Two weeks after Aleksandar Kocic highlighted the moment in 2012 when the market stopped caring about newsflow and reality, and, in a word "broke" with pervasive complacency setting in regardless of macro uncertainty...

... Deutsche Bank's post modernist master of stream-of-consciousness narrative is back with a new essay dissecting his favorite topic, the interplay between the Fed and markets, the so-called "umbilical limbo" that connects the two in the form of ultraeasy monetary policy and QE in general, and more importantly, the narrative that the Fed has spun over the past ten years, which while supportive of risk assets, has concurrently resulted in what Kocic calls a "permanent state of exception" from normalcy as a result of the Fed decision to defer the financial crisis indefinitely.

It is the unwind of this exceptional state, created symbiotically between the Federal Reserve and the markets, that is the source of consternation for markets, and manifests itself in the upcoming "tricky" renormalization of both the global rate structure, and the unwind of central banks' balance sheets and trillions in monetary stimulus. And, quick to revert to his favorite philosophical abstraction, Kocic notes that more than anything the Fed is hardly eager to "disown" the power it has been exercising for years in its attempt to avoid, or at least delay the next crisis:

The Fed (and central banks in general) carries an implicit responsibility for orderly re-emancipation of the markets, which makes stimulus unwind especially tricky. This highlights the deep dichotomy of power: While a state of exception is an exercise of power, there is a clear tendency to disown that power. And the only way to avoid facing the underlying dilemma is to never give up the power. This creates a new status quo -- a permanent state of exception.

In practical terms, this confirms what we have been warning about for years, namely that the Fed is increasingly "acting as a non-economic actor" - and a price-indescriminate one at that - whose "communications with the markets (“removal of the fourth wall”), excessive accommodation, unconditional support for risk, convexity supply to the market, etc. in place, its role is aimed more and more at achieving “social” and not necessarily financial goals."

In some ways, this was to be expected at a time when the traditional defender of social goal, key among them stability - the government - is increasingly unable to perform its duties due to a record and growing ideological chasm between the left and right, which has forced the Fed to resort to preserving the social order through the only "monetary channel" under its control: pushing asset prices to ever higher nosebleed levels, in hopes of boosting the confidence of the general public that "all is well, just look at the S&P", a trope most recently adopted by none other than Donald Trump.

Stock Market at new all-time high! Working on new trade deals that will be great for U.S. and its workers! — Donald J. Trump (@realDonaldTrump) July 15, 2017

At its simplest, this boils down to merely perpetuating the capital markets' status quo, or as Kocic calls it "Monetary policy continues to be supportive for stocks, bonds and USD at the same time."

This has been a radical departure from traditional relationships across different assets (in the long run, the two can only rally if the third one sells off). These correlations are the gift to the market. In the past years, owners of US risk assets and bonds (as a “hedge”) have been enjoying persistent positive externalities allowing them to make money on both stocks (the underlying) and bonds (the “hedge”).

To market participants who observe the lack of solid economic growth coupled with a global market cap that just hit a new all time high, this divergence creates a sense of deep confusion, yet one which few are willing, or able, to challenge in keeping with the mantra of "don't fight the Fed."

Still, problems are increasingly emerging, most recently from Bank of America, which in a note yesterday urged the Fed to finally "take that punch bowl away"...

... and warning that the longer the Fed's status quo persists, the greater the risk of a violent renormalization, i.e., crash.

If we are wrong and central banks do not take away the punch bowl, things will get much messier eventually. “Bubbles” may form that will eventually burst, leading to much higher volatility than necessary. Keeping rates low in response to persistent positive supply shocks that keep inflation low could lead to imbalances, with a painful eventual correction. Central banks did this mistake before the global crisis and kept monetary policies too loose as inflation was low, ignoring very easy financial conditions, excessive and sometimes irresponsible credit expansion and a housing price bubble. We do not believe, or at least we hope, they will not repeat the same mistake twice.

Amusingly, BofA was hopeful that central banks had learned their lesson from "making this mistake before the global crisis" adding that "we do not believe, or at least we hope, they will not repeat the same mistake twice." And yet, last week's events cast significant doubt on this "hope."

There are other problems with perpetuating a "permanent state of exception",not least among them the fact that the market will remain broken via an "indefinite suspension of traditional market exchange" which also means that the Fed must reinforce its control over risk prices every day through a "continuous uninterrupted exercise of power."

