Risk Update: February 2022 – The Road to Serfdom & Pascal’s Wager.

We are ready to accept almost any explanation of the present crisis of our civilization except one: that the present state of the world may be the result of genuine error on our own part and that the pursuit of some of our most cherished ideals has apparently produced results utterly different from those which we expected.”                      

Friedrich A. von Hayek, “The Road to Serfdom”

We have used the above quote previously to describe the behaviour and rhetoric of central bankers. For any that have read Hayek’s magnum opus, you will know that he was using it much more broadly to describe the inevitable failings of central planning. The above quote is the last sentence of the first paragraph in The Road to Serfdom. The first sentence in that paragraph states:

When the course of civilization takes an unexpected turn – when, instead of the continuous progress which we have come to expect, we find ourselves threatened by evils associated by us with past ages of barbarism – we naturally blame anything but ourselves.”                                                                               Friedrich A. von Hayek, “The Road to Serfdom”

Nobody should be surprised that developments in Ukraine in late February led our minds back to Hayek’s ponderings from his work originally published in 1944. We suspect the Ukraine situation, like all complex circumstances, displays the usual sandpile characteristics. It is a sandpile in its own right and, undoubtedly, part and parcel of ever greater sandpiles. As with all sandpiles, history matters. The long path of history, with endless interconnected fingers of fragility, that has culminated in the ever-broadening catastrophic series of geo-political avalanches today in Ukraine, is a topic for another forum. Here, we will stick with our knitting and focus on the implications as relates to the expansive critical-state sandpile relative to global economic and financial conditions.

We have reminded readers before of the note we posted back in February 2019 https://convex-strategies.com/2019/03/11/risk-update-february-2019/ where we recounted a not so hypothetical tale of a conversation from 2010 about where extreme monetary policy measures would inevitably lead. We will state it again, history matters, and a big part of current history is monetary extremism originating at the core of the fiat reactor, the US dollar, then spreading out to the rest of the world tied to the global reserve system.

We discuss the instability of the global economic sandpile over and over (see our August 2021 Update for a good overview https://convex-strategies.com/2021/09/22/risk-update-august-2021/), simplifying the sandpile’s fragility as a solvency issue and the ongoing cost to society of sustaining the imbalance as the destabilizing effect of broad inflation. Circumstances in Ukraine are both a result of, as well as feedback to, this ongoing interconnected system. It is in essence reflexivity, an interconnected finger of fragility.

The central bank and government narrative that their current unprecedented generation of money and credit isn’t inflation is fast coming apart at the seams. In his recent Senate hearing, Fed Chair Powell made the blunt statement “Hindsight says we should have moved earlier”. Again, begging the question – why isn’t he moving now?

Figure 1: US CPI yoy% (blue), Unemployment Rate (white-inverted), Fed Funds (orange), 2yr Swap (yellow)

Source: Bloomberg

Figure 2: US Taylor Rule (magenta), Fed Funds (orange), Wu Xia Rate (green)

Source: Bloomberg

Another mathematician cum philosopher icon, Rene Descartes (most famous for his “I think (doubt), therefore I am” as well as being the father of analytic geometry), put our view of central bank narratives very nicely:

“It is only prudent never to place complete confidence in that by which we have even once been deceived.”          Rene Descartes.

There are near endless examples of the misrepresentations of central bankers (we are increasingly unable to give them the benefit of doubt that they are merely incompetent) trying to distract from their failings, in practice and even in premise. Federal Reserve of Chicago President, Charles Evans, gave another great illustration in a speech this month entitled “On the Benefits of Running the Economy Hot.” Amazingly, the broad premise of this speech was a mea culpa from one of the more devout doves on the FOMC, though you would be challenged to catch that within the meat of his presentation.


“I enthusiastically embrace our dual mandate for maximum employment and price stability. The correlation structure of the economy means that usually there is no policy conflict in achieving both objectives.”

“My view is that as long as the U.S. and global economies are in a low r* world, nominal interest rates will remain low and we will experience episodes close to or at the ELB. Unless the FOMC is to jettison our responsibility to promote maximum employment and price stability, the financial stability burden should be primarily on financial regulators.”

President Evans shows the below chart as justification, despite the current historical extremes of their chosen price stability measure (what he, like all cult members, refers to as “inflation”), for their insanely irresponsible policy settings, ie ongoing ZIRP and QE. His point is that, on his chosen measure of PCE Core and his chosen time horizon of his tenure in the role, they are still below the trend level of their 2% price increase minimum target.

Figure 3: PCE Price Index Growth vs 2% Trend since Sept. 2007

Source: Federal Reserve Bank of Chicago

The chosen index and chosen period, not surprisingly, conveniently support Mr. Evan’s perspective. However, what happens if we choose another measure of price stability? Let’s run his same time period with both PCE Core as well as CPI, a still not particularly good measure but at least slightly broader than PCE Core.

