberg TV:
We will probably give additional guidance for the end of the year for the timing of the rate hike and the contingencies. We’ll see exactly how we formulate it. We’re predictable, and it’s a clear virtue of our gradual normalization path, but we are not precommitted.
The reference to “quarters but not years” put pressure on bunds, with 10Y yields rising above 60bps:
That underscores how tedious this is. Those comments led to a series of bearish trades. Here’s Bloomberg with the summary:
- Germany 10-year yields extended cheapening versus Treasuries following latest large block trade in bunds; demand for euribor downside protection in March 2020 options continued to surge following latest 50k blocks.
- 6,309 RXM8 blocked at 158.10, 4:24pm London time; joined earlier blocks of 5,984 and 5,123 for combined EU2.4m/DV01 over London afternoon session
- Demand for euribor put options continued to emerge; latest blocks see total 50k ERH0 99.50 puts for 6.5 and 7 (two separate blocks of 12k and 38k)
- Earlier, 50k block in ERH0 99.375 puts blocked at 4.5, part of 1×4 put spread structure with 12.5k ERH0 99.875 puts blocked at 16.5
You get the idea. And that’s a great setup for the latest from the above-mentioned Barnaby Martin from BofAML who, in a note dated Monday, writes that while “rising rates and tighter monetary policies is the new norm, central banks are embarking on this long journey [having] become more and more cognizant that higher ‘uncertainty’ and a volatility shock could be very damaging for the economy.”
That self awareness means that, to quote Martin again, “central banks remain the largest seller of vol in the market.”
Of course with the taper in Europe, forward guidance will need to supplant the flow of asset purchases as the main channel by which the ECB keeps a lid on rates vol. As you can see from the above, that can be tricky. It’s a “one false move” type of deal. Here’s BofAML:
So far, the ECB has managed to allow yields to move higher while suppressing volatility. Interestingly, even though yields have moved higher, rates vol has been anchored. Despite the recent spike, vol now sits back to the lows (chart 1). This is exactly what the ECB wants: a normalization of monetary policy while maintaining “price stability”. As Mario Draghi stated in the last ECB statement: “We continue to expect them (rates) to remain at their present levels for an extended period of time, and well past the horizon of our net asset purchases”. Forward guidance is now taking over from QE to keep vol low.
The read-through for the Fed is similar, although as detailed over the weekend, their task is complicated by a number of factors. The transparency from the Fed is most clearly evident in the extent to which rate hikes must be fully priced to go forward.
“Chart 2 shows that over the past ten rates decisions, the Fed always delivered what was expected (hike, or unchanged rates policy),” Martin goes on to write, adding that the June hike has been similarly telegraphed.
All of that goes a long way towards explaining how risk assets have managed to remain buoyant in the face of balance sheet rundown from the Fed, the ECB’s overt taper and the BoJ’s stealth taper which, you’re reminded, is part and parcel of YCC.
Here’s Martin on YCC in that context:
We have highlighted previously what a great example the BoJ yield targeting policy has been. Despite BoJ slowing down the pace of purchases since September 2016, rates vol has collapsed since then (chart 3). Yield targeting (another way to implement forward guidance) is achieving one major task: to dampen volatility by increasing substantially the certainty of the path of funding costs.
And so, the read-through here for credit (that’s Martin’s wheelhouse, so that’s where all of these notes end up), is that as long as rates vol. remains suppressed, so too can credit vol. remain low and spreads remain glued to multi-year tights despite the disappearing bullish technical from CSPP.
Of course there’s a problem with all of this. Excessive transparency creates a dynamic that optimizes around itself and facilitates myopia and short-termism. Horizons shrink and the trades that go along with that dynamic embed ever more tail risk into the system.
And on that note, we’ll leave you with another quote from Deutsche’s Kocic:
Transparency as a way of stabilizing the markets has become a tool of suboptimal control, one that reinforces the future risk in order to diffuse it — it is a tactics of delaying, rather than reducing risk. As a result of post-2008 regulatory changes and eight years of accommodation, there is currently more than $2tr of duration parked in mutual funds, not all of it very liquid. This is happening at the same time as regulatory restrictions are limiting dealers’ ability to extend liquidity in a way they used to. Anything that would force a disorderly unwind of this trade presents the biggest tail risk and the challenge of its managing requires creation and maintenance of the environment which ensures that: 1) probability of unwind remains infinitesimal, and 2) even if triggered, unwind cannot be realized. Managing these two barriers is likely to remain one of the main objectives of any policy making.