In essence, it is all about diluting the possible downside of stimulus unwind -- an attempt to have an option to obfuscate without losing one’s credibility. With traditional market rules and relationships breaking down, central banks appear to be chasing the illusive target, which means that victory and the final goal are not well defined, which in turn insures the persistence of the “battle” and indefinite continuation of the state of exception. This implies indefinite suspension of traditional market exchange, which means continuous uninterrupted exercise of power that must be won every day.

Kocic previously touched on this topic, calling it a state of market "metastability", in which the "persistence of low volatility causes misallocation of capital. This is how complacency leads to buildup of risk – it is the avalanche waiting to happen."

He continued:

Complacency is a source of metastability. It has a moral hazard inscribed into it. Complacency encourages bad behavior and penalizing dissent – there is a negative carry for not joining the crowd, which further reinforces bad behavior. This is the source of the positive feedback that triggers occasional anxiety attacks, which, although episodic, have the potential to create liquidity problems. Complacency arises either when everyone agrees with everyone else or when no one agrees with anyone. In these situations, which capture the two modes of recent market trading, current and the QE period, the markets become calm and volatility selling and carry strategies define the trading landscape. But, calm makes us worry, and persistent worrying causes fear, and fear tends to be reinforcing.

Fast forward to Friday, when in his latest tangent he points out that in order to minimize the "fear" experienced by market participants caught in the metastability trap, they have no choice but to be comforted each and every day by the central bank exercising its "power" by perpetuating the "indefinite suspension of traditional market exchange", something it can only do if the motives of all actors - central banks and investors - are aligned:

Everyone is incentivized to participate in the reinforcement of the state of exception, while various forms of contestation of the power are inhibited. For example, attempts at shorting bonds are penalized by a steep curve, protection against volatile unwind is discouraged through wide vol calendars, negative carry etc.

And yet this daily interference leads to the abovementioned build up of imbalances, which for a Fed now focusing on its "social" role results in a layering of paradoxes:

The fuzziness of its objectives, as seen through obfuscation of the objective function and metrics (a.k.a. moving the goalposts), has become a policy tool that undermines the power of a reality check. Collapse of short-dated volatility is a referendum on the near-term power of central banks, and softening of long-dated (and forward) vol represents first signs of acceptance of its extension and possible permanence.

Therefore, when going back to the original postulate, the discontinuity between existing and future policy, it is clear why the Fed is concerned, especially at a time when as the Deutsche Bank strategist writes, QE has become nothing more than "universal basic income for the rich."

The accommodation and QE have acted as a free insurance policy for the owners of risk, which, given the demographics of stock market participation, in effect has functioned as universal basic income for the rich. It is not difficult to see how disruptive unwind of stimulus could become. Clearly, in this context risk has become a binding constraint.

Putting it all together, Kocic - perhaps not surprisingly - urges his readers to revert to a state of learned helplessness, to borrow a term, and effectively not fight the Fed, at least as long as the Fed remains dovish:

In our view, as long as the Fed remains dovish, there is little upside in holding gamma. Although the market is vulnerable to event shocks, in the absence of additional information, it would be difficult to endure the time decay of a long gamma position. If anything, reshaping of the curve is likely to lead to steepeners and more curve volatility. Curve gamma is currently trading at all-time lows and could be perceived as a better value as a potential hedge against event risk.

Yet while the current episode of metastability appears firmly entrenched - in fact the longer it persists - the more volatile the outcome, although here in a surprising relent, even Kocic appears to have given up and and suggests that the "permanent state of exception" may indeed be... permanent:

"Vega is a different story. Given the continued tension between the Fed and the market, from this vantage point, higher vol in the future looks almost inevitable, but given a possibility of a (semi-) permanent status quo and the state of exception, this might be a long shot."

Still, not everyone has thrown in the towel: as BofA's Michael Hartnett wrote two weeks ago, "monetary policy will have to tighten to raise volatility, reduce Wall St inflation, and reduce inequality. There are two ways to cure inequality: you can make the poor richer, or you can make the rich poorer. The Fed will reduce its balance sheet in the hope of making Wall St poorer."

At this moment, whether or not Hartnett is right, is the most important question for both the market and Janet Yellen.

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Kocic' full note below

