Convex Strategies

Sorry, but we must return to our often-used Hayek quote yet again.

“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 use this in reference to a recent speech given by ECB Chief Economist, Philip Lane. As is usually the case, this isn’t so much a good and thoughtful read but, rather, aso valuable insight into the thinking of the wizards behind the curtain.

Central bank liquidity: a macroeconomic perspective (europa.eu)

Mr. Lane is laying out the construct for the upcoming ‘Operational Framework” review by the ECB, in particular as relates to the use of the ECB’s balance sheet and the role that central bank reserves play in their policy making. For us, what really stands out in the speech, and as relates to the above Hayek quote, is there has been no learning. Yet again, we are assured that the mighty central banks will bring together their ever-expanding set of tools and guide complex disequilibrium economies to the promised future steady state. All the while with no cognizant reflection that their past utilization of these very same tools has anything to do with the current state-of-play.

“The ECB’s monetary policy strategy statement recognized that financial stability is a precondition for price stability and that the pervasive role of macro-financial linkages in economic, monetary and financial developments requires that monetary policy decisions, including the evaluation of the proportionality of these decisions and potential side effects, are based on an integrated assessment of all relevant factors. Accordingly, their roles in preserving and restoring financial stability are central in understanding the macroeconomic impact of central bank reserves.” Philip Lane, November 2023.

Sounds good but is it really? Paraphrasing how our friend Bill White would put it, “they’ve got the wrong model”. Or more succinctly; “Central banks need to develop new models that are based on a better understanding of how the economy actually works”.

Unfortunately, as we regularly state (parroting Nasim Taleb), without accountability there can be no learning. Did the ECB’s unprecedented expansion of central bank reserves have anything to do with the failure to maintain their primary mandate of price stability? Did it impact the financial stability that they now seem so cognizant of? We certainly won’t learn anything of their thoughts on those two questions from the comments provided by Mr. Lane.

Figure 1: ECB Assets (blue) and Eurozone HICP Index (white)

Source: Bloomberg

There is one statement from Mr. Lane that we do agree with: “the appropriate level of central bank reserves can be expected to remain much higher and be more volatile in this new steady state compared to the relatively low levels that prevailed before the global financial crisis (GFC).” The blue line in the above chart gives some perspective on the increased volatility on reserves.

This fits nicely into our regular refrain around the “genie is out of the bottle” nature of the unprecedented historical volatility suppression of central bank’s price stability measures. Quoting Minsky, as usual, “stability begets instability”.

Figure 2: UK 20yr Historical Blocks of CPI Mean and Volatility

Source: https://personal.lse.ac.uk/reisr/papers/22-whypi.pdf. Millenium dataset of the Bank of England. Convex Strategies

Mr. Lane gives a masterclass in Sharpe World economic simplifications, putting to stunningly frequent use the magical terms “steady state” and “all else equal”.

“It is stipulated that the central bank sets the policy rate to deliver its medium-term inflation target in the steady state, so that there is no need to turn to additional instruments (such as QE or targeted refinancing operations) in the steady state. In addition, it is stipulated that the steady state is characterized by calm financial conditions. At the same time, the steady state configuration should take into account that the system can be hit by shocks and may subsequently be driven away from the steady state.”

“All else equal, the appropriate steady-state level of central bank reserves should be increasing in: the size of the banking system; the size of the overall financial system; and the overall size of the economy; the likelihood and potential severity of macro-financial tail events; the scarcity of safe assets; the effectiveness of micro-prudential and macro-prudential regulations (in combination with supervisory oversight) in curbing the incentives of banks to engage in excessive balance sheet expansion and maturity transformation; the mobility of deposits; and the policy prioritization attached to minimizing the risk of hitting the ELB.”

This really is a perfect example of the “nouns only” style of economics as critiqued by Brian Arthur in one of our all-time favorite notes; “Economics in nouns and verbs”.

https://sites.santafe.edu/~wbarthur/Papers/Nouns_Verbs_JEBO.pdf

In referencing standard algebraic mathematics as posed by Paul Samuelson, Mr. Arthur proclaims:

“We needn’t worry about the interpretation here; but notice the objects of discussion. They are symbolic quantities expressed in relation to other symbolic quantities – nouns related to other nouns. Any wordy narrative has been stripped; and any people trading, like the Tuscan shepherds, have vanished. There is only the faceless scientist. There are actions behind the nouns presumably, but only presumably; they are now invisible and unspecified – the language does not allow them. And of course no such scientist exists, optimally directing trade between England and Portugal. The problem has been fitted to the technique, here simple linear programming. We can debate the usefulness of Samuelson’s language of explanation. What I want to point to here is the lack of verbs. Verbs have vanished.”

