Structured Criticality
As I think about FOMC yet again abandoning the plan it laid out a few weeks ago to escalate the hiking cycle to front load 75bp and the spillover to market pricing of that to other rates, FX and equity markets, a concept I came across a while ago in graduate school came to mind - Structured Criticality.
From Wikipedia -
Structured criticality is a property of complex systems in which small events may trigger larger events due to subtle interdependencies between elements. This often gives rise to a form of stratified chaos where the general behavior of the system can be modeled on one scale while smaller- and larger-scale behaviors remain unpredictable.
Consider a pile of sand. If you drop one grain of sand on top of this pile every second, the pile will continue to grow in the shape of a cone. The general shape, size, and growth of this cone is fairly easy to model as a function of the rate at which new sand grains are added, the size and shape of the grains, and the number of grains in the pile. The pile retains its shape because occasionally a new grain of sand will trigger an avalanche which causes some number of grains to slide down the side of the cone into new positions. These avalanches are chaotic. It is nearly impossible to predict if the next grain of sand will cause an avalanche, where that avalanche will occur on the pile, how many grains of sand will be involved in the event, and so on. However, the aggregate behavior of avalanches can be modeled statistically with some accuracy. For example, you can reasonably predict the frequency of avalanche events of different sizes.
As the Fed increased its hawkish shift from earlier in the year, the number of Fed hikes priced in 2022 has kept ratcheting up as the Fed's response to deteriorating inflation picture. In using the sand pile analogy above, the pricing of additional Fed tightening is like a new grain of sand falling on top of the pile and at some point it leads to avalanches across asset markets. The avalanches are not synchronous and can be of varied magnitudes and which specific marginal increase in tightening will cause it is not easily predictable but the avalanches will occur for sure.
In my view, escalating the pre-announced 50bp move in June and July to 75bp in June and potentially July as well has induced a reflexive instability for major central banks forcing an accelerated response in many cases and markets challenging the lack of response in others. This already has and will continue to kick off a cascade of avalanches across global rates, FX, equity, credit and commodity markets. The implications are - rising volatility, unstable correlations and deteriorating liquidity conditions. The summer illiquidity will only act as an accelerator. This can quickly morph from what has been largely a fundamental macro and central bank driven price action to a positioning driven deleveraging with negative feedback loop into the economy. Historically these types of disorderly market moves have required intervention, often coordinated, by global central banks to arrest the instability but given that central banks are handcuffed by high inflation, the declines and speed of decline in risk assets needed to force a reversal are probably quite far away from current levels. Stating the obvious but will say it anyways - smaller positions, less complexity, staying in liquid assets, long jump risk and avoiding correlation or basis trades are the mantras to navigate this environment. Even seemingly rational positions can go awry if its crowded. Opportunity cost of being in a drawdown is high as dislocations and valuations could offer great entry levels on good trades.