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"What Changed?" - The Simple Reason For Yesterday's Sharp Selloff

Following yesterday's sharp market selloff, the biggest drop in two months, pundits have been banging their heads to explain what changed: after all we have had bad news for 6 years in a row - it is not as if the latest bout of deteriorating economic reality came as a surprise to anyone but the most lobotomized permabulls. So to say that algos and/or the few remaining human traders finally reacted to the newsflow is clearly wrong. The question is why they reacted the way they did. For the explanation we go to Citi's Steven Englander who has the most comprehensive, and accurate summary of "what changed."

From Citi's "Don't bring a knife to a gunfight --asset markets and central bank policy effectiveness"

We are getting panic selling across markets today and panic buying of bonds on fears of slowing global growth. However, the new information on global slowing may be less important than the realization that policymakers have few tools to deal with any kind of slowing, let alone a major shock. G3 10yr government rates now average 1.27, within 10bps of the all-time pre-tapering low of 2013 (Figure 1).  So if the last 100bps of rate reduction did not stimulate global growth, it does not seem likely that another 20-30bps or so in the presence of negative demand shocks will do the trick.


Fed speakers such as Dudley and Kocherlakota may be thinking that they are spurring confidence by telling investors that the Fed is in no hurry to hike. But they are emphasizing the tentativeness of the recovery, the potential sensitivity to rate hikes, the possibility of negative shocks from abroad, and the view that full normalization remains years away. The market takeaway from their comments is that the US economy is not strong enough to stand on its own, leaving little hope for the rest of the world, which is already slowing. Moreover since investors and business do not have particular confidence that the policy response will be effective, any upgrading of the risk of negative shocks raises the probability that we may be put into a zone to which there is no adequate response.

This also explains why bad news has become bad news. Bad news for the economy is good news for asset markets if investors feel that the policy response will  be effective in stimulating both activity and asset markets. When investors see no effective policy response on the growth side, at most another dose of QE, which is both politically unpopular and widely viewed as marginally effective, they buy bonds as the all-weather safe haven, basically on the view that there will be more liquidity but not much else.

The more effective response to a negative shock would be fiscal policy financed by central bank policy expansion. I was surprised at a client dinner at how many clients thought that ‘true’ helicopter money – tax cuts financed by the Fed balance sheet if you are a Republican, bridges, tunnels and airports if you are a Democrat --   has become a prevalent view. This view has been around for a while but has been controversial and does not seem at all accepted within the Fed.

And in case the above was TL/DR, here is DB's Jim Reid with his own Cliff Noted version.

The news flow isn't any worse in aggregate than it has been in recent months and indeed over the last couple of years but perhaps investors are realising that we're very soon to be in a world without US QE and therefore bad news can actually be bad news for markets rather than in more recent times when bad news was often good news due to the extended liquidity it might bring.

In short: when Fed gods become fallen idols, run far away... and sell Mortimer, sell.