Progress Opaque

Poor Mario can’t catch a break

Despite all his efforts to slake

The scourge of deflation

The last iteration

Of data showed progress opaque


It was a wild and wooly session in equity markets yesterday, with a significant divergence between tech stocks and the rest of the market. Meanwhile, Bitcoin exploded to new heights above $11k before tumbling more than 20%. I mention these to start because a pattern of increased volatility in markets is becoming far more obvious, and I am quite confident if this is the case, volatility in the FX market will be rising as well.

One of the hallmarks of the post crisis era, beginning sometime in mid-2009, was the extraordinary decline in the volatility of asset prices. This was caused by the extraordinary monetary policy decisions that expanded central bank balance sheets by some $15 trillion during that period. In fact, this was the explicit goal of the central banks.

Ben Bernanke explained it thusly in Jackson Hole in 2012, “In using the Federal Reserve’s balance sheet as a tool for achieving its mandated objectives of maximum employment and price stability, the FOMC has focused on the acquisition of longer-term securities–specifically, Treasury and agency securities, which are the principal types of securities that the Federal Reserve is permitted to buy under the Federal Reserve Act.  One mechanism through which such purchases are believed to affect the economy is the so-called portfolio balance channel, which is based on the ideas of a number of well-known monetary economists, including James Tobin, Milton Friedman, Franco Modigliani, Karl Brunner, and Allan Meltzer. The key premise underlying this channel is that, for a variety of reasons, different classes of financial assets are not perfect substitutes in investors’ portfolios. For example, some institutional investors face regulatory restrictions on the types of securities they can hold, retail investors may be reluctant to hold certain types of assets because of high transactions or information costs, and some assets have risk characteristics that are difficult or costly to hedge.”

So in essence, the Fed bought a lot of Treasuries and MBS forcing other investors to buy other assets, driving their prices inexorably higher.   And as long as the Fed reinvested the proceeds from maturing bonds, which they did assiduously until just last month, those assets remained unavailable to other investors. Guess what? All asset prices rose during this period, not just financials, but real estate, collectibles, and even virtual assets. And since the central bank bid was always there, fear of asset price declines disappeared. All told, if you were seeking to reduce volatility in markets, there was no better way to do so than to flood them with excess liquidity.

But now the Fed is turning the ship, reducing its reinvestment of maturing bonds and raising rates simultaneously. The ECB is on the cusp of reducing its purchases and we have seen higher rates in the UK and Canada as well. I assure you, we will be seeing much more volatility going forward as this process continues. After all, there is no way that the expansion of central bank balance sheets can do so many things while their contraction, however slowly, will not reverse those same effects, no matter what they say.

Now back to the headline. Despite Signor Draghi’s best efforts, Eurozone CPI printed at a lower than expected 1.5% with a core reading at 0.9%. This is clearly not the outcome that the ECB was seeking as not only does it draw them slightly further away from their goals, but also it puts their recent decision to begin the tapering under more pressure. The market’s initial reaction was a quick selloff of 0.3% in the euro, but since the release, we have essentially clawed back those losses. The thing is, the dollar is actually having a pretty good day overall, with only the British pound showing any strength vs. the greenback this morning amongst G10 currencies. The dollar strength seems to be predicated on several things; economic data continues to perform well; anticipation of a tax package passing Congress is growing thus boosting the economy further; and the idea that the Fed will respond to the continued growth with tighter policy. Quite frankly, it makes a lot of sense. To my mind, there is one other feature, the idea that if my opening monologue on increasing volatility is correct, then with the shedding of risk will come demand for dollars too.

A quick look at the pound, which has rallied another 0.4% this morning, shows that ongoing positive press about the prospects of a Brexit deal are causing the speculative elements in the FX market to unwind short positions in the pound. This is evident not only in the spot market, but also in the change in relative option prices for both puts and calls, with puts suddenly under significant pressure. After all, if you no are longer worried about the pound collapsing, why would you buy protection against such? This may have further to run for now. Longer term, however, I continue to believe that the pound will suffer, but if a deal is agreed, it may take a while for that to happen.

In the EMG space, KRW was the big loser, down 1.0% overnight despite the fact that the BOK raised rates by 25bps. There was one dissenting vote on the committee, so perhaps that was deemed to be the negative. More likely, however, given the won’s 4% appreciation in the past two weeks, this was simply a case of selling the news after all of those folks bought the rumor. But otherwise, even this space has been uninteresting. There are far more losers than winners, but I am hard pressed to find a critical story to discuss.

On the data front, yesterday saw GDP revised even higher than expected, up to 3.3%, the best quarterly print since Q3 2014, which undoubtedly helped push Treasury prices lower on the day. It also highlighted the schizophrenia in equities as the Dow made new record highs while the NASDAQ fell more than 1%. Today brings a raft of important data as follows: Initial Claims (exp 240K); Personal Income (0.3%); Personal Spending (0.3%); the Fed’s favorite PCE Core Deflator (1.4%); and Chicago PMI (63.0). There was also a story out this morning that the CBO claims that the US economy is now growing at ‘full potential’ for the first time since 2007. What that says is the Fed is not going to slow down its policy direction any time soon, so higher rates and a smaller Fed balance sheet are in our future. As I pointed out above, it was the growth in the balance sheet along with ZIRP that led to the current asset valuations. Things are going to change, and the dollar is going to be a big beneficiary of this going forward!


Good luck