Figure 4: US CPI Index (white). PCE Core Index (blue). 2% Trendline (red dash). Sept 2007 – Feb 2022

Source: Bloomberg

Clearly, using CPI as the indicator, we are well through his randomly determined target of a 2% per annum trend.

What if we picked some other start date to determine over what time horizon Mr. Evans and his esteemed colleagues should be achieving their target of a minimum loss of purchasing power? Instead of September 2007, what if we started in August 2016? Now we have both PCE Core and CPI indices significantly through the 2% annualized trend.

Figure 5: US CPI Index (white). PCE Core Index (blue). 2% Trendline (red dash). Aug 2016 – Feb 2022

Source: Bloomberg

To what extent are the current sufferers of this inflationary destruction expected to endure the pain to make up for some perceived past mistake of not imposing the suffering at some earlier era?

What if we go back to the initiator of the current regime of central bank reaction function, Alan Greenspan?

Figure 6: US CPI Index (white). PCE Core Index (blue). 2% Trendline (red dash). Aug 1987 – Feb 2022

Source: Bloomberg

Their preferred measure, PCE Core, on this longer time horizon has hardly wavered from the 2% trend target and has never underperformed that target. The current period of “outperformance” is as extreme as anything we have seen over the Greenspan-Bernanke-Yellen-Powell era. Another thing that stands out is that the only thing that one might term as “transitory” in this longer horizon are the rare and brief periods where these indices are not sailing along at their trend target or more. Meanwhile, policy rates are at 0% (ZIRP) and we are just about to end Quantitative Easing (QE). Anybody want to bet if this is the last we ever see of QE?

We think it wise to follow Decartes’ advice that it would not be prudent to place complete confidence in Mr. Evans.

When we are feeling gracious, still willing to provide some benefit of doubt, we have dubbed the ECB Chief Economist, Philip Lane, the “Worst Economic Forecaster in the World”. We now have updates on Eurozone HICP (their chosen price stability measure) for January and February so we can compare to the latest forecast/projections from December 2021 from the team at the ECB.

Figure 7: Eurozone HICP yoy% change (blue) vs ECB quarterly forecasts

Source: European Central Bank

Their poor forecasting prowess continues to be equally as persistent as the overshoot of their price stability measure. We will get a new set of forecasts, no doubt factoring in the implications from the events in Ukraine, in March. We look forward to any revisions, in particular if the expected impact from the war to the east, as well as the Russian related sanctions, factor into their thus far unwavering expectations of an immediate return to their long run target.

Mr. Lane gave quite a comprehensive recent interview:


This is well worth a thorough read. As specifically regards what he refers to as “inflation”, the annualized increase of their chosen price stability measure HICP, he notes:

“Inflation rates are indeed higher than expected, and these will persist for longer than originally thought. That mainly reflects energy prices and the supply bottlenecks, but the longer the origin of the shock remains, the more this affects a wider set of prices. So we are also revising our assessment of the persistence of inflation in this respect. But our instruments take 9, 12 or 18 months to affect the economy; that’s why we emphasise the medium-term nature of monetary policy. Many of the factors that are now driving inflation rates up will play less of a role in 12 or 18 months. The economy is not in an overheating zone. We think that most of this inflation will fade away.”

Just a week or so later (during which time circumstances in Ukraine had vastly deteriorated), he followed this up with a very comprehensive speech entitled “The Monetary Policy Strategy of the ECB: The Playbook for Monetary Policy Decisions.” This speech will likely remind readers of the Arthur Burns speech that we referenced at length in our December 2021 Update (https://convex-strategies.com/2022/01/17/risk-update-december-2021/) where Mr. Burns lays out extensively all the mistakes they made that allowed/caused the great inflations of the 1970s. As we quoted from Yogi Berra in December, “it is like déjà vu, all over again.”


“Policymakers must strike the right balance in responding to shifts in projected inflation. In one direction, if forecasts indicate that the inflation target will be reached within the projection horizon, waiting for realized inflation to converge to the target before tightening might be excessively costly, especially if inflation expectations become de-anchored to the upside. Under this scenario, excessive delay in monetary tightening runs the risk of a sharper subsequent hike in interest rates and a greater loss in output.

In the other direction, if current inflation is above the target level but the forecasts indicate that inflation will fall below the target level over the projection horizon, tightening policy in response to temporarily-high inflation would be counterproductive. Under this scenario, premature monetary tightening runs the risk of an economic slowdown and a reversal in the medium-term inflation dynamic, de-railing the prospects of ultimate convergence to the inflation target.”

