Do Deficits Matter?

In a previous post I described the theoretical implausibility as well as the empirical rarity of governments inflating away their debt. I concluded that a deficit-driven buyer’s strike was unlikely, by itself, to pop the bond bubble.

Does this mean that “deficits don’t matter”? Oh no, quite the contrary. Deficits do matter, but it’s important to understand the mechanism. Deficits don’t operate via a buyer’s strike unless you go into hyperinflation. Instead the channel is monetary policy.

The Treasury issues bonds. The Fed buys them. As far as I’m concerned, that’s just an internal transfer. The external effect is not bond supply; the bonds never hit the street. Instead, the external effect is government expenditure. Essentially the Treasury is spending dollars that have been newly printed by the Fed.

In the short run this policy will boost private sector consumption and employment, as indeed it is designed to do. But in the long run it will lead to inflation; seigniorage always does.

Note that this inflation will not necessarily manifest itself in the form of rising interest rates, at least not immediately. If the Fed is willing to buy 75% of each Treasury auction (matching China at its peak) then sure, bond yields will stay low.

But the increase in money supply has to be reflected somewhere. Two obvious candidates are the dollar and real assets. Sure enough, in the last year or so these two instruments have fallen and risen, respectively. Policymakers who look only at bond yields to determine inflation pressures are missing the point.

Ultimately of course rates will have to go up. If something cannot last forever, it will not.

Big Brother meets Ben Bernanke

[We interrupt our regular schedule of abstract pontification to bring you this quick note on price action]

All summer long, asset markets boomed while the US economy (in my opinion) more or less stunk. Why? Because of central bank policy.

Then on Friday we had a strong payrolls number (just 11k jobs lost, much better than expected).

I think this makes the Fed on the margin more likely to hike interest rates.

Sure enough, asset markets have been going down since the number came out.

It's almost Orwellian: war is peace, good news is bad news, strong numbers are weak numbers.

But that's what happens when you let asset prices be determined (supported) by central banks instead of by economic fundamentals.

Anyway, I'll go out on a limb and say that last week was the high for 2009 and we'll sell off into 2010.

This move will be reinforced by year-end risk reduction. Also, for what it’s worth, most technical indicators look really exhausted.

I have sold [EM] stocks aggressively over the last 3 days and now have plenty of [dollar] cash. Let’s see how things play out.

[Clarifications in square brackets added on 17 Dec; also, note that I currently own no US stocks.]

Buyers' Strikes and the Debt Treadmill

Here’s what I wrote last week:

Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory.

Sure enough, and with dreary predictability, commentators from left and right have divided along partisan lines in their analysis of the deficits. Here’s conservative historian Niall Ferguson:

There is no end in sight to the borrowing binge. Unless entitlements are cut or taxes are raised, there will never be another balanced budget. By 2039, when I shuffle off this mortal coil, the federal debt held by the public will have reached 91 percent of GDP, according to the CBO’s extended baseline projections.
...
Of course, our friends in Beijing could ride to the rescue by increasing their already vast holdings of U.S. government debt ... [But] the Chinese keep grumbling that they have far too many Treasuries already.

And here’s progressive economist Paul Krugman:

Right now, however, the bond market seems notably unworried by deficits. Long-term interest rates are low; inflation expectations are contained (too well contained, actually, since higher expected inflation would be helpful) ... This is truly amazing. It’s one thing to be intimidated by bond market vigilantes. It’s another to be intimidated by the fear that bond market vigilantes might show up one of these days, even though you’re currently able to sell long-term bonds at an interest rate of less than 3.5%.

Both Ferguson and Krugman seem to think that the danger is that of a “buyers’ strike” in the bond market. Both Ferguson and Krugman are wrong.

The way a buyers’ strike works is this: bond investors fear that huge deficits could lead to inflation down the road as the government tries to print its way out of debt. Hence they demand higher interest rates (lower bond prices) today to compensate for this risk.

Ferguson fears that a buyers’ strike could easily happen in the near future, and hence deficits are something to worry about. Krugman inverts this line of reasoning: he argues that low interest rates are prima facie evidence that a buyers’ strike is unlikely, and so deficits are nothing to worry about¹.

They both miss the point. The notion of a buyers’ strike caused by fears of deficit-driven inflation is conceptually flawed, for the simple reason that the government cannot inflate away its debt.

It’s all a question of loan duration. Sure, if the entire government debt were in the form of a single loan of very long duration, with no payments before the maturity date of the loan, then yes, the government could foster inflation / debase the currency over the lifetime of the loan, and thus gyp the lenders.

But in actual fact, the majority of the US government’s debt is in the form of short duration loans – bonds with 2 years or less to maturity. This debt has to be rolled over. If lenders suspect that the government is planning to inflate the currency, then at the time of rollover they will demand higher nominal interest rates on the rolled debt, to compensate for this expected inflation. They will also demand higher real interest rates, to compensate for the additional uncertainty. And so the cost of servicing the debt will actually increase, by an amount greater than the amount of inflation. It’s like running on a treadmill: the government cannot get ahead².

The facts bear this out. Here’s a chart from UBS showing that changes in government debt / GDP are broadly uncorrelated with the level of inflation.

(Source: UBS, via FT Alphaville; more here)

Note the strong element of feedback (a favorite topic on this blog) at work here. The possibility of a buyers’ strike in the future implies that inflation cannot work as a strategy for debt-reduction; the futility of an inflationary strategy suggests that a buyers strike will not occur in the present. A buyers’ strike is thus a self-negating prophecy; the present (no-strike) equilibrium is maintained; and market yields have nothing to do with the probability of such a strike occurring.

But wait. Does this mean that deficits don’t matter? Not quite. I’ll return to this question in my next post.

Footnotes

# ¹Their respective stances would be more credible if it weren’t for the fact that six years ago, Krugman and Ferguson were on the opposite sides of the deficit debate. Back then, Krugman was a vocal deficit hawk, raising the prospect that tax cuts, entitlement commitments and military spending could ‘drive interest rates sky-high’. Meanwhile, Ferguson claimed that deficits were necessary and desirable if that was what it took to maintain the level of military spending required for purposes of US hegemony.

Of course both sides claim to have switched allegiance for the best of reasons. But the cynic in me will perhaps be forgiven for concluding that whether one is a deficit hawk or not depends greatly on what type of spending the deficit is being used to finance.

# ²As a general principle, the only way a government can inflate its way out of debt is to print money so fast that the real value of the debt falls significantly before the debt comes due. For a short-duration debt portfolio (like that of the US), this means hyperinflation.

The Next Bubble: Are We There Yet?

My previous two posts make it clear that all the conditions are in place for a bond bubble: strong fundamentals, technical momentum, and a mechanism for positive feedback. But these conditions are merely necessary; they are not in themselves sufficient to generate or identify a bubble.

Nonetheless there are certain indicators that suggest we may be entering bubble territory.

Let’s start by looking at the fundamentals again. One sign that a market has transitioned from boom to bubble is when the fundamentals change from bullish to bearish, but prices keep rising. I believe that this is true for the bond market. Let’s consider each of the factors I identified in my earlier post, in order:

1. Monetary policy seems to have regressed in recent years. In particular, central banks are no longer strict inflation-targeters; they have become asset-price-targeters instead¹. Central banks are also less independent than before². Finally, central banks have explicitly moved from trying to head off crises, to merely reacting to them³. This reaction invariably takes the form of overly easy monetary policy, since policy-makers and politicians alike seem incapable of accepting short-term pain for long-term gain. Each of these is a backward step, in my opinion.

