From December ninth, two thousand twenty-four to December thirteenth, two thousand twenty-four

I. Foundation 

resistance to change and hence greater dependability for the results shown in the past.

Can tariffs be both a political tool and an economic tool?

A key question for next year is whether tariffs can serve as both a political tool and an economic tool.

Supporters of U.S. tariff policy have long argued that tariffs are versatile tools for achieving economic and political objectives. However, a closer analysis of these objectives and the reasoning behind them makes it clear that the actual effects of tariff policy often differ significantly from the expected results and may even involve deep-seated contradictions.

The first economic objective of tariffs is to protect domestic industries from “unfair competition” from abroad.

Supporters argue that foreign companies have a competitive advantage because of lower labor costs and state support, and that tariffs can offset this advantage by raising the cost of imported goods.However, research by the New York Fed reveals a very different reality.

The study found that those U.S. companies that could theoretically benefit from import protection instead saw significant declines in market capitalization on the day tariff policies were announced, and subsequently underperformed on key measures such as earnings, employment, sales, and labor productivity.

This suggests that tariffs may have failed to protect the targeted industries effectively, instead triggering market uncertainty and cost pass-through, ultimately weakening companies’ competitiveness. For investors, this “valuation shock” is one of the key risks on tariff announcement days, with particular attention warranted for manufacturing and consumer goods sectors that are highly sensitive to trade policy.

The second economic objective is to reduce the trade deficit by adjusting the relative prices of goods.

In theory, tariffs raise the prices of imported goods and encourage domestic substitute production, thereby balancing trade. However, the effectiveness of this mechanism depends on the adaptability of domestic supply chains and consumers’ sensitivity to price changes.

In the U.S. consumer goods market, many product categories, such as electronics, clothing, and auto parts, are highly dependent on imports, while domestic alternatives cannot ramp up quickly in the short term.

Thus, tariffs may improve the trade deficit in the data, but in practice consumers bear greater cost pressures. This deserves particular attention with inflation still elevated: tariff policy could push core inflation higher and trigger a chain reaction in market expectations.

From a political standpoint, tariffs are viewed as a tool of leverage to compel trading partners to adopt policies that align with U.S. interests.

This strategy was particularly prominent during the Trump administration. Its core logic is to use the scale of the U.S. market to make countries that depend on exports to the United States concede in the face of tariff costs.

The sustainability of this logic is in question because the political effectiveness of tariffs depends heavily on the United States maintaining large-scale imports and a trade deficit. If total imports decline, tariffs’ influence over trading partners will gradually weaken.

For example, U.S. imports from Russia have fallen to about 10% of their peak in 3 2022. The bilateral trade deficit has nearly disappeared. In In this situation, tariffs have become significantly less important to U.S.–Russia relations, showing that their leverage weakens considerably when trade volumes are small enough.

The long-term effectiveness of tariffs as a policy tool is also constrained by changes in the international economic system.

Some argue that tariffs may be a more sustainable tool of international influence than economic sanctions (sanctions).The effectiveness of sanctions depends to a large extent on the dollar’s dominance in the global economy, and this position is not unassailable forever. Although discussion of “de-dollarization” has picked up in recent years, the dollar still has no viable competitor as the global reserve currency.

This means tariffs remain a policy tool the U.S. government can rely on in the short term. Over the longer term, however, as global supply chains are reshaped and trade patterns diversify, whether the leverage of tariff policy can persist warrants further observation.Implementation could trigger significant market volatility in the short term, especially in valuation-sensitive industries and companies with high import dependence.

2024.12.10

After 14 years, what happened to markets following the “moderately accommodative” monetary policy of that time?

After fourteen years, monetary policy has once again adopted the wording “moderately accommodative,” signaling a major shift in the policy environment. The last similar wording appeared during the 2008 global financial crisis (GFC). At the time, China implemented a “4-trillion” fiscal stimulus plan and injected liquidity into the economy through large cuts to reserve requirements and interest rates, along with other policy tools. This historical backdrop can provide a useful framework for understanding the current policy shift.

