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G10 Macro Rates Blog – The Roaring 20's

Monday, January 20, 2020

Latest G10 Macro Rates Blog
With Shayne Dunlap, Co-Portfolio Manager

Trump started the new year and decade unleashing an armed drone from somewhere above Baghdad airport. Is this a forbear to a new period of uncertainty and a return of higher volatility? 

The much-vaunted return of vol has been prematurely forecasted so many times over the last decade, with each spike rapidly beaten down. Volatility as an asset has been so successfully sold by market participants that few would contemplate a reversal of this tactic. IG Credit spreads, VIX, VVIX and FX implied volatility are flirting with multi year lows, a testament to how little market unpredictability is expected in the foreseeable future.

So, what has suppressed the price of volatility recently? Look no further than the U-turn of Fed balance sheet reduction in early 2019. This policy reversal supported by dovish ECB, BoJ and PBoC, gave the green light for equity markets and a credit “risk on” rally. The simple fact is that volatility and capital liquidity are interconnected. If Central Bank’s (CB’s) can’t justify “throwing money at the problem” then we can assume volatility will be the benefactor. See chart below showing the VIX index vs the rate of change of balance sheet expansion in $ trillion for the Fed, BoJ, PBoC and ECB.


The minor balance sheet reduction via QT in 2018 / 2019 that caused so much anguish in bond and equity markets barely registers against the overall scale of balance sheet expansion over the last two decades. So, does the world need another $10 trillion balance sheet “hit” this decade to satisfy the liquidity addiction of the global financial system? And if this increase doesn’t eventuate, will the economic cycle finally come to an end and some serious “cold turkey” be had? We feel that the developed world is hooked on liquidity and isn’t willing to take the pain of a lifestyle change, and in turn is extremely vulnerable to the slightest reduction in access to capital. Hence the huge concern over the September 2019 repo market spike.

The Fed currently forecasts its own balance sheet expansion to slow to a crawl by mid-2020. Is this the prelude to a repeat scare similar to Q4 2018? If employment levels stay this high and wages continue to increase, it gets harder and harder for CB’s to justify the current expansionary policy. If they don’t react, then when and how are these CB’s going to wean the global markets off their addiction to cheap access to excess liquidity? It is feeling more and more unsustainable to prolong the inevitable end of this business cycle, but we know that market dislocations can last way longer than an active manager can position against.

However, there may be a catalyst – Inflation is picking up in various measures. 3-month annualized European core CPI has jumped to 1.7%; Demographics are going negative, with the Japanese population forecast to decrease by 1 person per second this year. There are now 1.62 jobs advertised for every 1 applicant, a 44year high; US wage growth is robust – with an average of 3.7% annual increase for 2019 according to Atlanta Fed.

“Never fight the Fed” they say, but it’s getting more tempting to do so with each month passing, lest we forget how the original “Roaring 20’s” ended.

Source: Pacific Asset Management and Bloomberg.

For further information on the Pacific G10 Macro Rates team, their experience and strategy please see below

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IMPORTANT INFORMATION: Issued and approved by Pacific Capital Partners Limited, a limited company registered in England and Wales, authorised and regulated by the Financial Conduct Authority . The information contained herein is not approved for use by the public and is only intended for recipients who would be generally classified as investment professionals. Information or opinions contained in this article do not constitute an offer to sell or a solicitation, or offer to buy, any securities or financial instruments or investment advice or any advice or recommendation in respect of such securities or other financial instruments. Where past performance is shown it refers to the past and should not be seen as an indication of future performance.

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