2. Since the fall of the Berlin wall and the ‘end of history’, the US has become embroiled in two expensive new wars, in Iraq and Afghanistan. In addition, entitlement spending (especially social security and health care for retiring baby boomers) will put a significant burden on the government’s fiscal position in the years to come. And a dysfunctional political process renders this trajectory very difficult to change.

3. The momentum towards lower global trade barriers seems to have turned; there are ugly signs everywhere of growing protectionism, higher tariffs, and incipient trade wars.

4. China may not export disinflation for much longer. Western politicians, pundits and plutocrats have been unanimous in calling for China to consume more and/or to revalue its currency upward, in order to reduce the global imbalances that (supposedly) lay behind the recent crisis. Either of these shifts (an increase in Chinese domestic consumption or an increase in the RMB/USD exchange rate) would be dramatically inflationary for the United States⁴.

5. The commodity supercycle is now in its bullish phase.

6. Increased regulation (for which there is plenty of momentum) could see a rollback of innovation, especially financial innovation.

Now, figuring out the impact of (changes in) fundamentals on asset prices is a tricky business. It’s very difficult to know how important any given factor is in determining bond yields; it’s also very difficult to know the extent to which any given factor has already been priced into the bond market.

Fortunately, my argument does not depend on my ability to perform either of these tricks. My point is much simpler. Every single fundamental factor that has driven the 30-year decline in bond yields has either weakened appreciably, or reversed direction. Yet bond yields continue to decline!

What’s going on here?

Well, for starters, many of the technical forces I identified earlier are still in play: Bretton Woods II (developing country exporters continue to finance the US twin deficits); baby boomer portfolio changes (stocks as a retirement haven are understandably less attractive now then they were a few years ago); and post-crisis risk aversion (unemployment and consumption data suggest we are still not out of the woods).

But in addition to these relatively ‘benign’ technicals, some rather more dangerous forces have come into effect.

First, ‘reflexive feedback’ has kicked in, as Wednesday’s post makes clear. Low long bond yields create the justification for the Fed to keep overnight rates low. And low overnight rates create the motivation for investment banks to buy long bonds.

Second, the ‘greater fool theory’ has kicked in: there’s certainly an element of it in foreign central bank purchases of US government debt. Various acronymic entities like the BOJ, SAFE, ADIA and so on know full well that if they don’t take down Treasury’s flood of new supply, their existing holdings will be mullered.

(As an aside, the fact that foreign CBs are price-insensitive buyers is often quoted as a justification for the low level of yields, whereas in fact it is a symptom that yields are in non-economic territory.)

Third, commentators have begun to emerge claiming that “this time it’s different”, most notably those whose belief in American exceptionalism blinds them to the parallels with Britain a century ago or Spain somewhat further back.

A fourth suggestive indicator is the level of supply. All true bubbles are characterized by dramatic increases in supply, which seem to have no impact on prices (until of course the bubble collapses). The Treasury market clearly embodies this dynamic: the August 10-year note, for example, had a float (after reopenings) of 67 billion. That’s more than the entire government of debt of say Switzerland or Australia. Just one single bond.

Put it all together, and the conclusion is obvious: we are entering a regime where fundamentals don’t matter any more; a regime in which technicals, feedback and short-term (institutional) considerations dominate the price action; a regime where supply has crossed the line from the impressive to the insane. In short, a bubble.

Footnotes

# ¹ We used to have a Greenspan put; now we have a Bernanke put; but there was never a Volcker put. I explain the link between Fed policy and asset price bubbles here.

# ² Witness the close cooperation between the Fed and the Treasury in rescuing Wall Street banks in 2008 – this could have come straight out of the Arthur Burns / Richard Nixon / Penn Central playbook. It’s not as if the Fed has much choice in the matter; see the last two paragraphs of this post for more.

# ³ A view reflected in ex-governor Mishkin’s recent comments on identifying bubbles, which I review here.

# ⁴ Actually, that’s sort of the point. Inflation is a monetary phenomenon; an increase in US inflation necessarily means a debasement of the currency, which is precisely what the US needs if it is to reduce its twin deficits.

Also, note that if China does boost domestic demand, revalue its currency or otherwise plug its trade surplus with the US, an immediate and necessary consequence would be a decline in Chinese buying of US Treasuries. And if China backs off, who will finance the US budget deficit? One more bearish indicator for bonds.

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.

The Next Bubble: Fundamentals and Technicals

In my opinion there are three necessary conditions that have to be in place for a bubble to inflate: fundamentals, technicals, and feedback. Let’s look at each of these in turn.

Preceding every bubble there is a boom: a justified increase in prices driven by positive fundamentals. In the aftermath of a bubble, it’s easy to mock the excesses that marked the bubble’s apogee (boo.com! ninja loans!) but all too often people forget the backstory. In fact there were very good macro and micro reasons why the tech sector boomed in the early 90s, and why real estate boomed in the early 00s; it wasn’t all froth.

So, have the fundamentals been positive for bonds? I think the answer is yes, they undoubtedly have. Here are some of the factors that have led to lower and more stable interest rates over the last few decades, in no particular order:

1. Improved monetary policy – specifically, central bank independence and inflation targeting – starting with the Volcker Fed
2. The end of the cold war; reduced military spending; the peace dividend
3. The lowering of global trade barriers and tariffs
4. China’s entry into world commerce and its export of wage and retail disinflation
5. The bear leg of the commodity supercycle
6. Improvements in business technology, especially in inventory management¹

But fundamentals alone are not the entire story. A number of technical factors have also supported bonds in recent years²:

1. The Bretton-Woods II equilibrium, in which countries on the periphery (Asia and the Middle East) lend money to (buy bonds from) countries in the center (North America and Europe) to finance the latter’s imports.
2. Aging baby boomers transferring capital from stocks to bonds as per life-cycle investment theory
3. Risk aversion in the aftermath of the crash
4. The dollar carry trade

Fundamentals and technicals working in tandem have driven 30-year yields from 15.5% in 1981 to 2.5% in 2008. That’s a boom in anyone’s book.

But is it a bubble? For a bubble to inflate, there’s a third, crucial element: positive feedback. I shall investigate this topic in my next post.

Footnotes

# ¹Paul Krugman puts it nicely: "Businesses spent two decades figuring out what to do with information technology, then found the answer: big box stores!"

# ²Note that these are just some of the technicals that are currently in play; at other times in the bull run, other technicals have applied.

The Next Bubble: Disclaimer and Disclosure

Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory.

So, in the interests of full disclosure, and for what it’s worth: I am not a US citizen or resident, I do not pay US taxes or receive US benefits, I am not currently connected with the US financial industry (except as an external observer and generic investor), and I do not support any US political party. In short, I have no dog in this race.

All I want to do is understand what has happened, what is happening, and what will happen, insofar as (and no further than!) it helps me as a trader and investor. And my current understanding, based I hope on unbiased analysis, is that we are in the middle of a bond bubble. I think that interest rates may go lower over the short term, but that they will go higher – significantly higher! – over the medium to long term. My portfolio is positioned accordingly. If I get my predictions correct, I will make money; if I get them wrong, I will lose money. It’s as simple as that.

The Next Bubble: Introduction

Bubbles fascinate me. Nowhere else will you find such a variegated proving ground for the vagaries of human psychology, nor such a vivid illustration of the wondrous complexity that is the market. The various tensions on display – between individuals and institutions; between incentives and emotions; between rationality and greed; between the short term and the long run; between macro economics and micro behavior; between fundamentals and technicals – offer limitless scope to the curious observer.