 Chart: Performance of Chinese assets during the 2008-2011 “moderately accommodative” monetary policy period

What happened in 2008?

Looking back at 2008, China cut the reserve requirement ratio (RRR) by 200 basis points in just three months, from 17.5% to 15.5%, and lowered lending rates from 7.47% to 5.31%.

The 10-year government bond yield quickly fell from 4.5% to 2.7%, while Short-term yields fell even further, from 3.6% all the way to 1%, driven by abundant liquidity. Meanwhile, the Shanghai Composite Index (SHCOMP) plunged 30% in the early stages of the crisis, but thanks to strong fiscal stimulus, the market subsequently bottomed out and rebounded and doubled in less than a year.

On the exchange-rate front, The renminbi stopped appreciating and was pegged to the U.S. dollar starting in the second half of 2008, until gradual appreciation resumed in 2010.

This policy mix clearly illustrates China’s objectives at the time:to stabilize liquidity quickly through monetary easing, stimulate domestic demand through fiscal measures, and ensure financial-market stability at the same time. The current call for “moderately accommodative” monetary policy clearly draws on this model.

 Chart: History of China’s macroeconomic policy stance

What might this latest “moderately accommodative” stance bring?

Reintroducing “moderately accommodative” policy will have a profound impact on bond, equity, and foreign-exchange markets. First, bond-market pricing logic will inevitably need to be reassessed. When monetary policy turns accommodative, rate declines are usually front-loaded. The previously expected 2025-year downside room of 40-50 basis points for Chinese interest rates may be realized more quickly over the coming quarters as the policy pivot comes earlier than expected.

The likelihood of a substantial reserve-requirement-ratio cut by the central bank has risen markedly. Governor Pan Gongsheng had already signaled a 50-basis-point cut, which could become the first step in subsequent policy measures. In addition, the use of unconventional tools such as open-market operations and direct purchases of government bonds (CGB) may expand, injecting medium- to long-term liquidity into the market.

One point to watch is that the full effects of the current policy mix remain to be seen, Monetary easing will benefit the bond market in the short term, but once the details of fiscal stimulus become clear, long-term rates may come under renewed pressure, bringing the risk of a steeper yield curve.In particular, If the scale of fiscal policy exceeds expectations, a rise in government bond yields similar to that of 2008 could recur.

Chart: Goldman Sachs expects China’s easing to continue through 2025 or even longer

On equities and foreign exchange

Underweight positioning in Chinese assets has returned to its previous trading range, particularly among offshore investors. If the improvement in risk appetite after the policy shift is gradually confirmed, it will certainly spur further foreign inflows, but this is a process, not a rapid rush into positions.Historically, A-shares have shown a strong beta effect under “moderately accommodative” policy, and this time is expected to be no exception.

In the short term, the Central Economic Work Conference, scheduled for 12 11–12, will be an important point for observing the direction of policy. Although the meeting may not provide specific data, its directional guidance on key areas of support will be crucial.

A clear signal of a policy shift has arrived, and markets need to prepare for larger interest-rate adjustments and asset-price revaluations. These changes will gradually emerge over the coming months. Ultimately, this round of “moderately accommodative” policy is not a return to the experience of 2008; it is more likely to be a new test of policymakers’ ability to manage market expectations.

2024.12.11

China’s Unusual Debt Accumulation

Using a narrow definition of debt—that is, adding bank credit to the private sector and government debt—the only country whose pace of debt accumulation has resembled China’s over the past 150 years, apart from European countries during the First World War, is Japan. Yet when Japan’s debt was growing rapidly, its income level was three times China’s today.

 Chart: China’s debt accumulation is unusual for a middle- or low-income country in peacetime

After adjusting for financial deepening

In fast-growing economies, debt growth—or even a moderate rise in the debt-to-GDP ratio—is not unusual; it is a natural result of financial deepening.

To consider the impact of this aspect of “financial deepening” on debt growth, we can calculate the change in the debt-to-GDP ratio over a 7-year period, then estimate the expected growth in the debt-to-GDP ratio based on the change in per capita income over the same 7-year period.

