Whereas many Wall Street strategists enjoy simplifying their stream of consciousness when conveying their thoughts to their increasingly ADHD-afflicted audience, the same can not be said for Deutsche Bank’s Aleksandar Kocic, who has a troubling habit of requiring a background and competency in grad level post-modernist literature as a prerequisite for his articles among the handful of readers who don’t already speak exclusively in binary. Here is an example of Kocic’s “unique” narrative style:
Volatility is a consequence of speed and speed is the result of fear. Acceleration of movement is a defensive maneuver, a tool of retreat — high speed and high volatility represent sophistication of flight (flight to quality is an example of the speed event). However, absence of volatility is not necessarily synonymous with absence of fear. Volatility is low not only when things become predictable, but also if the distribution of risks causes paralysis, when the state of no change, regardless how uncomfortable it might be, becomes the least undesirable of all alternatives.
While a passage like that is far more likely to have been taken from a book by Lacan, Derrida, Deleuze and Guattari, Foucault or any other prominent POMO-ists, in this case it comes from Kocic’ year end outlook which encapsulates many of the themes we have covered recently, most notably his recent take on the interplay between volatility and leverage, a topic which anyone who has read Minsky is quite familiar with, yet which Kocic decided to give it his unique post-modernist spin with the following “spiraling leverage” chart from one month ago…
… which he described as follows: “spiraling leverage cannot continue indefinitely. At some point, the bubble becomes too big and cannot be subsumed by a bigger bubble – the damage of its burst would become irreparable. Therefore, when that moment comes — and we believe that moment is now – the market is facing a following dilemma.”
- Permanent state of exception: We continue to operate in a regulated environment. Leverage is limited, but care is taken not to overconfine the system so we avoid the Japanese scenario. While this appears as a prudent approach to reality, it implies giving up all the ideas of unlimited growth, something that made US economy look better than the rest of the world. Compared to what we have seen before, this means settling for much less than this country is used to aspiring. Although a reasonable proposition, it is emotionally a difficult choice that is and will remain subject to substantial political manipulation. It is unlikely that populist narrative will not continue to challenge this choice [ZH: hey, one can just blame the Russians, right?]
- Flirting with high tail risk : Deregulation and deficit spending could result exactly due to abandoning the first path, as its direct challenge, under political pressure that American economy can restore its old status and resume its pace of the previous decades. This is a serious tail risk as it is playing against the backdrop of considerable overhang of the post-2008 one-side positioning. Central banks are massively short convexity in this scenario. Any inflationary maneuver, or anything that would be a bear steepener of the curve, could force disorderly unwind of the bond trade and reinforce the trend thus creating another crisis from which there could be no way out.
- Forced deleveraging: An overly hawkish Fed forces rates higher and triggers a disorderly unwind of the bond trade, thus forcing the system to deleverage. This is the policy mistake.
The Deutsche Banker’s conclusion was stark and certainly dramatic:
“The tension created by these three choices is in the center of both economic and political discourse. It will shape the market dynamics in the future, beyond the near term. Taper tantrum and the US presidential elections were the two most recent episodes that have highlighted the risk distribution opened by these choices. Policy mistake appears less likely at this point. The financial conditions are as loose as they have ever been. Fed hikes are only going to tone this down, but it is very difficult to see how they can create overly tight financial conditions and cause economic slowdown. Nevertheless, negative convexity of the central banks in the bear steepening or generally high rates scenarios are making risk of volatile deleveraging alive.”
Of course, Kocic could (far simply) have said that it takes more and more debt to kick the can, and keep the world’s biggest asset bubble ever created – with the explicit backing of central banks – from bursting. This is precisely what Bank of America’s Barnaby Martin did in far less words one month ago:
“the irony in today’s world is that central banks are maintaining loose monetary policies to generate inflation…in order to ease the pain of a debt “supercycle”…that itself was partly a result of too easy (and predictable) monetary policies in prior times.”
* * *
In any case, fast forward one month later when Kocic picks up where he left off on his favorite “spiraling leverage” diagram, and decides to once again paraphrase Minsky’s conclusion that “stability is destabilizing” using just a few hundred extra words than is necessary, although since he does so in a “cool”, Pomoist way, here is the paraphrase:
Persistent low volatility is like a sirens’ song. Low uncertainty engenders high leverage which leads to compression of risk premia and further buildup of risk, which, in the long run, destabilizes the system causing ultimately volatile deleveraging. This is generally harmful for the economy and requires stimulus injection in order to create an economic turnaround leading to subsequent decline in volatility and gradual releveraging as the system recovers. When described in terms of leverage and volatility, economic trajectories exhibit quasi-periodic pattern. These dynamic are shown in the Figure as trajectories in the vol-leverage plain across several “cycles”.
