If there were lingering questions about whether markets were going to return to the type of historically anomalous calm that characterized 2017, they've been answered this week.
Headed into March, investors hoped the turmoil that unfolded in early February was largely a one-off event. To be sure, there was plenty of evidence to support that assessment. The VIX "Minksy moment" on February 5 was in no small part attributable to levered and inverse VIX ETPs, whose vega-to-buy (i.e. the rebalance risk inherent in the structure of those products) had reached historic highs in January. The black swan vol. event triggered a VaR shock and thanks to the concurrent selloff in bonds, rules-based, systematic strats were forced to de-risk and the subsequent cascade effect culminated in February 5-9 being the worst week for U.S. equities in two years (it would have been the worst week since the aftermath of Lehman were it not for a late afternoon rally that Friday courtesy of a JPMorgan note that suggested the risk parity and CTA unwind was largely complete).
So the thinking was that with the deck cleared on the VIX ETP rebalance risk and with the systematic deleveraging out of the way, markets had the green light to calm down. Only that's not what's happened. Have a look at the following chart which shows the frequency of +/- 1% days on the S&P in 2018 versus 2017 (click it to enlarge):
Here's Bloomberg with a little color on that:
Two months into the new year, the equity benchmark has notched 15 days in which it moved 1 percent or more in either direction. That’s almost twice as many as the whole year of 2017.
At 36 percent of all trading sessions, the frequency of big days is higher than in all bull market years since World War II except one. That was 2011, when a downgrade of the U.S. sovereign rating sent the index to the brink of a bear market decline of 20 percent.
The persistence of this is attributable to a host of things, but the overarching point is that the "technical" factors have largely shaken out and so, what you've seen over the past two weeks suggests there's more going on here than Seth Golden blowing up, unwinds from managers whose positions were bumping up against pre-set risk limits ahead of vol. resetting higher , and programmatic deleveraging by rules-based strats.
Specifically, what's "going on" now is that the market is coming to the realization that something has to give here. All of this isn't consistent. Trump is piling fiscal stimulus and deficit-funded tax cuts atop a late-cycle economy running at full employment and pretending that somehow he can engineer wage gains without stoking the kind of inflation that would force the Fed to tighten aggressively. Meanwhile, he's engendering ill-will abroad at a time when someone needs to absorb the increased Treasury supply that goes along with financing his foray into fiscal stimulus, a foray that's taking place against a backdrop of a Fed that's running down the balance sheet. Somehow, all of that needs to play out without forcing yields dramatically higher because depending on the pace of rate rise, Trump's cherished stock market rally comes to an unceremonious end. Reconciling all of that is well nigh impossible.
Speaking of "well nigh impossible", Jerome Powell has nowhere to go here - that's becoming readily apparent. Although I kind of lampooned the over-dramatized presentation earlier this week, Paul Tudor Jones laid out the problem rather succinctly in an interview with Goldman published on Wednesday. Here's what he said (and again, pardon the hyperbole):
Let me describe to you where I think Jerome Powell is right now as he takes the reins at the Fed. I would liken Powell to General George Custer before the Battle of the Little Bighorn, looking down at an array of menacing warriors. On the left side of the battlefield are the Stocks—the S&P 500s, the Russells, and the NASDAQs—which have grown, relative to the economy, to their largest point not just in US history, but in world history. They have generally been held at bay and well-behaved, but they are just spoiling to show their true color: two-way volatility. They gave you a taste of that in early February. Look to the middle and there waits the army of Corporate Credit, which is also larger than ever relative to the economy, as ultra-low rates have encouraged it to gain in size, stature, and strength. This army is a little more docile right now, but we know its history, and it can be deadly when stressed. And then on the right are the Foreign Currency Fighters, along with the Crypto Tribe, an alternative store of value that only exists because of the games central banks are playing; the opportunity cost of Crypto is so low, why not own some? The Foreign Currency Fighters have strengthened by 10% over the past year. Compounding the problem, they have a powerful, ascending leader, the renminbi, to challenge the US dollar’s hegemony as the reserve currency. All of these forces have been drawn to the battlefield because of our policy experiment with sustained negative real rates. So Powell looks behind him to retreat. But standing there is none other than Inflation Nation, led by the fiercest warmongers of them all: the Commodities. He might take comfort that he is not alone on the battlefield. But then he looks over at the Washington, DC, fiscal battalion and realizes they are drunk on 5% deficit beer. That’s what Powell is facing, whether he recognizes it or not. And how he navigates this is going to be fascinating to watch.
Yes, it's going to be "fascinating to watch" and now you can add "trade war" to the list of factors that further complicates the inflation picture.
Meanwhile, the political situation is laughably fraught. Even if you can get past the constant rearranging of the deck furniture at 1600 Penn., the Mueller probe is perpetually lurking in the background. At any given time, news from the special counsel investigation could trigger a flight-to-safety bid and at this point, it is abundantly clear that the algos are programmed to sell first and ask questions later in the event a headline crosses with the word "Mueller" in it (just look at what S&P futs did a couple of Fridays ago when the 13 Russians were indicted).
Not to put too fine a point on it, but it's a miracle this hasn't come completely unglued yet. Call it a testament to the overriding faith in central banks, or chalk it up to the still prevalent global hunt for yield, or maybe just call it outright obliviousness, but whatever you do, don't call it a "stable" situation.
The fact that markets have now definitively moved into a new regime wherein 1% moves in either direction are the norm rather than the exception is clear evidence that at least some folks are waking up to the reality of the situation. One of the ironies of 2017 was the propensity of ostensibly smart people to maintain a rosy outlook for markets while simultaneously expressing their incredulity at the sheer brazen incompetence Trump demonstrated on a daily (and in a lot of cases hourly) basis.
That anyone managed to reconcile Donald Trump being President of the United States with a bullish outlook for risk assets is going to seem unfathomable one day.