Short-term data may be affected by temporary fluctuations, while too long a time span can obscure dynamics within the cycle.This 7-year timeframe provides a medium-term perspective that reflects the trend relationship between debt growth and economic growth.

The key to this step is to remove the natural debt growth component caused by “rising income levels.”First, calculate the actual change in an economy’s debt-to-GDP ratio over 7 years (actual debt growth), then estimate the economy’s “expected” debt growth based on the change in per capita income over the same period (that is, the reasonable expansion of debt attributable to income growth).

However, even after accounting for financial deepening, China’s adjusted percentile for 7-year debt/GDP growth had reached 96% as of 2015—surpassing almost all comparable cases. Among the 1960-2023 sample, only three countries met both criteria: a global GDP share above 10% and adjusted debt/GDP growth over 7 years exceeding 25 percentage points:the United States in 2007-2013, Japan in 1986-2000, and China in 2012-2020.

2024.12.12

Rising Debt: Vulnerability Mechanism

From Japan’s debt bubble in the 1980s to the credit boom in the United States in the 2000s, the outcome in both cases explains why rapid debt growth is worrying. High debt levels make the financial system and the macroeconomy more sensitive to external shocks, while rapid debt accumulation makes demand-side spending more vulnerable to adjustment as growth slows.

The core issue is that debt-driven economic activity has significant path dependence.

A new unit of debt can directly support an equal amount of spending. For example, an increase in debt of 100 dollars could generate an additional 100 dollars in consumption or investment spending.But to maintain this level of spending, the stock of debt must continue growing at the same pace in the future (increasing by 100 dollars each period). Once debt growth slows, the extra spending initially supported by debt cannot be sustained, and economic activity may quickly fall back to its baseline level without debt support.

Going a step further, from a dynamic perspective, The growth rate of spending is related not only to the level of debt, but even more closely to the acceleration in debt growth (the second derivative of credit).When credit growth starts slowing from a high level, that slowdown passes directly through to spending growth, weighing on aggregate demand. Credit cannot grow exponentially forever; once a turning point appears, economic adjustment becomes inevitable.

2024.12.12

Background and Impact of the Plaza Accord

In an interview in 2024 7, Trump said the United States had a “currency problem” with Japan and China because their weak currencies made U.S. manufactured goods less competitive in international markets. He said: “Right now, the dollar is very strong, the yen and the yuan are very weak, and we have a big currency problem. They always want to devalue their currencies, and I fought them on that in the past. I told them that if they devalue again, I will have to impose tariffs on you.”

The remarks prompted market speculation about whether the incoming Trump administration would ask Japan and China to address the problem through currency appreciation, potentially using tariffs as leverage. At the same time, people began discussing whether there might be a “currency accord” similar to the 1985 Plaza Accord.

From 1980 to 1985, the dollar appreciated by about 50% against the yen, Deutsche mark, French franc, and British pound—the currencies of the four largest economies outside the United States at the time:

Chart: Into the 1985 Plaza Accord, USD appreciated significantly; in 1985-1987, sharp appreciation of JPY and GEM against USD was also accompanied by Fed rate cuts

During this period, The U.S. trade deficit with major trading partners continued to widen, and the current-account deficit rose to 3% as a share of GDP:

Chart: After the 1985 Plaza Accord, trade rebalancing occurred gradually through 1990

Faced with this unfavorable situation, U.S. businesses lobbied Congress actively, calling for a weaker dollar to support U.S. manufacturing and promoting protectionist trade policies.In 1985 9, the United States, Japan, West Germany, France, and the United Kingdom signed the Plaza Accord. The document stated that “further orderly appreciation of non-dollar currencies is desirable” and pledged that “the countries involved will cooperate more closely when that would be helpful in achieving this aim.”

Major current-account surplus countries, such as Japan and West Germany, agreed to ease imbalances by expanding domestic demand and allowing their currencies to appreciate. Japan in particular relied heavily on exports for economic growth, while its high savings rate further exacerbated the imbalance.

