Wednesday, November 25, 2009

The Next Bubble: Positive Feedback

There are three types of positive feedback in the market: irrational feedback, rational feedback, and reflexive feedback. To distinguish between these, let me quote a previous post at length:
In a bubble, the dominant mechanism is positive feedback; the key to understanding bubbles is understanding this positive feedback. How, then, does positive feedback arise?

The most obvious explanation is the conventional one: positive feedback is a consequence of irrationality in the market. And there’s certainly an element of truth in this explanation. Greed, self-delusion, unjustified extrapolation, caring more about relative returns than absolute profits (a.k.a. “keeping up with the Joneses”), conformism (a.k.a. “if everybody else is doing it why can’t we?”), confusing the improbable with the impossible (“house prices will never go down nation-wide”) and other persistent behavioral flaws lead inevitably to bubbles. This has been true throughout the history of speculation.

But one doesn’t have to invoke irrationality to explain positive feedback. Positive feedback can arise quite naturally when rational traders encounter flawed institutional mechanisms, as my previous post makes clear. Short-term incentives, asymmetric outcomes, incomplete information and firm-wide pay structures could all lead to perfectly rational actors taking actions which lead to positive feedback and hence bubbles.

Both of these are what I would call ‘technical’ explanations, in that they depend on trader behavior (which has various causes) to move market prices away from some underlying fundamental value. But there is another, and to my mind more interesting, form of positive feedback in which the fundamental values themselves change.

Consider this example from the FX markets. A currency strengthens. This acts like a tightening of monetary policy. Hence inflation expectations diminish. Hence the currency strengthens further. The initial move has thus changed the underlying fundamentals so as to justify itself; it has become a self-fulfilling prophecy.
It is the third kind of feedback – reflexive feedback, wherein a rise in the price of an asset positively impacts the fundamentals underlying that asset – that drives the most extreme bubbles.

So, which kinds of feedback are at work in the bond market today? Well, for starters, I don’t think irrational feedback applies. There’s certainly no groundswell of investors clamoring to jump aboard the bond bandwagon, and I don’t expect this to change for some time yet (if at all).

As for rational feedback, there is certainly an element of it driving bond purchases by foreign central banks, pension fund managers and carry traders. But in my experience, rational feedback tends to be a reaction to (or symptom of) a bubble, not a precursor to it; at any rate it is not sufficient to inflate a bubble on its own.

Finally, let us consider reflexive feedback. This is the subtlest case of the three, and the most interesting. Is there a mechanism for reflexive feedback in the bond market today?

I believe so. It works like this:

The Fed lends money to banks at 0%, hoping that the banks will turn around and lend to businesses and consumers. But why should the banks do this? They'd much rather buy bonds at 4% and make the carry. Of course some amount of funds does in fact go to businesses and consumers, and some amount goes into riskier assets (this year, for example, these riskier assets have included commodities and emerging market stocks). But as a proportion of the whole, these amounts are minuscule.

Meanwhile the Treasury issues gigantic amounts of debt and that's where the bank money goes. And it creates a self-reinforcing dynamic: banks buy bonds and keep long rates low; the Fed sees low long rates as evidence that the market does not anticipate inflation, and so keeps short rates low; the Treasury sees strong demand for government paper and weak third-party lending and concludes that more issuance is both acceptable and required; and the cycle continues.

Note that it is precisely the fact of low overnight rates that makes buying long bonds attractive for banks. And it is precisely the fact of healthy demand for long bonds that encourages the Fed to keep overnight rates low. That’s positive feedback in its cleanest form.

Again, this is not (yet) proof either way that a bond bubble exists. It is merely suggestive evidence that a necessary condition – reflexive feedback – is in place for such a bubble to inflate. I will review some other pieces of suggestive evidence in my next post.

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