If the study of markets is the study of human nature, then the study of bubbles is the study of markets in microcosm.

My fascination with bubbles will come as no surprise to regular readers of this blog, as evidenced by my choice of subject matter. In recent weeks I have written about bubbles and the rational trader; scale invariance in bubbles; feedback effects in bubbles; the link between asset price bubbles and jobless recoveries; the identification of bubbles; and the stages in the evolution of bubble.

But these essays have been, for the most part, abstract and analytical; they say little about the state of the world today. Not so the next few posts. In the coming week I would like to talk about a bubble that I fear is developing before our eyes. And it’s not a bubble in emerging market stocks or in raw materials; it’s in something much closer to home.

Again, regular readers of this blog will know or have guessed what I’m talking about: I believe that we have recently completed the transition from a boom to bubble in the market for long term US government bonds.

Extraordinary claims require extraordinary evidence. Hence I will take a break from the usual ‘weekly column’ format of this blog, and instead provide a sequence of shorter posts in which I will expound on my thesis in greater detail. Coming up first: background information and necessary conditions.

Bulls and Bears: How Asset Prices Evolve

In last week’s post I mentioned three stages in the evolution of a market:

Identifying full-blown bubbles is easy. What’s not so easy is identifying the transitions that bookend a bubble. It’s not easy to know precisely when a rational, fundamentals-driven boom will morph into an irrational, sell-to-the-greater-fool frenzy. It’s not easy to know precisely when an irrational frenzy will reverse into an equally irrational stampede for the exits.

These three stages – rational boom, frenzied bubble, irrational panic – are in fact just three out of a total of six stages in my own idiosyncratic (and highly unscientific) taxonomy of bull and bear markets. Here’s how it works.

The first stage in any bull market is what I like to call the bounce. A sector or asset class that has been moribund for years or even decades suddenly starts rising in price. This could be due to exogenous shocks such as regulatory or technological changes; it could be due to Schumpeterian creative destruction, wherein prolonged low prices have driven out the weak and created a breeding ground for strong innovative companies; it could be due to simple cycles in supply and demand like the ‘commodity supercycle’. Whatever the reason – and often the operative reasons are not evident till many years later – prices begin to move upward. This is the bounce.

Typically during the bounce stage prices increase but the asset class remains unfashionable; only a few visionary investors recognize the bounce for what it truly is, the harbinger of a prolonged bull. Above all people don’t recognize the reasons for the bounce. Indeed, proselytizing for an asset class or sector during its bounce phase is a thankless job; you will probably get sniggered at by television talking heads for your trouble.

The second stage in a bull market is what I like to call the boom. During this stage, price rises have begun to attract more attention from the investment community. This is a stage of diffusion: the investment story spreads beyond its first few evangelists to an ever-increasing audience of relatively well-informed investors. To a large extent the strength of the sector becomes conventional wisdom. But prices continue to rise; it is not that contrarianism (going against the conventional wisdom) has failed; it is merely that the fundamentals continue to be so strong that they outweigh any technical factors.

The third and last stage in bull market is what I like to call the bubble. In this stage, the fundamentals have ceased to matter. In fact, the growth of the boom years has created sufficient supply to cause fundamentals to tilt to the opposite direction. But nobody notices. Drawn by strong performance, ever more investors flood into the sector. High prices create their own self-reinforcing dynamic. Positive feedback, mass self-delusion, ‘this time it’s different’, new paradigm stories, ‘permanently higher plateaus’, huge quantities of supply, sectoral employment shifts, dodgy startups, reality TV shows, easy funding – these are all symptoms of a bubble phase.

It’s pretty easy to distinguish between the three stages of a bull market. Certainly nobody could mistake a bounce stage (in an obscure and unfashionable sector) for a boom stage (where the sector is widely known for its strong fundamentals, albeit less widely invested in). Still less could anybody mistake a boom for a bubble: in a boom the fundamentals still rule, in a bubble fundamentals have gone out the window and the greater-fool theory rules. (Though well-meaning but misguided analysts inevitably try to justify bubble-era prices and try to coax the market into some sort of fundamental-based story; this usually involves invoking a new type of fundamental).

Just as a bull market has three stages, so too a bear market. The three stages of a bear are fairly accurate mirror images of their bull correlates.

First comes the blowup, in which the excesses of the bubble are purged. This purge is often quite dramatic, as the positive feedback loop that fueled the expansion reverses direction, causing prices to fall as precipitously as they previously rose. The excess liquidity that helped inflate the bubble is withdrawn with quite astonishing rapidity, leading directly to various closely related phenomena that are emblematic of a panic: the flight-to-quality reflex, the cash-is-king psychology, and the dynamic of the liquidity-death-spiral.

The next stage in the bear market is the bust. This is a long drawn out decline in prices as the market works out its overhang of excess supply (created in the boom) and anemic demand. The bust can last for years or (if markets are not allowed to clear) even decades.

The final stage of the bear market is the bottom. This is not a single point but a very lengthy period in which investor interest wanes, volumes and volatility decline, and sector news gets relegated to the inside pages of the financial dailies. Of course the bottom merely sets the scene for the next stage in the market, the bounce of the next bull market. And thus the circle is complete.

Identifying Bubbles: It's Really Not That Hard

In an opinion piece written for the Financial Times on Monday, former Fed governor (and current Columbia professor) Frederic Mishkin argues that central bankers cannot reliably identify asset-price bubbles; that certain types of bubbles – specifically, those without a credit element, which Mishkin calls ‘pure irrational exuberance bubbles’ (sic) – do not do much harm when they pop; that central bankers should not, in fact, try to pop the latter type of bubble; and that when in doubt a central banker should err on the side of benign inaction.

Implicit in all these arguments is the Greenspanist view that policy is better suited to mitigating the painful after-effects of a popped bubble, than it is to spotting and deflating the bubble in the first place. I was under the impression that this particular stance had been discredited along with the rest of Alan Greenspan’s philosophy of central banking, but evidently not. Here are the relevant quotes from Mishkin’s piece:

Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. (If policymakers were that smart, why aren’t they rich?) Tightening monetary policy to restrain a bubble that does not materialize will lead to much weaker economic growth than is warranted.

I find these arguments deeply unconvincing, and not just because it is precisely this line of reasoning that has led us to crisis after crisis in the financial markets. Let us leave aside for the moment the contentious question of what action (if any) a central bank should take to restrain a developing bubble, or to ameliorate the consequences of its collapse. (I do have an opinion on this question but will save it for a later post). Instead let us ask a simpler question: Is it in fact credible to claim, as Mishkin does, that central bankers cannot identify a bubble in the process of expansion?

I think not. I think it is fairly obvious that Mishkin is being disingenuous. The problem is not that the Fed is unable to spot bubbles, but that it is unwilling to do so¹.

Because the truth is, identifying bubbles is easy. When speculators use post-dated checks to buy stocks and sellers accept these checks because they assume the market can only go up: that’s a bubble. When an obscure fishmeal manufacturer offers a billion dollars to buy an internet portal: that’s a bubble. When people with no income and no assets are offered their choice of loans with which to buy million-dollar homes: that’s a bubble.

I repeat: identifying full-blown bubbles is easy. What’s not so easy is identifying the transitions that bookend a bubble. It’s not easy to know precisely when a rational, fundamentals-driven boom will morph into an irrational, sell-to-the-greater-fool frenzy. It’s not easy to know precisely when an irrational frenzy will reverse into an equally irrational stampede for the exits.