Actions and Market Impact

In 1985, the United States sold 40 hundred million dollars through foreign-exchange-market intervention to buy yen and Deutsche marks; West Germany sold 46 hundred million dollars to buy Deutsche marks during the same period:

Chart: Annual currency intervention in USDDEM (EUR for 2022) by the US and Germany 

Chart: Annual currency intervention in USDJPY by the US and Japan

Japan’s intervention data were not made public until 1991. As a result, the yen and Deutsche mark appreciated by more than 30% over two years, until the Plaza Accord was signed in 1987 2 to curb further dollar depreciation.

In 1987, the United States bought 86 hundred million dollars against Deutsche marks and yen, while West Germany bought 41 hundred million dollars during the same period. It is widely believed thatThe Plaza Accord’s substantial impact came primarily from the clear signal of policy intent it sent to financial markets and the threat of further dollar sales, rather than from the scale of actual intervention.

In addition, the Federal Reserve began cutting rates in 1985 12 in response to falling inflation. Consecutive rate cuts totaling 200 basis points from 1985 12 to 1986 8 further accelerated the dollar’s depreciation.

Economic Impact

The U.S. trade deficit reached a low as a share of GDP in 1987 and turned to a surplus in 1991. Japan’s current-account surplus as a share of GDP fell from 4% in 1986 to 1.4% in 1990. The sharp appreciation severely damaged Japanese exports, and GDP growth plunged from 7% to 1% in two years.

 Chart: Japan’s exports/GDP have contracted sharply since 1985

To address the economic shock, Japan introduced large-scale monetary and fiscal stimulus. This temporarily eased economic pressure but fueled an asset bubble that eventually burst in 1990, with severe economic consequences.

2024.12.13

II. Insights 

Our Viewpoints and ideas on market.

Trading Expectations: Fast Announcement, Slow Implementation

Tariffs, taxes, immigration, and regulation are the four core variables in market pricing. The new administration’s post-election policy cadence is clear: announce quickly, implement slowly. This combination is market-friendly in the short term, but poses clear risks over the medium term.

At present, the prevailing backdrop for U.S. equities is an expectation that policy will follow the path of Fast Announcement, Slow Implementation. “Slow Implementation” supports risk assets, as the negative effects of tariff and immigration policies arrive with a lag, while positive expectations for taxes and regulation lead valuation expansion.The negative effects of tariff and immigration policies take time to materialize, while positive expectations for taxes and regulation are driving valuation expansion.

Actual implementation inevitably lags behind what is priced into expectations.

The biggest risk now is the asymmetric distribution of risks around rapid implementation. If tariffs are applied across the board or immigration policies are accelerated, stagflation risks will intensify and market logic will quickly shift from momentum trading to defensive pricing. When rebalancing, investors should either build a more balanced mix or keep a close watch;If this paradigm shift comes, it will come quickly; don’t hesitate when it does.

The main strategy is to exploit the gap between policy announcements and implementation. Focus on sectors with stronger fundamentals that benefit from lower rates and deregulation, while adopting defensive strategies for highly valued, policy-sensitive assets. The bullish case for the dollar remains intact. Rotation between cyclical and growth stocks should be adjusted dynamically in line with the policy timeline; keep positioning flexible in the short term and capture structural opportunities amid volatility.

Key Background on Several Core Variables

1) High tariffs on Chinese goods are the most readily implementable policy. Existing executive authority is sufficient to support them, and implementation does not require congressional approval.But expanding the scope is constrained by the budget reconciliation process and lacks broad support within Congress. For markets, this“limited coverage, phased implementation” model will reduce supply-chain disruption in the short term, but the risk of gradual escalation over the medium term cannot be ignored.

If policy shifts to “broad coverage, rapid implementation,” stagflation risks will emerge. Once tariffs are fully implemented, they will certainly weigh on GDP growth and drive up imported inflation, strengthening the dollar through safe-haven liquidity flows. The consumer and retail sectors will face systemic pressure, Market logic will shift from trading expectations to pricing actual impacts.

2) Taxes: the extension of tax policy may be completed before the final deadline in 2025, but political wrangling over extending, raising, or cutting taxes will slow the process, The marginal improvement in corporate earnings will lag policy implementation, making its short-term alpha contribution to the market limited.

