A few thoughts about yesterday's bombshell

For many punters, yesterday was either the most fun they've had in ages or a potential one-way trip to the unemployment line- depending, of course, upon their perspective and (more importantly) their positioning.  Either way, it certainly re-ignited interest in macro, if the blog-o-meter is to be believed:

Judging by the reaction of the IMF and corporate Switzerland, it was not just lazy longs in EUR/CHF who were sideswiped by the SNB's decision.  It's hard to know whether the SNB misjudged the likely market reaction or whether they just didn't care.   Ignorance or apathy- which is a more cardinal sin for a central banker?

Regardless, yesterday served as a reminder that while old-school macro has seemed dead it was, to quote Billy Crystal in The Princess Bride, only "mostly dead."  That there was damage reflects how our markets have changed; in the old days, pegged exchange rates were targets to be taken on and wiped out if they deviated too far from fair value.   The ERM, Asia, Latin America; in the 90's breaking pegs was a great source of macro return.

Sadly, the post-crisis era has changed macro markets in a number of ways, none of them desirable:

* The myth of central bank omnipotence and credibility.  Although a lot us us here moan about "CB X is a fraud with no credibility", the fact is that the vast, vast majority of market participants believe in aphorisms like "don't fight the Fed."   Small wonder, too, since CBs did a generally excellent job of crushing vol, lowering the term structure of rates, and emasculating anyone who presumed to bet too heavily on an eventual change in the policy regime.   Europe has been the notable exception, but even there Draghi managed to extinguish the sovereign crisis throughout most of the Eurozone without buying a single bond (to date.)  

Of course, the problem with this myth is that no central banker is either omniscient or infallible, and policy error will occur eventually.   At the very least, policy shifts will occur unlike any that many market participants have ever seen before.   The last Fed rate hike, for example, was in 2006- meaning that no market participant under the age of 30 has ever seen one on a professional basis, and no one much younger than 35 has seen one whilst in a position of substantial responsibility.  Perhaps it's OK for such a significant cohort of the market population to be entering such uncharted territory...but you'd damned well better be prepared if they aren't. 

* Natural selection away from buyers of vol and risk premia in favour of sellers of vol and risk premia.  For intellectual and temperamental reasons, Macro Man has traditionally been a buyer of optionality.  He had a very good 2008-09 and a poor 2012, and for the last 9 months he's been sitting at home, cycling and doing some PA punting.  He knows another of other PMs and traders with similar profiles who've been spending their time in similar ways.  At the same time, some strategies focused on clipping coupons/selling vol/trading mean reversion in rates + FX have performed quite strongly.  Unfortunately (and your author will try not to sound bitter here), allocators and funds do not have the appetite to warehouse macro guys who merely pay for themselves during the lean years when the coupon clippers are having it off.

EUR/CHF has been a nonsense trade for the better part of a year, and it was pretty clear that a) the SNB wasn't going to raise the floor, and b) that EUR/CHF wasn't interested in rising by itself as the drumbeat of ECB QE grew louder.  If you really believed that it was going to rally, you could have been long calls with plenty of embedded leverage and modest (and pre-identified) downside.  Unfortunately, many punters who think like that have been naturally selected away, leaving those (not exclusively, of course) who have been rewarded for picking up the pennies.   However, if you never look for the steamroller, you won't see it as it's about to flatten you.

* Market liquidity has deteriorated very sharply.  It seems to be en vogue amongst a cadre of never-traded-professionally policymakers and regulators to state that a decline in market liquidity from pre-crisis levels is a good thing, as it will discourage excessive risk taking.   Be careful what you wish for, because you just might get it.  Lower liquidity, higher vol, and larger risk premium are certainly a recipe for substantially smaller nominal positions.  Unfortunately, lower liquidity, low vol, and low risk premia are a ticking time bomb, as VaR frameworks allow for large nominal position sizes.

However, low market liquidity warps the return distribution to a more non-normal shape, as witnessed by the EUR/CHF debacle.   Comments that the move was a "33 SD" event are nonsensical;   price action below 1.20 was never going to be normally distributed, so it is worse than useless to compare volatility there with that pre-peg break.  That EUR/CHF could trade down 30% (!!!) intraday should tell policymakers something about markets' ability to synthesize new news in an orderly fashion- it's evaporated.   OK, EUR/CHF impacts FX punters and Swiss corporates, but it's not an A-list financial price, is it?  Fine, but what happens when the same thing occurs in credit?   Hell, the same thing has kind of already happened in slow motion in crude oil, but because it helps consumers and screws Russia no one's complaining too much except a few holders of wildcatters' bonds.

Putting it simplistically, there are three classes of traders:

1)  Those that size trades based on current (low) levels of vol
2)  Those that size trades based on a perceived normal level of vol, and thus run 'low risk' in the current environment
3)  Those that do #1, but tell investors/CIOs/themselves that they'll switch to #2 when the time is just right.

In many ways, getting the sizing correct is just as important as getting the market direction right.   For the last several years, trader #1 has reigned supreme, but the rumblings over the last several months strongly suggest that you might want to think about switching gears to #2 earlier rather than later.  As for #3, they are like a (literal) black swan:  Macro Man knows they exist, but he's never seen one in the flesh.