But here’s the thing: nobody is asking central bankers to do this. Central bankers do not need to time bubbles perfectly (that particular cross is solely for contrarian traders to bear). Central bankers merely need to recognize when they’re in a bubble, and take action accordingly. This is a much easier task.

Mishkin elides this distinction. When he implies that recognizing a bubble is equivalent to timing it (“If policymakers were that smart, why aren’t they rich?”), Mishkin is pulling an ingenious (and underhanded!) bait-and-switch on his readers. I can only hope that his views do not reflect either the prevailing wisdom at the Fed, or its attitude towards the taxpaying public.

Footnotes

# ¹Why might this be the case? For a host of political, institutional and structural reasons, most of which boil down to one simple fact: bursting a bubble is unpopular and painful. And ever since Paul Volcker retired, the Fed has consistently shied away from any course of action that involves exchanging short-term pain for long-term gain.

History: It Ain't Just Bunk

Human beings are good at interpolation, passable at extrapolation, bad at identifying inflexion points, and downright terrible at processing one-off events. It’s no coincidence that these skills are, sequentially, associated with increasing investment success: the harder it is to do something, the more money one makes for doing it.

This particular progression from easy to difficult is not merely the artifact of some deep-seated behavioral tendency or evolutionary bias. Deterministic and presumably unbiased algorithms, faced with unprecedented events, perform just as badly as humans. This is only to be expected: the very word ‘unprecedented’ implies that there is no baseline to build from or compare with, a circumstance under which most algorithmic approaches tend to flounder.

Unfortunately for all concerned, real life is full of one-off events. What we call history is, as Rudge memorably puts it, just one bloody thing after another. And that’s precisely why I’m suspicious of attempts to mindlessly trawl through past data for aggregate patterns. Every episode is different; every episode is new.

This does not mean that history should be discounted entirely. Quite the contrary. A deep and broad knowledge of history (and not just the history of the markets!) is essential to becoming a successful trader. Events may not repeat themselves exactly, but they certainly rhyme; the trick is to find out what they rhyme with.

So how does one accomplish this trick? Regular readers will know the answer: by asking ‘why’. Questions such as ‘what’ or ‘when’ or ‘which’ or ‘how much’ are no doubt useful when it comes to short-term, tactical trading, but they are limited in their ability to throw light on long-term, strategic trends. Asking ‘why’ a particular historical event turned out the way it did, on the other hand, is the first step towards recognizing its kinship (or lack thereof!) with seemingly similar events developing today. Understanding the past is the key to understanding the present, to say nothing of predicting the future.

This sounds overly abstract but in truth it is anything but; the technique of asking ‘why’ at all times can (and should!) be used to analyze not just big-picture historical movements, but also individual trades. Indeed, finding out why a particular trade worked while others failed is a key component of the trader’s art.

Here’s an example from my own career trading bonds. My portfolio was, in general, designed to capture or monetize excessively rich risk premiums (curve, liquidity, capital structure, you name it). Risk premiums of course tend to widen in times of market stress, so my portfolio behaved as if it were short event risk. To hedge against this I invariably had a long position in Fed Funds futures and the first few Eurodollar contracts, confident in the knowledge that any ‘flight-to-quality’ would send these assets higher. (Also, in truly extreme cases the Fed could be counted on to step in and cut rates, helping the front of the yield curve.)

I was not alone in this practice. Here’s an excerpt from an interview with Christian Siva-Jothy, former head of prop trading at Goldman Sachs:

Being long fixed income is like a synthetic long gamma trade. More than 90 per cent of the time, if there is a major dislocation to the economy, fixed income will rally. I sleep better at night doing that.

Insurance is not the only reason to be long bonds. There’s also the widely-held belief that rallies tend to be slow grinding affairs while selloffs tend to be sudden sharp shocks¹; it’s a lot easier to ride the former than it is to time the latter. Here’s Siva-Jothy again:

Bear markets in fixed income are very short with powerful rallies. You can make money during a bear market but you have to time your trades perfectly.

As a matter of fact, most successful bond traders of the recent past, like Siva-Jothy, have had a perpetual long bias, and have justified it on similar grounds.

Looking back though, I wonder if this is not just post facto rationalization. After all, the Treasury market has been rallying more ore less continuously for the last quarter of a century; long bond yields have gone from 15.5% in 1981 to 2.5% in 2008. You would have had to be a spectacularly incompetent long-biased trader not to make money over this period. Conversely, no matter how good you were at trading from the short side, you’d have been hard pressed to make big returns in such a strong bull market. And that’s why most bond traders, through experience or by selection, tend to have a bullish stance².

All very well, but so what? So this: what if bonds turn? What if the 30-year bull market was a one-off event that will not be repeated, rather than a trend that will continue³? What if 2008 marked the low in bond yields? What if rates stay steady or trend higher over the next decade or two? Will the front of the yield curve still serve as an event hedge? Will rallies continue to be protracted and selloffs continue to be compressed? Right now, nobody knows for sure, but these are questions worth keeping in mind. A trader who does otherwise – who merely trades from the long side without asking why being long Treasuries worked in the past – risks being blindsided.

Footnotes

# ¹Here’s a cherry-picked illustration:



# ²Of course, this explanation merely pushes the question back one level. Why did the bond market rally for 25 years? That’s a question that deserves a full-length post in answer.

# ³30 years is, admittedly, a long timeframe for a ‘one-off’ event, but note that the current bull market was preceded by the greatest bear market in US Treasury history. Perhaps the entire rally in rates since 1981 is merely reversion to the long-run (pre-bear) mean.

Some Thoughts on Buttonwood's Trifecta

Buttonwood’s column this week is typically thought-provoking. She starts with the observation that three major asset classes – stocks, bonds and gold – have all produced double-digit returns in the last three months. She then points out that this is not usual: indeed, it has only happened thrice in the past fifty years ¹. And for good reason: the three asset classes have very different exposures to risk (equities are risky, bonds and gold are canonical safe havens) and to inflation (gold is a good inflation hedge, bonds are not, and equities lie somewhere in between). She describes various fundamental explanations (divisions in investor opinion; inefficient markets; central bank intervention; increasing risk appetites). And finally, she lays out her own explanation: liquidity.

Low interest rates are driving investors out of cash and into anything that offers either the prospect of capital gain or a yield that is higher than zero. Investors used to talk about a ‘Greenspan put’ that supported the stockmarket. This time there is a ‘Bernanke put’ supporting all asset prices.

I think that this is exactly correct, as far as it goes. But it doesn’t go far enough. Buttonwood leaves unanswered a host of interesting questions, such as: if there so much liquidity in the market today, why hasn’t it manifested itself in the inflation data? And why, on previous occasions when there was a lot of liquidity available (under, for instance, the Miller Fed), didn’t all three asset classes rally in tandem? Conversely, why did all three asset classes rally together in late 1982, a time when nobody could plausibly claim a surfeit of liquidity in the market?

The second question is the easiest to answer. Under Arthur Burns and then William Miller, realized inflation was very high and inflation expectations were well-entrenched. Asset prices reflected these fundamentals. Gold confirmed its status as an inflation hedge, rising from $35 (its pre-float peg) to over $800 over the course of the 1970s. In contrast, the fixed cashflows offered by bonds are very unattractive under inflation, hence bonds did horribly: 30-year yields rose from around 7.5% in 1970 to 15.5% in 1981. Equities merely treaded water, with higher nominal earnings cancelled out by higher discount rates.

