Stuck between Iraq and a hard place

Summary

• Outlook for 2020: TMI, and I'm uncomfortable.

• The ebb and flow of markets: interest rate volatility.

• Macro data update — uninspiring.

• QE lite turns into outright QE.

• Market Dynamics: Wicked long gamma.

• The week ahead: Locking in the phase one deal.

Too much information. No, I'm not talking about my commentary, although I understand where you're coming from. Every day, I sit down and let it all marinate, the ostensibly consequential headlines that are whipped at you like Aroldis Chapman's record 105.1 MPH fastball. When all these headlines come flying at you as fast as they do, you can't help but sit there and watch as the long-term outlook becomes so uncertain that any attempt to forecast the future feels like a hopeless endeavor. One solution is to tune things out, close a few tabs on your internet browser as Hasan Minhaj from the Patriot Act described it. There may be some merit in that approach, after all, the critical development last year came in the first week of January when the Fed did a complete 180 and signaled it would provide more accommodative policy. Of course, hindsight is 20/20, and having the foresight to pick out these events isn't easy. Another approach is to not worry about the long-run and focus on the short-run. That seems to be the approach for many market participants as volatility and risk premiums continue to compress despite a widely uncertain outlook. That's the broad theme for 2020, rising geopolitical and economic uncertainty juxtaposed with decreasing risk premiums and implied volatility. Nothing can dictate this phenomenon more clearly than the apparent disconnect between the market-based gauges of uncertainty and the news-based measures. The chart below gives you a flavor of the disconnect between the two, but this chart can be reproduced with plenty of different volatility series.

What has caused this disconnect? Central bank forward guidance is at the heart of the problem here. Many have argued that predictable monetary policy has fostered unpredictable trade policy. Bill Dudley, the former NY Fed president, certainly had a few words to say about that last year, and indeed, I've highlighted how President Trump has leveraged the adverse effects of a trade war to engineer more rate cuts from the Fed. Although there's truth in that mechanism, I think the elephant in the room is inflation targeting altogether. Remember that central banks set interest rates according to inflation as per their mandate. As such, interest rate policy becomes unpredictable when prices become unstable and, well, prices have been very predictable. Couple that with a promise to keep rates lower for longer, and you've got yourself a probability distribution for interest rates that has limited upside. Predictable and low interest rates have put a damper on risk premiums as a result of investors sliding down the quality ladder in search of anything with a decent yield. That means investors are piling into higher risk bonds, equities, and even private stuff (both equity and credit). While in the past, low volatility, a flattening yield curve, and equity markets at all-time highs would have been a rather ominous sign, today they're merely the status quo. Low interest rates, an aging population, falling productivity, and burdensome regulation has worked to depress global growth. That's created a world where we no longer see high-speed collisions, only parking accidents. That's to say, the business cycle as we know it is far smoother than in the past.

How does any of this change? For things to change, interest rate volatility needs to rise in a meaningful way. The least likely way in which that happens is through inflation expectations directly, i.e., a significant rise in inflation. That could come from a sustained increase in oil prices, which, up until a few days ago, seemed like a possibility given the conflict between Iran and the US. Another is through regulatory reform, which may have the potential to liberate bank balance sheets and allow for more lending, although I'm less convinced about that one. The last "hope" and, in my opinion, the more realistic of the three comes from fiscal policy. The beat of the fiscal drum has been getting stronger, with countries like Japan, Hong Kong, Chile, and "green stimulus" out of Germany emerging. The hope is that these policies will boost growth and inflation, given that tax cuts haven't managed to do so. The real fear for policymakers is entering a deflationary environment. Early last week, a pair of former central bankers, Mario Draghi and Janet Yellen, were in a panel discussion about the risks of deflation in Europe. In keeping with his plea for fiscal stimulus, Draghi was quick to highlight the absence of government spending despite record-low borrowing rates. The reality is, the threat of secular stagnation is no joke, and factors that have anchored interest rates have proven to be persistent. Monetary policy still has a role to play, but it's doubtful that the efforts of central banks will be enough to reflate the global economy.

