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2018 Idiosyncratic Events Becoming 2019 Systemic Issues

February’s vol spike. March’s LIBOR/OIS divergence. May’s Turkey/Argentina crisis. June’s political changes in Italy. For most of 2018, the market priced these as a series of idiosyncratic shocks.

They are shaping up to more than idiosyncratic risks. These idiosyncratic risks are stress fractures spreading to an increasing number of asset complexes, leading to re-rating. Decent economic numbers led to meaningful Fed tightening, hence Fed policy rates have doubled in the last 15 months. Further, the Fed is reducing its balance sheet by $50 billion a month, reducing excess reserves parked at the Fed, lowering prices on assets that anchor the yield curve, and driving multiple credit spreads wider.

Market are getting real. Buying has stopped, but selling is only starting. Selling is the next port of call, along with a flight to quality. This won’t stop until central banks come to the rescue.

Proposition: Every time central banks scale back, investors head for the exit.

Corollary: Buy the dips when central banks are adding liquidity. Don’t buy them when central banks are scaling back.

Corollary: When central banks scale back, be short inflation, and flat the yield curve.

Remark: Short inflation implies long duration.

Corollary: Markets are trapped between multiple, very different attractors and transition from one basin of attraction to another can be abrupt.

Remark: Implement cheap and long convexity through barbells.

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