The 1980s saw exactly the opposite dynamic. The Fed under Paul Volcker committed itself to fighting inflation no matter what the cost in terms of temporary economic pain. As a result financial assets enjoyed a golden run: stocks entered a 20-year bull market (to 2000) while the bull market in bonds lasted even longer (to 2008 – and counting). Meanwhile gold was pummeled, dropping all the way to $250 in 1999.

So far so good; all these are precisely what you would expect when changes in (Fed-sponsored) liquidity drive asset prices, first one way and then the other. And as theory dictates, the three asset classes never moved strongly in the same direction, throughout this lengthy period.

With one exception: the last quarter of 1982. Gold, stocks and bonds all rallied very sharply into the end of the year. What happened?

Here’s my theory, propounded as always with the benefit of hindsight. 1982 was the year that the markets finally ‘got’ Volcker’s plan. Tight monetary policy had already caused a short, sharp recession in 1980. 1981 saw a partial recovery, but then the economy entered a crippling double dip in 1982. Nonetheless Volcker kept policy relatively tight (certainly tighter than his predecessors would have done in the same situation). Gold rallied in expectation that this tight policy would hurt the economy and force Volcker to capitulate and ease rates ². But Volcker stood firm. This gave stock- and bond-markets confidence that inflation was truly going to be beaten, and so it proved. Stocks and bonds continued to rally, while gold gave back its gains within a matter of months. And so it continued, for the next 20-odd years.

Which brings us to 2009. I agree with Buttonwood that the ‘Bernanke put’ (in the form of easy liquidity) is supporting all asset prices. But why don’t Treasury prices reflect this? Where are the bond market vigilantes?

I suspect the answer is that these days, bond traders, like the Fed, care more about wage and retail inflation than about asset inflation ³. And wage and retail inflation has been kept quiescent by the entry of Chinese labor into global commercial flows (a point I have made before, at length). That’s why the current flood of Fed-sponsored liquidity hasn’t entered the official figures yet; and that’s why bonds continue to be bid up.

Will it last? Or will bonds be the next great bubble to burst? We shall see.

Footnotes

# ¹ Try as I might, I cannot replicate Buttonwood’s numbers for government bonds. The high in yields over the past 4 months was on 7 August; the subsequent low was on 7 October. Between those two (cherry-picked) dates, 10-year Treasury notes rallied by about 70 basis points, which corresponds to a return of roughly 6% in price terms. The price gains for 2-year, 5-year and 30-year Treasuries over the same period were 1%, 3% and 8% respectively. Given that Treasury issuance is overwhelming skewed to the short end of the yield curve, there is simply no way that bonds have returned double digits in the last quarter. Also, Buttonwood talks of a fifty year sample; this is actually meaningless, since the dollar was pegged to gold until 1971. But I digress; this is mere quibbling over numbers, and the arguments made elsewhere in Buttonwood’s column remain valid.

# ²There was also a large technical element to gold’s 35% rally, coming as it did on the heels of a 65% selloff.

# ³FX traders are not so accommodating; witness the continuing weakness in the dollar versus pretty much every other currency in the world.

Some Thoughts on the Phillips Curve

Of all the economists, journalists and assorted financial industry participants who comment on the web – and there’s certainly no shortage of them – the one whose views align most closely with my own is James Hamilton of UC San Diego and Econbrowser. I find that I rarely disagree with him, whether it’s on macroeconomics, oil, securitization, financial markets, or anything else. So I was interested to see him make the case that ‘high levels of unemployment are a factor that will put downward pressure over the next two years’.

His argument is straightforward: he regresses historically realized inflation against unemployment, and also against lagged inflation (the latter is to account for expectations of inflation). He finds a statistically significant negative coefficient for the period from 1948 to 2007, validating the classical Phillips Curve relationship. Since unemployment is currently very high, inflation is (ceteris paribus) likely to be contained over the next few years.

My quibble with this analysis is that I just don’t think historical data, aggregated like this, is a very useful guide to the future. For instance, the period from 1948 to 2007 had several very distinct macroeconomic regimes. Let’s go decade by decade:

1940s: World War II has massive effects on consumption, production, resource allocation and labor markets, effects which do not end with the end of the war. The Fed buys long bonds to finance government spending, but reduces the money supply to pre-empt post-war inflation of the kind seen in 1919-20.

1950s: A boom in capital goods and in consumer credit (think: demobilization and reconstruction) leads to a sustained period of strong employment and benign inflation; the misery index will never be this low again. But a balance of payments deficit hints at trouble to come.

1960s: Operation Twist. The Great Society. Tax cuts combined with spending increases bring about the first persistent, large budget deficits. Congress eliminates the gold reserve requirement for the Fed. Inflation rises. The draft reduces unemployment.

1970s: The US leaves the gold standard in 1971. Nixon imposes wage and price controls from 1971 to 1974. OPEC embargos oil. Arthur Burns argues that it’s okay to countenance ‘temporarily’ higher inflation if that can alleviate economic shocks. He is succeeded by William Miller who thinks Burns kept policy too tight (!).

1980s: Paul Volcker breaks the back of inflation. The Reagan recessions are followed by the Plaza Accord and the devaluation of the dollar.

1990s: China. See my previous post for details.

I think it’s fairly clear that at different times over the last 60 years, very different factors have driven inflation and employment in the US. Certain drivers remain important to this day, but others have changed utterly. (For instance: every decade has seen a different role for the Federal Reserve, from financing government debt in the 1940s, to twisting the yield curve in the 1960s, to fostering stagflation in the 1970s, to satisfying the bond market vigilantes in the 1980s). If causation has changed so much, how can we expect correlations from the past to apply today?

In fairness, I don’t think Prof. Hamilton himself fully believes the case he presents. He merely makes the observation that a forecast for low inflation going forward is not ‘crazy’, while pointing out that other factors (the dollar, commodities) may pull the other way. I can’t disagree with that ... so I guess I’m back to agreeing with him on everything.

Postscript: I’m embarrassed to admit that I only found out recently that the James Hamilton who co-writes Econbrowser is the same James Hamilton who wrote Time Series Analysis, a text which I used a fair bit in my professional career.

Jobless Recoveries and Asset Market Bubbles

Asset markets around the world have rebounded quite substantially from their lows of earlier this year. As a result, attention has increasingly become focused on the Federal Reserve’s ‘exit strategy’¹. Can the Fed raise interest rates, or even credibly threaten to do so, given the bleak state of the labor market? Some central bankers think so; here’s the Philly Fed’s Charles Plosser:

As the economy and financial markets improve, the Fed will need to exit from this period of extraordinarily low interest rates and large amounts of liquidity. We recognize the costs that significantly higher inflation and the ensuing loss of credibility will impose on the economy if we fail to act promptly, and perhaps aggressively, when the time comes to do so. The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels.

Others are more cautious, and would like to see a rebound in employment data before removing policy accommodation. Here’s the St Louis Fed’s James Bullard:

We’ve got this short term deflation risk; if we get into that trap it’s going to be hard to get out of, and that’s why we want to avoid the Japanese style outcome right now.
...
We know labor markets are going to lag, but we’d at least like to see them go in the right direction and start to improve. We’d like to see positive results in labor markets.
...
You want some jobs growth and you want to see unemployment coming down. That’s a prerequisite [for an increase in interest rates].

This entire debate misses the point. In my opinion the emphasis on labor markets is overdone, simply because we are not likely to see a rebound in the employment data – payroll expansions or wage increases – any time soon. The mechanisms for robust and rapid growth in payrolls and wages just do not exist any more.

