The Hedgehog and the Fox
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The Greek poet Archilochus wrote a parable with the moral - "The fox knows many things, but the hedgehog knows one big thing." The Oxford philosopher, Isaiah Berlin, made this phrase famous in his essay titled "The Hedgehog and the Fox" in which he divided thinkers into two categories, hedgehogs and foxes. The hedgehogs base their thinking on a big idea while the foxes are more accepting of nuance and open to using different approaches to different problems. Analyzing past central bank cycles, certain actions like the response post-GFC or post-Covid, BOJ QQE after Abe’s election, Draghi OMT announcement can be distinctly characterized as hedgehog policies whereas certain other ones like delay in the Fed's 2015 hiking cycle, the Fed's mid-cycle adjustment cuts of 2019 are clearly fox-like.
Why is this relevant? I think from a risk-taking standpoint it is relevant to understand which type of policy cycle we are in to identify the trading regime we are likely to be in.
The characteristics of a hedgehog cycle:
Economy has strong momentum in one direction
Higher macroeconomic data volatility
Central bank is clearly behind the curve
Distribution of risks is skewed such that benefits of aggressive central bank action outweigh the costs
In contrast, the characteristics of a fox cycle:
Mixed signals from the economy
Lower macroeconomic data volatility
Central bank policy is in the vicinity of appropriate
Distribution of risks is skewed such that a central bank being patient and gradualist is the prudent course of action
In my opinion, we are about a quarter away from the Fed's transition from a hedgehog cycle into a fox cycle. In Q4, with inflation in high likelihood headed lower, the growth outlook worsening and the Fed policy rate above its estimate of neutral, each FOMC decision will become more nuanced. Hiking at a 50bp pace or stepping down to 25bp or even taking a pause will all be options within the probability distribution of outcomes for each meeting. In case of central banks that are lagging like the ECB, they could still very well be in the hedgehog phase of the cycle - though if the negative global growth impulse is large enough it could truncate their cycles and force a pre-mature shift to the fox phase. This cycle transition if it does happen has important implications for markets:
Sharpe / Sortino ratios for hedgehog inflation cycle macro directional trades - short front-end, flattener, short risk assets, long USD - will deteriorate in the very least and some may stop working all together
While near term volatility could stay elevated through the initial phase of transition as positions get readjusted, longer-dated volatility - particularly in rates - should normalize somewhat
Fox cycle are generally good environments for relative value trading and after a couple of difficult years for these strategies, they should see their returns and Sharpe ratios improve
While a broad-based carry seeking environment is still unlikely given that risk premium has to stay high due to the shift in liquidity from the shrinking of central bank balance sheets and rising recession risks, idiosyncratic alpha opportunities to harvest carry within EM / credit should offer good risk-adjusted returns
The risk to my view is that the Fed transitions quickly from the hedgehog inflation-fighting cycle to the hedgehog recession-fighting cycle. While this is certainly possible, I think the more likely outcome is a drawn out transition from inflation-fighting cycle to a recession-fighting cycle. The Fed has to cement its inflation credibility beyond any doubt and will be hesitant to reverse policy absent convincing evidence that inflation is close to target. Secondly, the policy bazooka that was rolled out post-Covid was a function of the large economic and markets shock that the lockdowns posed and the strong belief (influenced by the post-GFC experience) that the risks of doing too little dwarfed that of doing too much. The recent inflation outcomes will make the Fed a lot more circumspect in unleashing an aggressive large scale easing program and instead its more likely to adopt a fox-like incremental approach in response to a deteriorating economy via a pause in rates hikes, followed by ending QT before embarking on carefully calibrated rate cuts intended to manage downside economic risks without substantially increasing risks of sharp rebound in inflation.
In summary, in my opinion Q4 will likely mark the transition of the trading environment that currently strongly favors pure directional macro strategies and has been a difficult one for relative value or carry oriented strategies to one that is conducive for a blend of macro, relative value and idiosyncratic carry strategies.