Is Mr. Lane truly The Worst Forecaster in the World, or is he misrepresenting his forecasts in some effort to manage expectations and supposedly mitigate concerns of market participants and consumers? Is being perceived as bad at his job better than being suspected of being intentionally disingenuous? Which one is destroying ECB credibility faster?

Again, we look forward to what can be discerned from the March update as to their economic projections.

For yet another example of more of the same, we refer you to the most recent policy statement from RBA Governor Philip Lowe.


“The Board is committed to maintaining highly supportive monetary conditions to achieve its objectives of a return to full employment in Australia and inflation consistent with the target. The Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. While inflation has picked up, it is too early to conclude that it is sustainably within the target range. There are uncertainties about how persistent the pick-up in inflation will be given recent developments in global energy markets and ongoing supply-side problems. At the same time, wages growth remains modest and it is likely to be some time yet before growth in labour costs is at a rate consistent with inflation being sustainably at target. The Board is prepared to be patient as it monitors how the various factors affecting inflation in Australia evolve.”

Simply put, central banks all seem to be going to great lengths to justify why their policy settings need not be on “tight” yet, amazingly, deem it unnecessary whatsoever to justify why policy should stay on or around all-time “loose”.

The broad question in the immediate realm of monetary policy is to what extent central banks will use issues related to events in Ukraine, and the economic repercussions of the global response to Russia, as excuses to delay adjustments to their historically extreme accommodative policies? Most prognosticators are of the opinion that said circumstances will add to the upside challenges of everybody’s price stability measures. Nevertheless, few would claim that such will result in a more aggressive removal of the extreme policy accommodation. Quite the opposite, in fact.

As is commonly stated, pay attention to what they do more so than what they say. Chair Powell and Treasury Secretary Yellen both officially dropped the term “transitory” and shifted to “persistent” as regards inflation back in November. Meanwhile, the Fed continued right along with ZIRP and QE. In February, as we noted above, Chair Powell admitted that the Fed should have responded sooner. Yet, the Fed carried on with ZIRP and QE.

“If you would be a real seeker after truth, it is necessary that at least once in your life you doubt, as far as possible, all things.” René Descartes.

Our old friend Bilal Hafeez, over at MacroHive, reminded us recently of the relevance of another of our forebearers, Blaise Pascal, also a famed mathematician cum philosopher. What is known as Pascal’s Wager is, by our interpretation, a very early argument for a convex payout structure. It is a classic ‘f(x)’ solution to an unpredictable dilemma. Wikipedia describes it thusly:

“Pascal argues that a rational person should live as though God exists and seek to believe in God. If God does not exist, such a person will have only a finite loss (some pleasures, luxury, etc.), whereas if God does exist, he stands to receive infinite gains (as represented by eternity in Heaven) and avoid infinite losses (an eternity in Hell).

Unbounded upside. Bounded downside. He should have been an investment manager.

Another relevant Pascal quote aligns perfectly to our concepts of the relevance of performance in the wings versus performance in the middle of the distribution and the flawed utilization of Gaussian based financial methodologies. This parallels Per Bak’s conclusions, in his sandpile modelling, that the smaller regularly occurring avalanches don’t amount to much, but rather it is the large, interconnected avalanches that matter.

“Man’s sensitivity to the little things and insensitivity to the greatest are the signs of a strange disorder.” Blaise Pascal.

Along this theme, we were once again referred to an interesting piece of work this month. This time courtesy of some research published on the Chartered Alternative Investment Analyst Association (CAIA) website. The title of the article is “Building a Long Volatility Strategy without Using Options.”


It starts out with the following opening line: “Almost all asset classes are implicitly short volatility as they are bets on the economy doing well.” We wholeheartedly agree that almost all asset classes are implicitly short volatility but might question the second half of the sentence and note that may have more to do with correlation than volatility and instead posit that foregoing liquidity for a return is what makes investments generally short volatility. Still, we are ok with the general premise.

From there the author goes on, through historical back-testing, to attempt to find “asset classes” that have displayed negative correlation to S&P through various past market events. Those asset classes include US Treasuries, JPY/AUD FX cross, USD/KRW FX, etc. The premise being that one could systematically construct risk mitigating strategies to benefit overall portfolio construction without incurring the cost that makes explicit long volatility strategies “emotionally difficult to hold as they tend to generate strongly negative returns most of the time, and only occasionally positive returns.”

(Small side note. It is unclear to us whether his methodology accurately captures the not insignificant negative carry component of something like JPY/AUD over the time horizon you would have owned it.)

The note shows this picture, presumably in justification of the results, comparing their proposed systematic strategy against a VIX ETN (VXX).

Figure 8: CAIA Proposed Systematic Long Volatility Strategy vs VXX ETN

Source: CAIA.org

The author notes the somewhat obvious in that the systematic strategy “did not lose money consistently, but it also did not produce outsized returns when volatility spiked during stock market crashes.” He might have done well to note the fact that the explicitly long volatility strategy did produce such desired outsized returns.

