Last June, when describing the series of events that will emerge once central banks lose control, Deutsche Bank’s Aleksander Kocic coined the term “metastability“…
… and to explain how the current system is poised on the verge of collapse in either direction, and which – at its moments of peak instability (think relentless central bank intervention and propping) is paradoxically defined by peak and widespread complacency, and which Kocic compares to an avalanche: “a totally innocuous event can trigger a cataclysmic event (e.g. a skier’s scream, or simply continued snowfall until the snow cover is so massive that its own weight triggers an avalanche.”
How does the regime change from the current “metastable” regime to an “unstable” one? To Kocic the transition will take place when systemic uncertainty, for whatever reason, is eliminated: “Big changes threaten to explode not when uncertainty begins to rise, but when it is withdrawn.” He also pointed out that while there is punishment for those who seek to defect from a “complacent regime” such “metastability” is in itself unstable:
“Persistence of low volatility causes misallocation of capital. This is how complacency leads to buildup of risk – it is the avalanche waiting to happen.”
Ultimately, the crash takes place when peak complacency smashes into peak, artificially low volatility:
Endemic complacency, which continues to take hold of the markets, is likely to play an increasingly adverse role the longer markets continue to operate as they recently have. However, although volatility remains depressed, the risk continues to be pushed to the tails. This is a buildup of metastablity. The longer the stick remains still, the more surely it will fall.
And while “avalanche’ is one perfectly apt metaphor for what will follow sooner or later in capital markets, what Kocic effectively described is a concept that is very familiar to Austrian economists. The simplest analogy to “Austrians” like Mark Spitznagel, is the lack of controlled “forest fires” to eliminate old trees (i.e., systemic excess and “zombie corporations” from central bank intervention and record liquidity), ultimately resulting in a catastrophic conflagration of epic proportions – a lack of “creative destruction” sowing the seeds of the system’s collapse, as Schumpeter would put it:
In the financial forests of our own making, suppression is particularly problematic — and even deadly. Excess and malinvestment thrive for a time, only to be destroyed by ravages caused by their own vulnerability. Yet, as we will see, even such high-intensity “fires” (of the forest and financial varieties) will has up and redistribute resources; in the case of the market, it releases capital to areas previously avoided the to the myopic distortions of monetary intervention. (The Austrian School naturally understood this well, as explained by the Austrian Business Cycle Theory.)
The above is a good segue into the latest note, and vacation, from SocGen’s “permabear” Albert Edwards, who writes that “I am just back from a two-week trip to Lake Tahoe and Yosemite/Sequoia Parks” where the macro strategist learned some important lessons that he would now like to impart to the Fed:
It was significant that we didn’t see any bears at either venue despite doing a 7.30am, 13 mile valley floor hike! I’m sure the absence of fellow bears was a significant countertrend sign. I learned something else on my trip worth sharing. We took the Yosemite Tram tour of the valley floor and the ranger gave a very interesting talk about fire. Until 1970 Yosemite Parks was extinguishing regular small-scale fires to prevent property damage. The resultant rise in dense small tree growth meant that although fires were less frequent, they quickly got out of control. Since 1970 they have allowed more fires to burn, resulting in less damage.
Edwards’ advice: “Central bankers should learn this lesson.“
Of course, they won’t because as we have observed in the past 20 years, the central bank M.O. is to allow a bubble grow too big for its to be successfully deflated without causing massive damage, and replace it with another, even bigger bubble.
Furthermore, as we also know, every market crash is caused by the Fed tightening too much, usually into a recession or depression, and causing the market reset that the Fed will then replace with yet another bubble. Here, the good news is that as Bank of America has shown previously, we are still early on in the tightening cycle that always ends with a market event.
But are we really? What if the Fed has tightened far more than the simple Fed Funds rate will suggest? That is the follow up point made by Edwards, who references some recent work by his SocGen colleague Solomon Tadesse, in which Solomon notes that although nominal Fed Funds is bounded at 0%, the impact of additional monetary easing due to QE was to further reduce the ‘implicit’ true underlying rate (also called the Shadow rate) below zero.
Solomon adopts the methodology for estimating shadow short rates for the US found in the widely circulated Wu and Xia (2016) paper. He shows that the Shadow Fed Funds rate hit negative 3% in mid-2014, but more importantly that a pronounced tightening cycle actually started through 2015, and by the end of that year the Shadow rate had converged back with the effective nominal Fed Funds rate (see charts below).
In other words, if one uses as the baseline not the X-axis, but the trough in the Shadow Funds Rate, the Fed’s tightening is now well past the point where the abovementioned “avalanche” is expected to start.
Solomon notes that although the six Fed Funds rate hikes since Dec 2015 amount to a total of 170 basis points (bp) of tightening, one can argue that if we add the 300bp (Shadow) rate hike to the current Fed Funds rate of 1.70%, the degree of monetary tightening in the current cycle stands at 470bp.
This number is troubling because it is in line with the peak rates of tightening cycles in the post-inflationary era of the 70s and early 80s (see charts below).
What is the implication? As Edwards concludes, “it is therefore reasonable to argue that the US has already faced a normal tightening cycle and any additional rate hikes are taking us into territory not seen in recent times. This already may be enough for the Fed to have broken something.”
And the punchline:
… if that is not enough and the Fed is to be believed, rates are heading to 3.4% (ie another 170bp rise) for a total of 640bp of tightening at a time when the US corporate sector is drowning in a sea of debt. That might be the time for me to revisit Yosemite and Sequoia where the bears should be a lot more visible.
If the SocGen analysis is accurate, the Fed will have a very big fire on its hands very soon.
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