Where does the sudden bout of optimism fit into all of this? The fourth quarter of 2019 served as a turning point for the macro narrative. Progress towards a skinny trade deal between the US and China, coupled with a blowout election for the Conservatives in the UK, helped alleviate some of the geopolitical risks. There's also a universal belief that all the central bank stimulus pumped into the system last year will result in better economic data this year. In reality, the incoming data has been far from inspiring. German factory orders continue to be a dumpster fire, and the US economy printed lacklustre manufacturing data along with a lukewarm jobs report on Friday. Data out of China has also been disappointing, with consumer prices rising while producer prices have continued to fall (compressing company margins). These ugly dynamics have put the People's Bank of China (PBOC) in a bind as lowering interest rates risk magnifying the rise in consumer prices. Beijing has delivered several rates cuts in response, but the stimulus continues to come in dribs and drabs. The good news is that the Chinese Yuan has been strengthening against the greenback, reducing the risk that President Trump will ramp up rhetoric against currency manipulation. Ultimately, the scope for global reflation seems far-fetched, at least without a sizeable macro catalyst such as a massive spending package in the US, Germany or a rebound in China. With Fed policy asymmetric and tilted to more rate cuts, there's little risk that the inflation outlook will change. The US economy continues to outperform the rest of the world and, although slowing, will likely continue to motor along.

The dysfunctions in the overnight markets will likely push the Fed into outright QE, resulting in more accommodation and support for riskier assets. In my last market update, I flagged concerns that the Fed would lose control of the overnight money markets at the end of the year. These concerns were motivated by pressures in lending markets, which are more pronounced around quarter-end/year-end because companies tend to clean up their balance sheets ahead of their quarterly/annual reports. The Fed ramping up repo operations at the end of the year served as more of a bandaid solution, while their Treasury bill purchase program is the ideal long-term solution. Overtime, repo operations should peter out while bill purchases continue until reserves are at least US$ 1.7 trillion according to analyst expectations. That's about US$ 200 billion more than where we currently are. Of course, it's not all sunshine and rainbows, tax settlements in mid-March and personal tax collections in April will put pressure on repo markets well before we hit that ideal buffer. The long-rumored standing repo facility is a promising solution, but, given these significant collection days are a few months away, it seems unlikely anything will be put in place. Complicating things further, the Fed may create liquidity issues in the T-bill market by gobbling up all the supply. That produces a less than ideal situation for the Fed where, as the T-bills begin to mature, the Fed will need to reinvest the proceeds further out the curve, increasing the maturity of the SOMA (System Open Market Account) portfolio. That means that the Fed's current quantitative easing (QE) lite is expected to transition to outright QE, creating support for yields and riskier assets while complicating communication surrounding asset purchases.

Equity markets have enjoyed the good vibes in the market, posting a 3-5 percent gain across the globe in the last month. The renewed optimism described above has resulted in a massive build in gamma amongst the dealer community, with the total gamma needing to be hedged, sitting at around US$ 10.2 billion. As a reminder, positive gamma means that dealers will be hedging against the flow of the market, acting as a sort of shock absorber to any news. The wicked long gamma coupled with a relatively strong rally in equities has pushed the market well above any sell points for any of the momentum trading community. That means the risk of any feedback loop selling amongst the systematic investing community seems very low for the time being.

Trade negotiations will be in the spotlight after taking a backseat to the Iran/US tensions, and there's plenty of data coming out around the globe. Chinese Vice Premier Liu will come to Washington next week to sign the "Phase one" trade deal. There have been rumours that the President wishes to postpone working on a phase two deal until after the election. For the time being, the two sides have agreed to restart semi-annual talks to help resolve economic disputes. That's a step in the right direction, but there's plenty more to be done. On the data front, the US will report retail sales and inflation, which is expected to reinforce the bull case for bonds. That's primarily due to Powell's assertion that there would need to be extremely hot inflation to change the decision calculus of the Fed. For the reflation narrative to gain traction, we would need to see some robust data out of Germany and China. Indeed, both nations will post GDP estimates this week. Another highly anticipated data point will be the ECB meeting minutes from December, featuring the wise owl Christine Lagarde. There is a bit of something for everyone next week.

Tiago Figueiredo