If I ever find myself sitting Indian-style in a windswept tent slamming shots of “Genghis Khan’s champagne” with Nassim Taleb (or if he ever unblocks me on Twitter), one of the things I’ll ask him is whether it makes sense to make a chart of “the most underappreciated” tail risks.
There’s something paradoxical about the idea of crowdsourcing a list of “tail risks” because by virtue of being black (or at least “gray”) swan-ish, one wonders how it’s possible for the “crowd” to identify them ahead of time. Sure, a couple of stone-lifting, eccentric geniuses will be loading up on OTM puts (while simultaneously tweet-shaming fellow Metro riders) in anticipation of some cataclysm that came to them in a vision quest, but as for us mere mortals, it doesn’t make any sense to ask us about tail risks because by virtue of not being demigods, we wouldn’t know.
Given that, I’m inclined to feel a bit better about the odds that a sudden uptick in inflation triggers a disorderly unwind of the bond trade by forcing central banks to lean aggressively hawkish with their forward guidance.
As you’re probably aware (and if you’re not, then you’re not paying attention), “bond tantrum” is at the top of everyone’s 2018 “tail risk” list. Specifically, the worry is that if inflation finally shows up, central banks will find themselves woefully behind the curve and that, in turn, will force them to withdraw transparency and thereby revoke the market’s license to co-author the policy script (to paraphrase Deutsche Bank’s Aleksandar Kocic). If the two-way communication loop between policymakers and markets is severed, bond vol. spikes, and then the dominos start to fall on the way to triggering the dreaded VIX ETP rebalance risk and, in the final act, forcing the systematic crowd to deleverage into a falling market.
Ok, so that’s the nightmare scenario and before you go accusing me of being “that guy”, remember that unlike the batshit crazy market cynics I’m sometimes compared to, I’m just the messenger here. So don’t shoot my ass, ok? That is, I’m just telling you what multiple analysts (including JPMorgan’s Marko Kolanovic for those of you who need to attach a “brand name” to it) have posited as the doomsday scenario. I’m not telling you that’s likely to happen.
In fact, it’s you who is telling me that’s likely to happen. Or at least that’s the case if “you” are one of the fund managers who participates in BofAML’s monthly survey (incidentally, the bank’s rates and FX surveys tell a similar story, but it’s Michael Hartnett’s FMS polls that get all the attention). Have a look at the latest iteration of BofAML’s “tail risk evolution” chart:
The survey period on this was from January 5th to January 11th, which means it captured both the BoJ’s decision to pare 10-25Y JGB purchases and the Bloomberg story which suggested that China may be considering “halting” purchases of U.S. debt. It also captures 10Y yields hitting nine-month highs, Bill Gross calling for a bond (and “men”) bear market, and a period of generalized angst about whether a bond selloff could become acute enough to spill over into equities and derail the longest bull market in 100 years for balanced portfolios by flipping the stock-bond return correlation positive. Oh, and it captures the decent AHE print in December payrolls as well.
That gets me back to the original question posed here at the outset. If everyone knows this is the biggest “tail risk”, is it really a “tail risk”? How many times does the catalyst for an unwind end up even remotely approximating what everyone was worried about headed into said unwind? Not very often. And even if everyone knows what the most important risk is, trying to piece together the series of events that would lead to that risk materializing is well nigh impossible. Here’s how Citi, channeling their inner Hans Christian Andersen, put it last month:
Spotting the specific trigger in time and predicting the magnitude of the cascade of events it sets off in markets is akin to picking out the right little boy in the crowd of onlookers and reading his mind.
Ultimately, I’m not sure what it would say about us, as a group of market participants, if what ends up toppling the castle we’ve all spent a decade constructing in the sky ends up being a risk factor we’ve all been flagging for months. At the very least, that wouldn’t say much about the extent to which we trust our own intuition.
So coming full circle, perhaps the real “most underappreciated tail risk” is indeed “underappreciated”; not readily discernible to those of us who spend our days steeped in the research and staring at our Terminals.
But just because the real “tail risk” eludes the mortal among us doesn’t mean it’s not knowable.
It just means we’re not looking in the right places.
If it is “tail risk” you seek, try trekking through Northern Phoenicia. If you see a man planting olive trees, you have found what you seek.