Starting with the internet bubble in 1999, we reach the 2001 recession and subsequent recovery on the back of the real estate boom (2003-2007). The figure suggests that after each volatile deleveraging (e.g. 2000 and 2007), subsequent sweep leads to a bigger bubble. After each sweep, amplitudes grow bigger and the damage more substantial, requiring a heavier hand in terms of policy response as crises they create become deeper and recoveries longer and more difficult.
Kocic then reuses the same chart he showed back in November to indicate the four distinct endgames should the leverage cycle be pushed into one of four final states of “instability.”
Where the narrative differs from last month, however, is in the slight but perceptible shift to Kocic’ conclusion: he now appears resigned that the current twist of the vol spiral is also the last one, beyond which the current financial and monetary system will no longer exist, something his just as gloomy colleague Jim Reid concluded not too long ago and which we described in “This Is Where The Next Financial Crisis Will Come From.”
Here is Kocic explaining why we may be approaching the end of financial history (at least as we know it):
It is clear that the spiraling trajectory cannot continue indefinitely; it has to stop at some point beyond which there will be no more bubbles. In many ways, it looks like the post-2008 represents the last lapse. A new game has to be reinvented for the old future to materialize, or a different paradigm altogether has to take over.
As to what happens next, after the two sweeps of the spiral, both of which culminated with crashes, Kocic reverts back to his forecasting self and writes that “we arrived at the juncture point (2017) from which four possible trajectories emerge, none of them are looking very attractive at this point.” For those who may have forgotten the November report, here they are again:
- Throughout the post-crisis period, policy response has been designed around an attempt to avoid the lower left corner of low volatility and low leverage. It is safe to say that we have been able to stay clear of this outcome.
- At this point, with regulated financial sector and restricted leverage, we have found what appears to be a “reasonable” base case trajectory – a middle ground between Japanese style liquidity trap and repeat of the same mistake of the previous lapse — with regulated markets, lower leverage, and subaverage growth (a.k.a. Permanent state of exception).
- Alternatives represent risk scenarios and correspond to volatile outcomes. The lower right corner is the policy mistake territory of forced deleveraging (without inflation) triggered possibly by overly aggressive Fed.
- The most acute risk is associated with the path leading to the upper right corner where possible deregulation and reckless fiscal spending could trigger rise in inflation leading to stagflationary outcome with potential currency decline and forced unwind of the bond trade. Both of these trajectories represent high risk alternatives to be avoided.
Unfortunately, as recent social events have demonstrated, the current “reasonable base case” of a “permanent state of exception” is becoming increasingly improbable because the forced surreal financial relationships are starting to tear apart the social fabric itself. Not only that, but the fact that the “stability” has only been bought thanks to some $15 trillion in central bank liquidity is lost on only the biggest fools, and socialists, pardon – MMTers – in finance. Here again is Kocic:
As much as the base case trajectory appears as “reasonable” and a worry-free choice, its biggest problem is its legitimation. Easy money provided by central banks to restore growth was easy for capital, but not for labor. Policy response to crisis added further to inequality by blowing up the financial sector and inviting speculative rather than productive investment. The Keynesian bond which ties profits of the rich to the wages of the poor seems to have been severed, cutting the fate of the elites loose from that of the masses and the well-being of the economy.
Confused? You can thank Bernanke and Yellen for president Trump. Anyway, Kocic continues:
With subaverage growth and highly skewed wealth distribution, the economy is converging towards what for a growing majority increasingly resembles a zero sum game. To the vast majority, that is saying that the best days are behind us. This is the most difficult aspect of the base case scenario: There has been no political system in modern history — inclusive, exclusive, democratic or oppressive, all the same – that has promised anything but better future to its constituents. For any ideology the gradient between the present and the future has always had to be positive. It is difficult, if not impossible, to conceptualize any political narrative capable of making the reverse acceptable. And in a context where economic growth is a universal metric of progress, problems with the base case become even more acute. The legitimation of the base case will continue to define the populist narrative as a voice of change. Politics will be shaped along the lines of looking to disrupt the status quo with quick short-term fixes, which could emerge as outright triggers of stagflationary trajectory.
Well, considering that years and decades of endless political lies that “the future is brighter” is the reason why the world finds itself on the edge of a social, political and financial catastrophe, and which has made a handful of people richer than their wildest dreams while pushing the vast majority of the population into considering that socialism – and even communism – may be a wise alternative to capitalism, perhaps it is not so bad that for once the truth will be told and someone will have the temerity to admit that no, the future will not be better, especially when one admits that after the next crash – and the wars that follows – the future, or as it will be known then, the present, will be the worst since the world wars.
And finally, for those who lament the disruptions to the status quo by populist elements promising “short-term fixes”, well just look where said status quo got you: a world where the markets have to close their eyes and pretend they can exist forever in the artificial, central-bank created “permanent state of exception.”
Which, thankfully, is impossible.