Thanks to a lowering of international trade barriers, thanks to outsourcing and off-shoring, and thanks above all to Chinese labor’s entry into the global marketplace, workers in the first world have no bargaining power any more². Gone are the days of strong unions and collective wage agreements.

It is no coincidence that the last few recessions – specifically, those after China’s entry to world commerce – have been followed by jobless recoveries.


Source: Calculated Risk

Indeed, the shape of the world’s labor market today is such that ‘jobful’ recoveries are guaranteed not to happen. A policymaker who waits to see such a recovery before raising rates will have waited too long.

If the flood of liquidity provided by central bankers does not go into the labor market, then where does it go? Into asset markets. It is also no coincidence that the last few recessions and jobless recoveries have been followed by asset market bubbles, first in technology stocks, then in housing.

Thus the conventional wisdom, that China ‘exports deflation’ to the world, is only partly true. Over the last twenty-odd years, China has indeed exported deflation, but this has been concentrated in very specific segments of the economy: in the prices of retail goods, and in worker salaries. It so happens that these segments are precisely the ones captured in standard measures of consumer inflation. Central bankers, lulled by this quiescence in measured inflation, have time and again erred on the side of loose monetary policy, leading directly to the asset price bubbles that have done so much harm in recent years.

Of course, there is no guarantee that the Federal Reserve will go down the same path this time around. Policymakers today are very sensitive to the charge that they kept rates too low for too long in the early 2000s, and thus inflated the housing bubble; they will be keen to avoid repeating this mistake. But policy is inseparable from politics, and it will be difficult if not impossible for the Fed to completely ignore labor market conditions when making its next few interest rate decisions³. These will be interesting times indeed.

Footnotes

# ¹‘Exit strategy’ is the currently fashionable euphemism for the painful process of raising interest rates. In the 2004 hiking cycle, the euphemism of choice was a ‘measured removal of policy accommodation’.

# ²If anything, this lack of bargaining power is even more obvious, and its effects even more pronounced, during economic downturns. Corporations increasingly take advantage of recessions to make dramatic cuts to payrolls, cuts that they would find politically inexpedient to make in good times. When the recovery comes (as it eventually must), the replacement hires are, more often than not, made overseas. Thus cross-border labor arbitrage – the gradual replacement of first-world workers with their cheaper third-world counterparts – is not a smooth process but a step function.

# ³Personal opinion: while I sympathize with the intent of those seeking to alleviate the condition of the working middle class, who have been hammered hard in recent years, I can’t help but feel that monetary policy is absolutely the wrong tool for the job. If you want to improve the employment data, implement deep-structural changes (investments in education, infrastructure, research and technology; a better tax code; incentives to save and invest rather than consume; and so on – all easier said than done, of course) designed to bring about that outcome; don’t count on the Federal Reserve to come to the rescue. In any case the Fed can, at best, merely buy a few years of breathing space; it cannot change the underlying fundamentals, and it would be foolish to expect otherwise.

Feedback in Financial Markets

In a previous post, I mentioned that bubbles were characterized by – indeed, defined by – positive feedback. This idea, and more generally, the importance of feedback in driving market dynamics, deserves a lot more ink. Here’s a first installment.

Classical economics is often concerned with analyzing various equilibrium outcomes (“comparative statics”). These outcomes are usually generated or maintained by some sort of negative feedback. The simplest example is that of security prices. Under the efficient markets hypothesis, each security has a fair price reflecting its ‘fundamental value’; furthermore, this fundamental value is known to market participants in aggregate. If the actual market price drops below this value, people step in to buy the security; if the price rises above it, people step in to sell. As a result of this negative feedback, the market price equilibriates to its natural or fundamental value.

Unfortunately markets do not always tend to equilibrium. Negative feedback is not always the dominant mechanism at work. And fundamental value is not always well defined. Bubbles provide a clear example of each of these counterfactuals.

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.

Or consider this example from the equity markets (private email from my friend WB):

Markets prices impact fundamentals. If Amazon's stock price goes up as it did in 1999-2000, it makes it that much easier to raise capital either from debt markets or from equity markets. If Amazon raises more money it can invest more and make improvements which make the future look that much brighter. That pushes up prices even higher. That's not a negative feedback cycle. In fact it's downright positive feedback. This can go on for a very long time, but then one day the reality just doesn't offer as much as was priced in and we have an enormous collapse which again acts in a positive feedback way. So in the end over medium horizons, markets can be mean-averting or create trends while in the longer term picture they are mean-reverting.

Or, closer to home, consider this example from the real estate markets (lifted from Wikipedia):

Lenders began to make more money available to more people in the 1990s to buy houses. More people bought houses with this larger amount of money, thus increasing the prices of these houses. Lenders looked at their balance sheets which not only showed that they had made more loans, but that their equity backing the loans—the value of the houses, had gone up (because more money was chasing the same amount of housing, relatively). Thus they lent out more money because their balance sheets looked good, and prices went up more, and they lent more.

Of course, the conditions required to foster a ‘fundamental’ positive feedback loop don’t arise very often, but when they do, the outcome is dramatic.

The final word belongs to George Soros, who treats feedback as a special case of his larger socio-economic theory, ‘reflexivity’. Soros’ book The Alchemy of Finance contains many more examples of ‘fundamental bubbles’; rather than quote them all, I’ll leave you with two short excerpts from this 1994 speech:

I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy

...

For instance, in a freely-fluctuating currency market, a change in exchange rates has the capacity to affect the so-called fundamentals which are supposed to determine exchange rates, such as the rate of inflation in the countries concerned; so that any divergence from a theoretical equilibrium has the capacity to validate itself. This self-validating capacity encourages trend-following speculation, and trend-following speculation generates divergences from whatever may be considered the theoretical equilibrium. The circular reasoning is complete. The outcome is that freely-fluctuating currency markets tend to produce excessive fluctuations and trend-following speculation tends to be justified.

And there you have it, straight from the greatest trader of the twentieth century. Further comment would be superfluous.

Bubbles and Scale Invariance

In yesterday’s post I mentioned that bubbles were exponential, scale-invariant and self-similar, making it virtually impossible to time their collapse.

Let’s flesh out this assertion by looking at a particular market index.

For the first 17 years of its existence, this index had a mean of 100 and a standard deviation of 56. (Prices have been scaled to avoid easy recognition). That’s a pretty stable time series.

Then something happened. Over the next 8.5 years, the index went from a starting value of 200 (already near the upper end of its previous range) to a value of 700. What’s more, this rise took on exponential, maybe even super-exponential characteristics, as the graph below makes clear.


Would you sell? If you did, you’d be out of luck. Because over the next 25 months, the index went from 700 to 1100. Once again the rise looked exponential or better:


(Note that this graph has the same start date as the previous one, but different scales on each axis).

Would you sell? If you did, you’d be out of luck again. Because over the next 15 months the index went from 1100 to 1500, with the pace of expansion growing ever higher


(Once again, this graph has the same start date as the previous two, but different scales on each axis).

Now would you sell? How much further and faster can the market rise? The answer is, quite a bit. Over the next 5 months the index rocketed from 1500 to 2800. If you had sold the index at any of the previous junctures – and note that at each of those points, the graph looked convincingly bubbly – you would almost certainly have been carried out at a loss.

2800 was, in fact, the high; over the next 31 months the index dropped all the way back to 600. Here’s the full graph, with dates and true (unscaled) values.


I’ve marked the extrema of each of the previous graphs onto the composite graph, to demonstrate how scale-invariance works. Although zooming in on any sub-graph gives the impression that it’s an exponential curve about to pop, these curves just get lost in the main graph. It’s not easy to time bubbles.

