| Inflation – cyclical or structural? |
| Zoltan’s last note is a good read (as always). How do you see inflation? Cyclical or structural? He writes: “…do you see inflation as cyclical (a messy re -opening after Covid, exacerbated by excessive stimulus) or structural (a messy transition to a multipolar world order, where two great powers are challenging the might and hegemony of the U.S.). If the former, inflation has peaked. If the latter, inflation has barely started, and could actually be understood as an outright instrument of war“.
Now go figure out what VIX and likes should be pricing… |
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| All about the 10 year |
| The US 10 year has continued moving sharply lower. We are well below the 100 day. The longer term moving average, 200 day, comes in around 2.25%. What about the short term levels? 2.5% is a big “psychological” level to watch. Note the trend line since late 2021 comes in slightly below that level. Fundamentally things aren’t looking great with credit impulses weak and commodities back to falling, but nevertheless, 2.5% is a big short term level to watch in the 10 year. |
 Refinitiv |
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| The 10 year has moved already |
| Some people do not like to “chart” yields, but for some perspective, the move in the 10 year has been rather “violent” already. RSI of the US 10 year yield… |
 Refinitiv |
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| The pillar of low inflation is changing |
| Zoltan poetry: “…central banks are done with fighting deflation with asset price inflation, and are now fighting inflation with asset price deflation. Central banks are adapting to a world that’s gone from having too much stuff and not enough demand, to a world that has not enough stuff and too much demand. Today’s inflation… …is more about supply and less about demand, and… …is more about geopolitics than (domestic) politics.” |
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| Fundamental volatility on the rise |
| Business cycles have become less volatile over the past decades. Covid-19 broke a lot of things, possibly the great moderation as well? TS Lombard writes: “… the more volatile cycles of the pre-Great moderation period may come back.” What happens to VIX if the economy becomes more volatile? |
 TS Lombard |
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| Don’t forget QT |
| Global central banks are all in hike mode, but don’t forget there are several running QT as well, i.e “draining” liquidity from a market where they have been the main buyer. Liquidity is poor, but it can also decide to “vanish” suddenly. We have not seen that take place, not yet at least… |
 TS Lombard |
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| Soft landing – good luck |
| We can all talk about a soft landing or not, but according to Zoltan we need the big L. He writes: “…we need an “L” -shaped adjustment in activity, and an “L” -shape has two parts: first an “I” which you can think of as a vertical drop (perhaps a deep recession); second, an “_” which you can think of as a flatline (stagnation, as in stagflation).”
Doesn’t sound overly “soft”…We need to think outside the box and appreciate the pattern according to Zoltan. He adds: “… the Fed went from transitory to not transitory; no hikes to hikes; hikes to a string of rate hikes; a string of 25 bps to a string of 50 bps; a string of 50 bps to a string of 75 bps; a string of 75 bps with forward guidance to the same without any comments…” |
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| The market doesn’t think much about that… |
| There is only one Zoltan: “If we’re right that the economic war is the right context to understand inflation, then Western central banks will not have any good options to slay inflation. They can surely reduce demand by raising rates, but what if supply curves shift inward faster than demand curves? The market doesn’t think much about that …” |
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| “They” will push rates higher |
| We are far from neutral rates. TS Lombard writes: “…real rates remain deeply negative and will have to increase sharply before monetary policy is appropriate. Some of that increase should result from slowing inflation, but the rest will come from further hikes. The Fed will keep pushing rates higher until it creates sufficient slack in the labour market to bring inflation close to its target.” |
 TS Lombard |
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| Re-pivot |
| MS Rates-guru Guneet Dhingra, thinks a re-pivot may be necessary in the end:
“We think it is remarkable (and a dovish surprise) that the Fed thinks that ‘moderately restrictive’ policy, reached with a shallower pace of hikes, will be enough to quell the highest inflation in 40 years, and even more remarkable, when you consider that the latest two CPI prints were clearly the strongest CPI prints in at least 40 years.
…we think there is a risk that the Fed is underestimating the task of lowering inflation, and may need to pivot back to being hawkish – a medium-term risk that rates markets are highly unprepared for.”
(Morgan Stanley) |
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| Are we still hedging the wrong tail? |
| What if inflation really takes off? What if mighty central bankers can’t control this one? How do you price assets, and above all, how do you price options and the “real tail”?
Frequent readers of TME know we are big fans of Chris Cole and his work on volatility. Attached below is an extract from a paper he wrote years ago, which is well worth a read if you haven’t yet, but let us recall what Bernanke said back in the days:
“The US government has a technology, called a printing press, that allows it to produce as many dollars as it wishes at essentially no cost…Under a paper-money system, a determined government can always generate higher spending and, hence, positive inflation.”
Below an excerpt from Chris Cole’s, “Volatility at world’s end”:
“Imagine the world economy as an armada of ships passing through a narrow and dangerous strait leading to the sea of prosperity. Navigating the channel is treacherous for to err too far to one side and your ship plunges off the waterfall of deflation but too close to the other and it burns in the hellfire of inflation. It is said that de-leveraging is a perilous journey and beneath these dark waters are many a sunken economy of lore. Print too little money and we cascade off the waterfall like the Great Depression of the 1930s… print too much and we burn like the Weimar Republic Germany in the 1920s… fail to harness the trade winds and we sink like Japan in the 1990s”
As Cole noted back then, if real inflation (ever) kicks in, the right tail is totally mispriced: “…risk in the right tail is not priced into the options market and this is remarkable given a careful study of economic and world history”.
Just imagine how you would need to price the upside crashes in a more extreme inflation scenario. The left tail risk would basically become the right tail risk, i.e upside crashes would be the biggest “problem”.
Full read here. |
 Artemis |
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