3) Immigration: policy changes may be announced quickly, but their actual impact in reducing labor supply takes time. Structural changes in the labor market will affect wage growth and consumer capacity over the medium term, The market is currently underpricing this variable.

4) Deregulation is expected to be announced quickly, but implementation will take a long time; historical experience shows that rewriting rules is extremely time-consuming. This factor provides strong valuation support for highly leveraged industries such as energy and finance, but has limited impact on near-term earnings growth, The risk to watch is that expectations of future policy implementation could arrive early and create a mispricing in trades.

2024.12.09

U.S. Dollar Shorts: The Pain Trade

Over the past few days, I’ve seen some traders who are good at Pain Trades contemplating a short-dollar position. The risk is extremely high. Here I’ll explain the logic behind the trade; the risk really is very high, so this is just for everyone’s information.

For some traders who like to go against the trend, the risk/reward profile of shorting the dollar now is very attractive. On the one hand, the good news for the dollar is already heavily priced in, including strong U.S. data, optimistic expectations for fiscal and trade policy, and the market’s pricing of the Fed’s rate-cut path.

Positioning data show that dollar longs are heavily skewed; technical indicators such as RSI show market sentiment is too one-sided. The current Economic Surprise Index (ESI) is also near its historical high. Once data start to diverge from expectations, sentiment could reverse rapidly and sharply.The current consensus long-dollar position is not only a concentration of risk, but also, in some people’s view, the perfect setup for a pain trade.

The three pillars of the bullish-dollar thesis have begun to wobble:First, the advantage in U.S. data is still there, but the market has already priced it in too aggressively; extremes in ESI often go hand in hand with expectations being adjusted, and the “surprise window” for economic growth may already have closed. Second, the market is too optimistic about the impact of changes in trade policy, particularly by significantly overestimating the potential expansion of tariffs to regions outside China. Third, the mismatch in the Fed’s rate-cut path gives dollar shorts clear room to fall, The market currently prices in rate cuts at only the next four meetings50bp; this pricing gap will come to a head as the Federal Reserve cuts rates further.

12 is a key window for dollar bears:Upcoming CPI data (12 11) could come in below market expectations, reinforcing expectations of continued Federal Reserve rate cuts; the FOMC meeting (12 18) is currently expected to deliver a 25bp cut and provide guidance on subsequent cuts. If that guidance later diverges from current pricing, it would significantly weaken the support front-end rates provide to the dollar; the ECB meeting (12 12) could also dampen bullish sentiment on the dollar with a moderately dovish stance. Meanwhile, if CN’s Central Economic Work Conference announces more easing than expected, it would lift the renminbi and curb the dollar’s relative strength.

From a trading perspective, AUD/USD and GBP/USD are in fact the best expressions These two have relatively little exposure to trade tensions, while also offering higher carry returns. Technically, they are near the bottom of their historical ranges, giving these long trades a clear risk/reward advantage.

EUR/USD face long-term yield and fundamental headwinds, but near-term risks have tilted to the upside. The market’s extremely pessimistic pricing of the euro creates scope for a technical rebound, with short covering likely to be a key driver. Trade risks are already largely priced in, leaving limited room for further downside; an upside surprise could instead prompt the market to reassess the euro’s potential.

2024.12.09

Politburo meeting: the most aggressive stimulus tone in ten years?

The meeting clearly set the policy direction, placing consumption-driven demand expansion at the center. This wording is clearly a policy response to weak domestic demand. The dual easing path in fiscal and monetary policy strengthens the credibility of the policy signal, but the key lies in the pace and scale of actual implementation. Property and consumer sectors could benefit from this policy push, while the bond market could strengthen further on larger liquidity injections and expectations of rate cuts. In addition, renminbi assets may attract more foreign inflows amid expectations of economic recovery and policy support.

In short, near-term risk is greater than in the previous policy trade, and near-term returns are lower. Rather than an endpoint, this is more likely the true starting point of a long-term trade. Make your own decisions.