The author quite rightly goes on to show the, while slight, justifiable portfolio benefit from his systematic strategy with these two representations. His strategy, along with reduced allocation to S&P (ie. driving slower in our F1 analogy), clearly reduces his measure of risk, Maximum Drawdown, while also reducing the CAGR over the period.

Figure 9: CAGR and Max Drawdown for S&P + Systematic Allocation Portfolios. 2006-2021

Source: CAIA.org

Using the market favourite measure for risk/reward analysis, he shows the improved Sharpe ratio from his proposed portfolios, indicating that the “risk” benefit is a positive contribution despite the reduced returns.

Figure 10: Sharpe Ratios of S&P + Systematic Allocation Portfolio. 2006-2021

Source: CAIA.org

Broadly, we think this is a reasonable piece but are disappointed that the author stopped there. He is trying to solve for the noble problem of improved risk managed long term compounded returns. We commend him for this! That is what everybody should be trying to deliver to end capital owners. However, he conditions his analysis on the avoidance of some presumed cost of explicit volatility ownership, with no evaluation of the efficacy of that strategy. Were the end capital owner to get greater portfolio compounding benefit from the explicit volatility ownership, why should one care about the perception of a cost?

We reiterate: “Man’s sensitivity to the little things and insensitivity to the greatest are the signs of a strange disorder.” Blaise Pascal.

We would have liked to see him extend his analysis to apply the same to some explicit long volatility strategies. We have taken a stab at doing so, as well as centring the analysis around the traditional Balanced Portfolio 60/40 benchmark.

Figure 11: CAGR and Max Drawdown for S&P + Systematic Allocation, Fixed Income, Explicit Long Vol

Source: Convex Strategies, Bloomberg

We have used here some of our regular examples of positively convex theoretical investment portfolios. “Barbell” (S&P 80%/CBOE Long Vol 40%), “Dream” (S&P 60%/Gold 20%/CBOE Long Vol 40%), and “Always Good Weather” (S&P 40%/NDX 40%/CBOE Long Vol 40%).

A couple of things that stand out are 1) none of the portfolios combined with the systematic allocation do nearly as good a job as just good old fashioned balanced portfolio with just US Treasuries, and 2) only the explicit Long Vol strategies are able to reduce Max Drawdown without reducing returns. The benefit of having good brakes so you can drive faster.

It is disappointing that, after appropriately utilizing Max Drawdown as a risk measure, the author defaults to Sharpe Ratio, and as such volatility of portfolio returns as a risk measure, in his subsequent comparison. We would much prefer that he uses Sortino Ratio and thus downside volatility. Nevertheless, the superior convexity portfolios outperform even on the flawed Sharpe Ratio methodology.

Figure 12: Sharpe Ratios of S&P + Systematic Allocation, Fixed Income, Explicit Long Vol + Sortino. 2006-2021

Source: Convex Strategies, Bloomberg

There are a number of problems with the analysis in the CAIA piece, not least of which being the reliance on historical correlation to persist in future events. More particularly, back to our point about focusing on the little things that don’t matter, the work which sets out to solve the “big” problem of compounding, then impedes that solution by imposing conditionality on an irrelevant (to end capital owners) problem of perceived short-term costs (the fiduciaries concern). The proposed solutions add nothing to the standardized solution of a 60/40 portfolio, the existing predominant risk management practice of driving slowly.

We can fire up the Scattergram Tool and do a quick comparison over this period of the Balanced Portfolio and the theoretical Dream Portfolio; two approaches with similar Sharpe Ratios but, as we will see, very different outcomes for end capital owners.

(Note: we have produced the table with annual rebalancing, the Scattergram and Compounding lines assume no rebalancing.)

Figure 13: Scattergram and Return Distribution: Balanced Portfolio (red) vs Dream Portfolio (blue). 2006-2021

Source: Convex Strategies, Bloomberg

Figure 14: Compounding View: Balanced Portfolio (red) and Dream Portfolio (blue). 2006-2021

Source: Convex Strategies, Bloomberg

Clearly, two strategies with similar Sharpe Ratios are not like for like to the end capital owner. It is the core of every conversation we have. What we like to call “the challenge of measurement.” The industry has standardized a premise based on a random walk and normal probability distributions that is wrong and, just so happens, benefits the fiduciary at the expense of the capital owner. Again, to some extent, it is the streetlight effect – looking for your keys under the light, not where you dropped them, because that is where you can see.

As ever, everything under the sun has been done before. Descartes was aware of this concept some 400 years ago.

“We do not describe the world we see, we see the world we can describe.” Rene Descartes.

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