Jay Powell and the Fed: Between a Rock and a Hard Place (w/ Danielle DiMartino-Booth & Chris Cole)
CHRISTOPHER COLE: And of course, you have the, which is something you've written quite brilliantly about, the reaction function of central banks. And that's something I also talk about in a 2015 paper, where they are preemptively getting in front of-- DANIELLE DIMARTINO BOOTH: Yes, this is-- I've tried to communicate this. And I don't think that the market quite understands Jay Powell and how different he is because he does understand credit volatility, and he does understand what's at stake. So he's unlike his three predecessors. He's actually trying to get out in front of what's happening. And that-- it truly changes-- it's not reaction function right now. He's trying to proactively get out in front of this. CHRISTOPHER COLE: That's right. Preemptive-- very similar to the way that the Bush administration sought to do preemptive strikes against terror. They are doing preemptive strikes on financial stress. And I think we saw this-- we have different models that look at thousands of different economic indicators. But this last-- economic and technical indicators. And a lot of the drivers of volatility were there in the fourth quarter of last year. We saw CCC yields begin exploding higher. DANIELLE DIMARTINO BOOTH: They still haven't come back in, a lot of them, though. CHRISTOPHER COLE: They still haven't come back in, yeah. We saw value begin to outperform momentum stocks-- very interesting. We saw, obviously, a re-steepening of the yield curve after an inversion. That's a bear signal. And then, finally, the granddaddy of them all, we began to see blow outs in the repo market. Of course, what that will do is, inevitably, if that continues, you have a deleveraging of various hedge fund strategies that will impact asset markets. All of these things were big risk-off flex. However, I think the Fed obviously saw the same thing. I don't think people fathom this. They created $400 billion worth of liquidity to inject into the repo system, the largest expansion of the balance sheet since 2009. DANIELLE DIMARTINO BOOTH: Well, it was only $85 billion when it was QE3. So this is bigger. CHRISTOPHER COLE: Bigger. It's remarkable. DANIELLE DIMARTINO BOOTH: It is bigger. And I understand what J Powell is trying to do. I get it. Because he saw the credit volatility genie start to come out of her bottle in the fourth quarter of 2018, and it scared the Dickens out of him. Public pensions had the worst returns for that quarter. It's anarchy, and we'll get to that in just a minute. So he understands the gravity of the situation. But it seems like the market has begun to play him. For every 100 decline-- 100 point decline in the Dow, you have 1 basis point of rate cut immediately priced in. You can follow it on your Bloomberg terminal. It's like clockwork. CHRISTOPHER COLE: It's the moral hazard of the problem. DANIELLE DIMARTINO BOOTH: And they're playing the Fed. The market players are playing the Fed. And I don't think people-- this is the last thing that Jay Powell wanted. CHRISTOPHER COLE: Yeah. It absolutely has become this point where it appears that they're really between a rock and a hard place. Because on one aspect, you are risking a complete melt up in markets, which is already occurring. You look at the behavior of Tesla, for example. It's fun to try to watch the media justify it, but there's no justification. I think Tesla's vol term structure was dramatically steeper than the vol term structure of the VIX the other day. DANIELLE DIMARTINO BOOTH: Yeah you tweeted that out. I was like, wow. CHRISTOPHER COLE: It's really-- DANIELLE DIMARTINO BOOTH: There's so many different ways to look at it. But the main is there. This is like 1999 and 2007. You walk into a bar and hook up. Sorry, that probably wasn't very politically correct, but you've got the leverage and you've got the mania. You've got the two of them together. CHRISTOPHER COLE: I could not put it any better myself. I think you're right. And these are the two realities. And maybe they're trying to keep it together until the election. DANIELLE DIMARTINO BOOTH: We don't have to go there. But I don't I think Jay Powell is probably the least political fed chair since Paul Volcker, but he also understands credit volatility, and he talked about it in October 2012 specifically. CHRISTOPHER COLE: And this ends up-- it's interesting how this ends up impacting so many different things, because not only is there market expectations built on this, this results in the enhancement of that mean reversion effect that we talked about. I think one of the reasons why volatility worked for 70 years in all of its forms is because there was not mean reversion in markets. It had less to do, sometimes, about the absolute spikes or the big down days or up days in markets and more to do with the fact that markets would trend. Well, now, because people anticipate this reaction function, the mean reversion is so baked into markets, and then that incentivizes people to follow financial engineering strategies that profit from that mean reversionary expectation. And today, there's a whole cottage industry in the vol world about gamma hedging. That's something that people talk a lot about now. And it's a complicated issue, but effectively, when big institutions come out in short volatility, the hedging of those volatility shorts reinforces mean reversion to markets. It's a little like a rubber band, the gamma hedging. And what I mean by that is that the rubber band stretches out, and you have a down day or an up day. And the hedging of all the short volatility products results in it coming back in. So people will buy the dip or do the opposite of what the market's doing. The dealers will do this to hedge. But if you get a big enough shock where that rubber band stretches too far, it could snap in either direction. It can snap on the left tail or the right tail in either direction. So in essence, it's not just the human beings that are now anticipating what the Fed-- anticipating this behavior pattern from the Fed. But now you have machines that are being attenuated-- DANIELLE DIMARTINO BOOTH: That's why it feels so systemic. CHRISTOPHER COLE: That's right.