Postscript: The index in question is of course the Nasdaq composite in the days of the dot-com expansion. Interestingly, Alan Greenspan warned about ‘irrational exuberance’ in December 2006, shortly after the first of the graphs above. Three years later he had changed his tune (‘capitulated’?) quite substantially.

Bubbles and the Rational Trader

A few weeks ago, Paul Krugman wrote a lengthy essay on the history of macroeconomic thought for the New York Times Magazine. His article prompted a flood of commentary both pro and con; I do not propose to add to this deluge.

I do however want to take issue with one particular assumption that runs through both the original article, and through many of the responses to it (from both left and right). This assumption has to do with the relationship between rationality and bubbles.

One group of economists argues that traders are rational and markets are efficient; hence bubbles (if they do arise) are likely to be short-lived and self-correcting. Since markets are largely self-regulating, the role of government is to intervene as little as possible¹.

Another group argues that traders are often irrational and markets are often inefficient; hence bubbles may last a long time before eventually (and painfully) bursting. Since markets cannot be trusted 100%, the role of government is to intervene whenever necessary.

Some members of the interventionist crowd go further: they take the (to them, self-evident) existence of bubbles as proof that traders are not rational.

Meanwhile, some members of the non-interventionist crowd invert this logic: they assume the rationality of traders to argue that bubbles cannot in fact exist (“the price is always right”).

Running through all these arguments is the assumption that rational traders will not foster bubbles; indeed, that they will trade against any bubbles that they encounter.

This assumption is wrong. Ask any experienced macro hand what he would do when confronted with an incipient or actual bubble, and the answer comes pat: ride the trend. Contribute to the bubble’s expansion, don’t counter it.

Why is it rational to ride bubbles?

The first reason is the simplest: it is exceedingly difficult – bordering on the impossible – to predict when a given bubble will burst. The canonical financial bubble follows an exponential growth path; such a path is scale-invariant and self-similar, hence there is no way to tell, just from looking at a chart, whether one is closer to its beginning or its end.

Second, the pattern of gains and losses during a bubble’s expansion and subsequent collapse is typically asymmetric. Expansions tend to play out over a scale of years, while collapses often occur within a matter of weeks or months. Expansions involve steady gains gradually accumulating (and eventually exponentiating), while collapses involve sudden massive drops and large amounts of wealth wiped out in very short time spans. From a portfolio point of view, the overall effect is a wash (as indeed it should be, given that bubbles, by definition, do not involve true wealth creation). Hence a portfolio should be agnostic towards bubbles.

But for an individual trader the incentives are quite different. Most professional traders make an annual performance-linked bonus if they’re successful, and face firing if they’re not. Clearly, for a trader it is better to bet on a continuing expansion (and be right 9 years out of 10) than it is to bet on a crash. The payoff matrix is straightforward:

When the crash comes (as eventually it must) the trader’s portfolio will lose far more money than it would have gained in the event of no crash, but the cost to the trader is no more severe than if he had bet against the bubble and been proven wrong.

It’s not just short-term risk-reward considerations that make bubbles more likely; there’s also a long-term selection effect at work. A trader who stays contrarian throughout an expansion is likely to be out of a job by the time the crash finally comes. Rational contrarians recognize that “you have to be in it to win it”; hence they swallow their skepticism and become (or act like) true believers. Bubbles thus tend to create their own boosters, while forcing out all the naysayers. This is selection at its most insidious.

Finally, consider the case of the prescient trader who stays in the game long enough to counter-trade the bubble just before it pops. Does he profit from his acuity? In many cases, the answer is no. Trader bonuses are paid out of firm-wide compensation pools; if the rest of the firm has lost money (and remember, the rest of the firm is full of herd-followers who were riding the bubble, for all the reasons detailed above) then our hypothetical trader would not get paid. One more reason not to counter-trade the bubble (or rather, not to counter-trade your colleagues, which is much the same thing).

Notice that these arguments depend to a large extent on endogenous or even circular reasoning. Bubbles grow exponentially because everyone rides them; but one reason why people ride bubbles is because the growth is exponential. Similarly, traders conform because they fear that contrarianism, even if successful, will go unrewarded; but one reason why contrarianism goes unrewarded is because all the traders are conformists².

This should be no surprise. The defining characteristic of a bubble is positive feedback. Without positive feedback, incipient divergences from ‘fundamental value’ will always be counter-traded, causing reversion to the mean. And what is endogeneity (or circularity) but a positive feedback loop? The triggers may be various and even insignificant, but once a bubble gets under way, it’s very hard to pop. And despite the conventional wisdom, no rational trader would even try.

Addendum: bubbles have many progenitors. This article focuses on the incentives governing one group thereof, namely professional traders. Not everyone has exactly the same payoff profile, or is exposed to exactly the same group dynamics, as traders. Nonetheless it turns out that analogous factors are at play for almost everyone concerned in inflating a bubble. I will return to this topic – how different actors face similar structures leading to similar outcomes – in future posts.

Footnotes:

# ¹ This view, incidentally, provided much of the intellectual ballast for the deregulation policy followed by the Greenspan-era Fed-Treasury-SEC.

# ² This applies to the specific case of multiple traders within a particular firm during a bubble. There are other situations in which being contrarian is profitable and also not inconsistent with trend-following; I will address such situations in future posts.

Implicit Regulatory Arbitrage: The Puts-Payers Trade

Yesterday’s post revealed how (and why) a large portion of the financial industry’s revenues came to depend on explicit regulatory arbitrage. This is fairly common knowledge, and should come as no surprise to industry observers.

What’s not so well known is that many ‘classic’ arbitrages, which appear at first glance to be regulation-independent, also depend implicitly on regulatory asymmetries to work. The textbook example is bond futures arbitrage. While anyone can buy bonds, some market participants are forbidden to sell bonds short. To express a bearish view, this latter group has to sell bond futures. This makes bond futures systematically cheap relative to cash bonds. Arbitrageurs have only to take the opposite side of this transaction to make easy money.

Of course, the classic bond futures arbitrage no longer exists (‘”too many eyeballs”), but other, subtler examples abound. Consider a trade that was very popular with fixed income arbitrageurs earlier this decade: the puts-payers combo. This trade involves selling Treasury puts and using the proceeds to buy payer swaptions, for zero net premium. Both the puts and the payers are struck slightly out of the money.

How does the trade work? If the market rallies or stays rangebound, the options expire worthless. But if the market sells off, the options are exercised, and the trader finds himself long Treasuries and paying fixed in swaps – in other words, long swap spreads. So, the trader is making the bet that ‘swap spreads will widen in a selloff’ – and he’s making this bet for free (remember, there’s zero net premium to enter this trade).

Is this a good bet to make? Let’s look at some history:


That’s a pretty strong relationship between two supposedly independent variables, and hints at some serious inefficiency in the bond market. What’s going on?

The answer is simple. Just as in the bond futures trade example described above, the arbitrageur in the puts-payers trade is taking the other side from entities who are forced by regulations to behave sub-optimally. In this case, these entities are the government sponsored agencies Fannie Mae and Freddie Mac.

Some background may be useful here. In the early years of this decade, Fannie Mae and Freddie Mac were massive players in the bond market. At the time, they had very large mortgage portfolios which were characterized by significant ‘negative convexity’. This characteristic meant that when the market rallied, they needed to buy; and when the market sold off, they needed to sell, in order to keep their portfolios properly hedged.

