Over the past, oh, I don’t know, four weeks or so, we’ve talked a lot about what “caused” February’s rout (inflation scare coupled with the realization of the VIX ETP rebalance risk, subsequent VIX spike and forced de-risking by the systematic crowd) and what factors have recently conspired to constrain the market’s ability to fully recover from that rather harrowing episode (trade war jitters, domestic political turmoil, geopolitical tension catalyzed by an escalation in Syria, etc.).
Playing out in the background is the Fed’s effort to continue along the path to normalization. That effort, combined with a safe-haven bid for the long end, has of course helped catalyze a relentless flattening of the curve following a brief steepening episode that accompanied the early February, inflation scare turmoil (more on the “breather” dynamic here).
Complicating this – and thus adding to the generalized sense of consternation – is the increased Treasury supply associated with the Trump administration’s ill-conceived foray into late-cycle fiscal stimulus. The knock-on effects of the tax cuts and the spending bill (e.g., repatriation effects and T-bill supply) have themselves conspired to help push up funding costs and all of this comes as the Fed is attempting to wind down the balance sheet.
Clearly, all of this can’t peacefully co-exist. Over the weekend, in “Inner And Outer Limits: Resolving An Inconsistency And What It Means For Risk“, we brought you some highlights from the latest by Deutsche Bank’s Aleksandar Kocic and Steven Zeng who talked at length about the the dynamics discussed two weeks ago in a note from JPMorgan, whose Nikolaos Panigirtzoglou flagged the first signs of inversion in the U.S. curve. We ultimately tied Deutsche’s discussion back to the idea that the Fed “put” needs to be restruck. Here’s how Kocic and Zeng explain that in the context of the Eurodollar curve (and this goes to a discrepancy between what 3y / 2y looks like it’s saying about the end of cycle, and what, 1y / 2y fwd is saying):
The inconsistency priced beyond the Green sector can be resolved through two modes: bull steepening or bear steepening. Despite both being steepeners, their causes and implications are quite different. A rally led by Greens would be a bull steepening resolution. Continued turbulence and weakness in equities could propagate through financial conditions and force a softening of the Fed path. The market reprices more dovish Fed and Reds and Greens rally (parallel of steepening), while Blues remain static together with long rates. The policy gap remains unchanged, but now the wider spread between Greens and Blues is consistent with the rest of the curve. This is also bullish for risk. It presents effectively restriking of the Fed put closer to ATM and as such is a convexity supply to equities.