For what it’s worth…
FED Regime Change
In case you are wondering what is happening in the stock markets this week, the FED has a new head. On February 1st, FED Chairwoman Janet Yellen left office to the adulation of many a FED staff who “Popped Their Collar” in a tribute to their well-respected boss. And the next day, the stock market collapsed. On February 5th, the following Monday, the Short Volatility ETN (XIV) was terminated after a 115% spike in the VIX.
Perhaps not so incredible, if anybody bothered to look at new chairman’s Jay Powell statements from past FOMC discussions. There is this exchange between then Chairman Ben Bernanke and Jay Powell right before the onset of QE Infinity from the October 2012 FOMC meeting. Jay Powell was against QE Infinity and thought it was completely unnecessary (which is a view that I share, by the way); he fought against it vociferously and was particularly concerned about how the FED would exit the policy:
My third concern—and others have touched on it as well—is the problems of exiting from a near $4 trillion balance sheet. We’ve got a set of principles from June 2011 and have done some work since then, but it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think. Take selling—we are talking about selling all of these mortgage-backed securities. Right now, we are buying the market, effectively, and private capital will begin to leave that activity and find something else to do. So when it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position. When you turn and say to the market, “I’ve got $1.2 trillion of these things,” it’s not just $20 billion a month—it’s the sight of the whole thing coming. And I think there is a pretty good chance that you could have quite a dynamic response in the market. And I would just say I want to understand that a lot better in the intermeeting period and leave it at that. Thank you very much, Mr. Chairman.
Having read through the whole transcript, it is pretty clear that Jerome Powell as against QE Infinity. He may have voted for it, because he seems to be an astute political player and has high ambitions. But if he were to lead the decision, QE Infinity would not have been done. As such if markets have any hope that the FED will come in with QE at the first sight of market trouble, they better abandon that hope. The QE cavalry is not coming with Powell in charge.
What is most incredible is that Powell describes the unwinding of the balance sheet as “unloading our short volatility position”. Literally, the day after he takes charge – a Short Volatility product goes bankrupt. Unreal.
The FED Short Volatility trade that we have been doing since 2012 is over. New sheriff in town.
Every FOMC Meeting is Live
In addition, it is speculated that Powell will bring a press conference to every FED meeting which means that every FED meeting is a live meeting for an interest rate hike. Not only is the FED going to move and raise rates higher, they may be doing it on an accelerated schedule – a rate hike every month or so. If you think your 30 year mortgage is 4% and will get to 5.5-6% in 2-3 years, you might want to revise that view. We may be at 6% by the start of 2019 if Powell makes every meeting a live meeting.
Week of FED Speak
This was a week of a lot of FED speak. Many of the FED governors and presidents gave speeches. Not one of them said anything to soothe market concerns. Not one of them uttered the word “data dependent”. They all basically said, we need to stick to the FED rate hike plan if not accelerate it. Let’s look at a sampler of what was said:
Bill Dudley (New York FED President, Big Kahuna): “So far I’d say this is small potatoes” about the market drop! The 3 most important FED player (after the FED chairman and vice-chairman) is calling a -10% correction “small potatoes”. Hmmm. Well that FED put is a hell of a lot lower than the market thinks it is. “Clearly the market is adjusting to the fact that the global economy is growing quite quickly and as a consequence of that, monetary authorities around the world are either starting to remove accommodation or thinking about starting to remove accommodation, and that’s a little different than the environment we were in the prior seven or eight years” Translation: Tough shit if you lose money in the market.
John Williams (San Fran FED): The FED will stick to its plan for steady and gradual rate hikes despite stock market gyrations and wage growth. “I am going to try to dispel you of the myth that the Federal Reserve is going to overreact or somehow undermine the good news on the economy”… “The stock market plunge does not fundamentally change my outlook on inflation to rise to 2% by next year. The economy can clearly handle gradually rising interest rates. I am not really worried about the downside risk of the economy slowing too much”
Robert Kaplan (Dallas FED): In a speech in Germany, Kaplan said that recent market volatility in itself was not enough to change his base scenario, although he was “highly vigilant” about the turbulence and would study whether it has any effect on the real economy. “At this point, I don’t see this market adjustment spilling over into financial conditions… 2018 will be a strong year in the United States”
Patrick Harker (Philly FED): “I think there are risks to the upside where I would be open to doing 3 rate hikes. March is definitely on the table”. He also said the heavy-duty volatility in financial markets over recent days hasn’t altered his view on the outlook for monetary policy and the economy. “I’m not going to tell the market if it’s healthy or unhealthy” to have seen asset prices fall, Mr. Harker said. But he’s not entirely surprised. He said long-term bond yields are rising because market participants are taking the view that Washington’s current policy regime will mean big deficits and an increase in government borrowing, boosting supply of debt securities. He added, “If you start to believe the long end of the curve is going to go up, it makes sense equities would have an adjustment.”
Then of course you had permanent doves Neel Kashkari and James Bullad ask “Why cool the economy down?” Like anybody cares what they say right now. It doesn’t really matter what is going to happen in the economy or if the FED projections are right or not. The only thing that matters is that rates are going up and perhaps faster than expected. And that market gyrations don’t matter to the FED as much as they did before when Yellen was FED chair or vice chair.
Short Volatility: Dead Man Walking
It will be a while before Short Volatility prints the money it printed for the past few years. Get ready for a few down years in SVXY. Outside of short day or swing trades, short vol is going to go down and down and down. Because realized stock volatility is simply going higher and then will stay high. I feel bad for everybody that is piling into SVXY right now. All the new money is going to get whittled away.
I have to do a little “mea culpa” here. I thought the market would take some time to separate Short Volatility buy and hodlers from their money last week. I really didn’t expect a one day sword chop at all. The market surprised me on Monday. I am still in shock. But one thing I am sure of going forward – all the money that is going into Short Volatility ETFs like SVXY now is also going into the furnace as well. Sooner or later. Stay out of Short Volatility ETFs like SVXY. Even ZIV will suffer big losses over time. ZIV is actually the next shoe to drop since the long side of the curve needs a dramatic readjustment. The FED has changed, the market regime has changed.