Key Fed “Brain” Now Controls The Fate Of The World

Alright, so next week is critical.

We’re just going to be honest with you because it’s the sad truth. All eyes are on this “mystery” Brainard speech on Monday where for some reason everyone seems convinced she’s going to inexplicably morph into a hawk in front of our very eyes. Of course we could always be wrong, but our guess is you’ll get a whole lot of obfuscation and “on the one hand…” doublespeak.

But after Friday, we’re a little concerned. There’s blood in the water. We’ve mentioned risk parity, vol. targeting, CTA (trend following), etc. before. To put it in the simplest possible terms, these vehicles are running leveraged fixed income portfolios and low historical vol has also allowed them to lever up in equities too. Here’s a chart we’ve shown before at various times:

This is why you get VaR shocks. This all works beautifully - until it doesn’t. When volatility spikes, they have to scale back their exposure. Here’s a look at some history from BofAML:

(Chart: BofAML)

Here’s what BoFAML had to say recently:

“The main takeaway here is the most risk of model driven deleveraging from vol controlled risk parity funds comes when both volatility and correlation of the underlying components rise together.”

Right. Now if you want to talk about a perfect storm, re-read that quote and then look at these two charts:

So you’ve got cross-asset correlation on the rise and volatility poised for a spike. Here’s a bit from WSJ on the now all-important Brainard speech:

“Conflicting signals from the Federal Reserve on the timing of the next rate increase jolted financial markets on Friday. Soon, though, investors may be pining for more of the Fedspeak they have been cursing.”

“While odds are still good that the Fed will hold rates steady at next week’s policy meeting, as has been expected all summer, recent comments from some Fed officials have sown doubts. Tuesday marks the onset of a one-week quiet period ahead of the Federal Open Market Committee’s Sept. 20-21 meeting. The information vacuum will be especially irritating if a once-reliable dove changes her tune before it begins.”

“Fed Governor Lael Brainard’s remarks slated for Monday afternoon will be watched closely. The talk has exaggerated importance because most traders only became aware of it last Thursday, adding to Friday’s market anxiety that saw a nearly 400-point plunge in the Dow Jones Industrial Average.”

“One useful and counterintuitive aspect of Fedspeak is that it acts as a trial balloon, intentionally or not. Judging from Friday’s reaction, at least, the prospect of tighter policy went down like a lead one.”

“Trial balloons?” Really? This is like reading tea leaves at this juncture. As we’ve said before you might as well just stop off at a palm reader on Broadway and see what the tarot cards can tell you.

Good luck on Monday.