Fighting the Fed's short volatility position - Hold some divergent trades and strategies for tail risk

I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.

[W]hen it is time for us to sell, or even to stop buying, the response could be quite strong; ... it’s also unloading our short volatility position.

it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think.

Comments from yet to be named Fed Chair, Jerome Powell, during the October 23-24, 2012 FOMC meeting 

These insightful comments from Jay Powell eight years ago capture the core monetary policy and fixed problem we will be facing. It may not be an immediate problem, but markets are forward-looking. Although many moan about market short-sightedness, there already is discussion about the Fed end game, and most do not think it will be pretty. If you are a macro thinker, this can be described as an inflation issue. If you are a trader, it is a micro problem of a massive player being short fixed income volatility. Once the short volatility pressure is relieved, markets will adjust rapidly.

The Fed is the ultimate convergent trader; forcing convergence to their short-rate target and what looks to be a target yield curve. Being short volatility impacts more than just bonds. It reduces risk across all financial assets and markets will respond as predicted. Investors think about total risk, price times quantity. If price risk is capped, then investors will take a greater quantity of risk. This is especially true if the "risk" being discussed is the downside or left tail.

There may be little reason today to trade against the bond convergence to the Fed goals; however, there is every reason to hold some investments to take advantage of divergence or tail opportunities that may arise. Out of the money puts and strategies like long-short trend-following are perfectly suited as a long volatility Fed offset. When the market is dominated by convergence trading by the central banks, it still makes sense to prepare for an alternative divergent world.