Now, Fannie and Freddie, being government agencies, faced restrictions on their size and trading activity. Consequently, they decided to do the bulk of their convexity hedging (described above) in swaps rather than in bonds, since swaps are off-balance sheet instruments, while bonds have to be reported. Every time the market sold off, Fannie and Freddie would be out there selling (paying) in swaps, in size. Swaps would therefore underperform bonds in selloffs; hence swap spreads would widen. (Note that the mortgage market is much larger than the government bond market; hence Fannie’s and Freddie’s trading actions, determined by the former, would invariably move prices in the latter.)

This pattern repeated for years and years: it was that rarest of beasts, a persistent and captureable anomaly in the market. Many arbitrageurs took advantage of this, via structures like the puts-payers combo.

Did these arbitrageurs generate alpha? Well, yes and no. Within the context of the bond market, the answer is yes: the agencies behaved sub-optimally, and thus transferred wealth to the arbs. But viewed at a larger scale, the answer is no: the agencies behaved rationally by paying the arbs to move their interest rate exposure off-balance-sheet. The arbs were therefore being compensated for a service they were providing; they were harvesting alternative beta rather than capturing alpha.

(This is just a particular case of the general truth that any alpha is merely a beta within a larger universe. In this case, bond-market alpha turns out to be service beta. I will return to this concept in future posts.)

Of course, even this persistent anomaly couldn’t last forever. The previous scatterplot shows data from April 2000 through March 2006; the following one shows data from April 2006 through August 2008 (Fannie and Freddie went into conservatorship in September 2008):


The inefficiency has all but disappeared. What happened?

The obvious answer is the correct one: over the years, Fannie and Freddie scaled back their interest rate trading activity considerably. Fannie Mae, for instance, shrank its mortgage portfolio (the “owned balance sheet”) from 917 billion in 2004 to 728 billion in 2007. Over roughly the same period, Fannie reduced its duration gap (a measure of the mismatch between assets and liabilities, and a strong proxy for the portfolio’s negative convexity) from over 1 year to less than 1 month, by buying swaptions and issuing callable debt. With a significantly smaller and better-hedged portfolio, Fannie simply didn’t have to trade that actively.

Obvious, yes, but only in hindsight. An arbitrageur who tried to play the puts-payers game after 2006 would not have made any money. Once the regulations changed (and make no mistake, Fannie and Freddie’s portfolio redesign owed a great deal to regulatory pressure), the regulatory arbitrage disappeared.

Why does any of this matter? The case study of Fannie Mae, Freddie Mac and the puts-payers trade highlights a theme that I will return to again and again on this blog: the importance of understanding the source of your returns. It’s not enough to spot an inefficiency (opportunity) in the market; you must also know why the inefficiency exists. Only then can you avoid being blindsided when circumstances change and the opportunity disappears.

Why Is Regulatory Arbitrage So Attractive?

When the histories of today’s very interesting times are finally written, I suspect that the phrase ‘regulatory arbitrage’ will feature prominently. One may point to the housing bubble or the bubble in finance as proximate causes; or to unsustainable global macro imbalances as a more distant cause. But the grease that lubricated the wheels of the runaway train was regulatory arbitrage.

Why was regulatory arbitrage so prevalent during the boom? There are several reasons.

First, regulatory arbitrage is easy. It’s certainly easier than trying to beat the market in ‘legitimate’ ways, as many retired traders can testify. What’s more, this state of affairs is likely to persist. Regulatory agencies in the USA are notoriously understaffed; their few workers are notoriously underpaid. Anyone competent enough to understand the complexities of modern financial instruments (which, incidentally, are often designed specifically to avoid or evade regulatory scrutiny) would waste little time in quitting and joining the very Wall Street firms he is supposed to be monitoring. Add in the phalanxes of lawyers and compliance officers whose job it is to ensure that the shenanigans stay on the right side of the letter of the law, and it’s an unequal battle. The investment banks will always win.

Perversely, this outcome is often reinforced by legislative action. Consider the practice of jurisdiction-shopping, wherein firms migrate their corporate entities to domiciles where the regulators are friendlier, or set up multiple entities in various jurisdictions such that key issues ‘fall through the cracks’. Confronted with this reality, the dominant response on the part of legislators has been to ease regulatory burdens, so as to stanch the corporate exodus. Unchecked, this merely leads to a race-to-the-bottom as countries compete to offer the most lax regimes. The long-term consequences of such a race can be devastating, as recent events make clear.

Second, regulatory arbitrage, unlike say interest rate arbitrage or index arbitrage or cross-border arbitrage, is true arbitrage: the arbitrageur takes no market risk at all. In all other real-world arbitrages, the arbitrageur takes some sort of liquidity or timing or event risk. Even if the final outcome is a guaranteed profit, there may be some path along which the arbitrageur goes bankrupt before he can realize that profit. This is not the case with a ‘pure’ regulatory arbitrage.

It gets even better: the diminished market risk means that the arbitrageur can take much larger positions, and presumably make much larger profits. (Consider the case of SIVs designed to stockpile risky assets off bank balance-sheets. If the assets do well, the bankers get paid. If the assets do badly, well, nothing happens – they weren’t on the bank’s balance sheet, so who cares?) Regulatory arbitrage is thus not only easier than other forms or arbitrage, it is also more lucrative.

But what about non-market risk? Clearly, if regulatory arbitrage is sufficiently widespread, the system as a whole can come crashing down. (Think of the role played by credit ratings abuse in inflating the housing bubble.) Unfortunately, risks to ‘the system as a whole’ are not borne by individual bankers. This brings us to our third contributory factor: incentives. Thanks to the quarterly-earnings / annual-bonus culture on Wall Street, practitioners have almost no incentive to play for the long term. Indeed, anyone who chooses to do so would be quickly forced out or passed over in favor of his more aggressive colleagues. Poorly-structured incentive schemes reinforce the attractiveness of regulatory arbitrage, and ensure that traders will take full advantage of any loopholes they can find.

Will things change? It’s unlikely. The talent mismatch between regulators and Wall Street is not going to diminish. Nor are traders going to be held accountable for non-market risks; indeed, if anything the bailouts have firmed the Street’s expectation that systemic risks will always be backstopped by the government (moral hazard, anyone?). And regulatory arbitrage will continue to be easier as well as more lucrative than other forms of speculation.

The only way to prevent regulator arbitrage is to eliminate the incentive structures that support it. But even if the government took advantage of its post-bailout leverage to impose drastic salary caps or other behavioral restrictions (a scenario improbable in the extreme, given the current condition of de facto state capture), bankers would simply work their way around them. The example of Barclays makes this eminently clear:

Two former Barclays execs are starting a fund called Protium Finance. Protium has two equity investors who are putting in $450 million. Barclays is lending Protium $12.6 billion. Protium is using the cash to buy $12.3 billion in what we used to call toxic assets from Barclays. Protium’s 45 staff members get a management fee of $40 million per year.

Although Barclays is recognizing its exposure to Protium, Protium is a different company, and it’s not a bank. That’s important these days, and this is Tett’s main point. In particular, because it’s not a bank, British regulators can’t do anything to it. In particular, they can’t prevent Protium from paying its managers whatever they want to pay it, and they probably can’t force Protium to even tell them what its managers are making.

So here we have the ultimate form of regulatory arbitrage. If you’re a bank exec worried about public exposure or, even worse, regulation of your compensation, go create a new special-purpose vehicle to manage bank assets, entice the equity investors in with a sweetheart deal, and pay yourself whatever you want.

Brilliant, devious, lucrative, and almost impossible to police. That, I’m afraid, is regulatory arbitrage in a nutshell.