The Politburo meeting sent a strong signal of support for consumption, which directly drove a reversal in offshore Chinese markets despite their initial weakness at the open. The meeting mentioned increasing support for consumption, policy preferences for the property sector, and a moderately accommodative shift in monetary policy, but Clearly, the phrase ‘boost consumption forcefully’ is the core focus of current market trading.

Chart: Offshore Chinese stocks rallied sharply after the Politburo meeting, with HSCEI/HSTECH gaining 3%/4%, respectively.

Morgan Stanley’s Xing Ziqiang also commented on the meeting, saying“The pre-CEWC Politburo meeting sent most aggressive stimulus tone in a decade.”This Politburo meeting sent the strongest stimulus signal in ten years ahead of the Central Economic Work Conference.

The meeting statement exceeded market expectations, especially against the backdrop of relatively subdued expectations for its outcome beforehand.Compared with the 9 meeting, this The meeting’s wording included many new phrases, showing that policy thinking is gradually shifting from supply-side adjustments toward a balance on the demand side.

The key points are as follows:

1) The wording on monetary policy was changed to ‘moderately accommodative’; this is the first time since 2011. We may see larger rate cuts in the future (with cuts of 40-50bp expected next year); the People’s Bank of China may also use new tools more proactively, such as buying government bonds (CGB) and conducting outright repo operations, to increase liquidity.

2) Fiscal policy emphasizes being ‘more proactive’ and adds the wording ‘strengthen countercyclical adjustment’, signaling that the policy mix will tilt further toward easing. It explicitly calls for ‘actively promoting consumption and improving investment returns’ and ‘expanding domestic demand comprehensively’; judging from the wording, this is clearly a direct response to the current shortfall in demand。

3) Emphasizes the leading role of economic reform in the economy, while also proposing greater high-standard opening-up and the stabilization of trade and foreign investment, reflecting a policy focus on balancing domestic and external considerations.

4) For the first time, ‘stabilizing the housing and real-estate markets’ is presented as a single phrase, and the wording ‘prevent and resolve risks in key areas and external shocks’ has been added. ‘External shocks’ clearly refers to uncertainties in the international trade environment, such as tariffs. ‘Stabilize expectations and revive the economy’ has also been added, which reflects policymakers’ concern about low market expectations and a lack of ‘animal spirits’。

The Central Economic Work Conference will also take place this week. With the Politburo meeting having already significantly lifted market sentiment, the market will certainly expect more policy details to follow. If policy has indeed shifted, then not only the Chinese market, Some lagging sectors in European and U.S. markets outside China, such as luxury goods and mining stocks, and even some commodities trades, may have more room to catch up.

It should be noted that this meeting provided no quantitative figures for specific stimulus measures, and the upcoming Central Economic Work Conference, which is likely to take place soon (12 11-12), may also offer no clearer details. This may explain the relatively muted market reaction.

In fact, the direction of the bond market matters more than the meeting itself.

Chart: Government bond yields hit a new low

It never moves in just one direction; it fluctuates both ways. This time, the consistent trend may mean something more.

Judging from the Politburo meeting’s strong statements, policy implementation could be forceful.

From a market perspective, given that offshore market positioning is now significantly lighter than in 9-10 a tactical rally in mainland markets driven by policy expectations could continue. Going forward, attention should focus on the actual implementation of more proactive policies. With consumption and the property market potentially benefiting further, the A-share market may continue to receive capital inflows and sentiment support in the near term.

Chart: Positioning in the China market

For the medium-term outlook, the consensus among foreign investors is still that an ‘expansionary fiscal package’ will be introduced in 2025, led by investment, but with a slightly better balance between consumption and investment, for example by expanding the consumer-goods trade-in program. On monetary policy, there will be more action than the market generally expects between now and the end of 2025. The central bank may also inject further liquidity by lowering the reserve requirement ratio (RRR) and buying government bonds in the secondary market.

On the other hand, the likelihood is increasing that the official deficit will reach GDP of 4%, slightly above the previously expected 3.5%-4.0%; the market should interpret this positively.In addition, more quasi-fiscal expansion measures, such as special bonds issued by central state-owned enterprises, could also be adopted, further strengthening policy support.

