“I think you’ve got some time in a healthy economy to figure out whether this is an economy that’s gently moving into a normalizing state”

It’s possible to read too much into things. Consider it a flaw in our nature. But when we are told the “Worst of market sell-off might be over but hold on tight”, we can’t help but wonder about the hedged language. After all, if Goldman sees recent price action as prompted by a “giant global margin call”, surely the sell-off is an opportunity? Apparently not, as the GS note in question suggested that the flows they have seen were not consistent with “a ton of selling”. Is this diagnostically useful, and if so, in what way? If forced to offer an opinion (and we are), we would agree with GS that volumes have certainly not been indicative of capitulation. In fact, recent volatility might be better thought of as evidence of preternaturally low levels of liquidity. That in itself begs the question of why liquidity is so poor. August doldrums, or evidence of a Potemkin market?

But what prompted this “giant global margin call”? Step forward Kasuo Ueda! It seems the cautious Mr. Ueda managed to catch the hedge fund world napping and terrify them that there was more to come (Here’s Kasuo!). The result was a shockingly sharp rally in the Yen: sharp enough to constitute a VAR shock. Japanese equities were a notable victim, but global risk markets suffered a rapid de-grossing. As a colleague reminded, only senior MDs should take August off.

Ueda has since repented of his lack of caution, helping to calm markets, although it does seem as if he will have to do penance. The question now is how much risk-taking capacity has been impaired by the recent VAR shock. Some part of what has cushioned risk markets was the increased expectation of sizable Fed rate cuts into year-end: 100bps of cuts by the Dec 18th meeting is now the base case.

In the circumstances, it should come as no surprise that Mr. Dudley is pressing his case. Bill suggests that monetary policy should move to neutral at the least and that neutral is below 3.80%. Markets are already persuaded that Bill is right (which raises the stakes), but there are alternate views. Richmond’s Barkin and Kansas City’s Schmid both recently argued that the economy was resilient enough to give them time to make a more considered decision. Still, Bill is no fool, and he had reasons to take fright, even if you might suspect politics was a factor. The “Sahm Rule” is a rule for a reason.

Hawks and doves are both optimistic that inflation will continue to recede. Those for whom the glass is half empty might wonder what would happen if we were to get an unfriendly CPI print in the next few months.

https://www.gocomics.com/calvinandhobbes/1987/09/09

 

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