Chart: Trading flows in the China market

We do not view this as the endpoint of the trade. On the contrary, looking back after a long time, this could well prove to be the true starting point of a long new trade. This also means there is no need to rush in; there is still a long road ahead.

2024.12.10

III. Market Pulse 

Our latest Comments on the economic and market environment

Note: All content in this article is for reference only and does not constitute investment advice or serve as a basis for any laws, regulations, or regulatory policies. Investors should not use or rely on this information as a basis for their decisions.

A Federal Reserve focused on liquidity

The message here is that although QT continues and the balance sheet is gradually shrinking, the potential release of liquidity from lowering the ON RRP rate could ease funding pressures to some extent, creating a potentially supportive backdrop for risk assets.

The minutes of the latest FOMC meeting indicated that The Federal Reserve is considering lowering the ON RRP (Overnight Reverse Repo Facility) rate.This development reflects the Federal Reserve’s continued focus on liquidity management and could affect markets in several ways.

Background and current situation of ON RRP

ON RRP are important tools introduced after the pandemic, primarily intended to provide money market funds (MMFs) with a safe place to park cash and prevent yields from turning negative due to excess liquidity. At the time, large-scale QE and fiscal stimulus measures prompted MMFs to buy large amounts of short-term government bonds, putting yields at risk of falling below zero.

However, the situation is quite different now. Yields on ON RRP are more attractive than those on short-term government debt such as T-Bills, so large amounts of money remain parked in RRP rather than flowing into the bond market or the broader economy.The Federal Reserve plans to lower the ON RRP rate to encourage MMFs to move funds out of RRP and into T-Bills.

Potential liquidity injection

If MMFs transfer funds from ON RRP into T-Bills, this process effectively puts cash back into the banking system, increasing reserves and systemic liquidity.Although ON RRP balances have fallen to a cyclical low, there is still about 1500 hundred million dollars of potential liquidity reserves, which is no small amount. Especially with the Federal Reserve conducting quantitative tightening (QT), this operation would be equivalent to offsetting part of the liquidity drain caused by balance-sheet runoff.

2024.12.11

The market is quietly pricing in a black swan

Low volatility does not mean low risk. Many institutions in the current market are using trade structures such as VIX Call Spreads to hedge or bet on tail risks in a cost-efficient way. Beneath the market’s apparent ‘calm’, there may be intense concern about potential risks. This also reflects deep disagreement among volatility-market participants about the future direction and demand for hedges against extreme scenarios.

Although overall market volatility, represented by VIX Spot, is low and reflects relative calm, demand for protection against extreme events (tail risks) is exceptionally high. Other activity is taking place beneath the relatively calm surface. The cost of tail-risk protection, especially against upside risk in the panic index, has reached an all-time high, The elevated VIX Call Skew currently reflects a surge in investor demand for protection against extreme-risk scenarios.

The current VIX Spot is low, indicating limited market volatility and relatively stable overall sentiment. Yet concern about tail risks is rising sharply beneath this ‘surface calm’.

The all-time high in Call Skew means market participants are willing to pay a higher premium to buy longer-dated VIX Calls, reflecting concerns about extreme risks or expectations of a sharp rise in volatility, Investors are somewhat concerned about extreme events.

VIX (the ‘fear index’) has passed several important milestones since its launch:

1) 1993 4 19 – VIX Spot officially launched, becoming the benchmark indicator for market volatility

2) 2004 3 26 – VIX Futures launched, giving investors a tool to hedge and speculate on volatility

3) 2006 2 – VIX Options launched, further expanding the range of volatility-trading strategies

4) 2008 10 24 – VIX Spot hit an all-time high during the financial crisis at 89.53

5) 2017 11 24 – VIX Spot touched its all-time low of 8.56

6) 2024 12 12 – VIX Call Skew reached an all-time high of 1.5 times (3M 5DC/50DC)

The cost of protection against Tail Risk is reaching unprecedented levels!

Heavy trading in 2-month-expiry Call Spreads also shows that the market is concentrating its positioning in short-term volatility exposure, indicating that investors expect volatility to fluctuate significantly before the 2 expiry date.

2024.12.13