Mr. Lane is that faceless scientist. Believing that his tools can deliver the economy to its steady state equilibrium, where it sits until being knocked askew by some unforeseen shock. Only to return with his necessary manipulations to restore the steady state once again. He lays out a list of things that his reserve tool needs to be responsive to, all the while unaware of the interactions of all the moving pieces. There are no Tuscan shepherds. There are no verbs.

Further, there is no recognition of time and entropy. There is no concept of self-organization. There is no reflection that, as we quoted Mr. Hayek above, “the present state of the world may be the result of genuine error on our own part”. With each iteration, the interventions get larger.

Figure 3: Euro System Bank Reserves Over Total Asset

Source: Central bank liquidity: a macroeconomic perspective (europa.eu)

Mr. Lane sees no linkage from their past interventions to their recent and current challenges of price and financial stability. He sees it as merely a response to a disequilibrium, not as a cause of ever greater sandpile-esque fragility.

We harp on this to make the point that neither we, nor seemingly the market, believe central banks have learned. Mr. Lane is telling us that the explosion of the central bank balance sheet is simply what was needed to mediate divergence from the steady state. As we regularly say, about something attempting to maintain a critical state, if it doesn’t work do more. If it does work, do more.

As we have stated over recent months, the ‘good outcome’ would be to get to the recession, and we see people willingly buy and hold bonds. We would argue this is what happened in what was an epically ‘good outcome’ November 2023. Pauses by central banks, softer CPI and employment numbers, and the firm belief that central banks will follow the same old playbook, saw an aggressive repricing of imminent interest rate declines, ie. a willingness to buy their bonds, and that was GOOD!

Figure 4: Total Return Indices: US TSY (white), US Corp (orange), US High Yield (blue), YTD Nov 2023. Normalised

Source: Bloomberg

The willingness to buy bonds, in anticipation of the Pavlovian response function of central banks to sharply resume accommodative measures, had an even greater reaction in equity markets.

Figure 5: Total Return Indices: SPX (blue), NDX (orange), MSCI World (purple). YTD Nov 2023. Normalised.

Source: Bloomberg

For some of the bond indices, November was the best month since Q4 2008. SPX and MSCI World were up over 9% for the month. Nasdaq was up nearly 11%. It may seem somewhat counterintuitive but, at least for now, the reaction to an imminent recession is that it is indeed the ‘good outcome’. Yay!

This, of course, begs the question as to whether the robust enthusiasm with which markets responded to the anticipated imminent recession might, in themselves, offput the very arrival of said recession? Keen observers are not so unfamiliar with the past enthusiastic responses to central bank pivot expectations (depending on your count somewhere between 4-7 thus far) leading to yet further economic strength and higher for longer interest rates. We even titled our October 2022 Update “PIVOT!™” and spoke in some detail on one of the versions from just over one year ago.

https://convex-strategies.com/2022/11/17/risk-update-october-2022-pivot/

If readers have the time, it is good fun going back and re-reading this note. It amazes us as to how naïve we were to not have be even more mocking of the PIVOT!™ narrative back then.

It is a tougher call as whether or not the current phase deserves the same cynicism. With the obvious exception of Japan, all the relevant players have much higher policy rates and much lower year-on-year changes in their price stability measures. Though, as we always like to point out, still higher CPI indices from a significantly higher base. There have also been modest upticks in unemployment rates, though all are still well below what historically would have been considered their NAIRU levels.

Figure 6: CPI Indices: US (white), UK (blue), Eurozone (orange), Australia (purple). Oct 2022 (white vertical)

Source: Bloomberg

As we have noted in past months, despite the central bankers persisting with rate hikes through a good portion of the year, financial conditions have not really tightened. Obviously, given the exceptionally strong performances of equity markets in November, financial conditions loosened fairly aggressively in November.

Figure 7: Chicago Fed National Financial Conditions Index

Source: Bloomberg

Another asset market that caught our eye and seems to also be in the camp of believing central banks will knee-jerk right back to their old habits, is Bitcoin.

Figure 8: XBT/USD (Bitcoin) Dec 2022 – Nov 2023

Source: Bloomberg

Long-time readers may recall our observations, now 3 years back, in the December 2020 Update – “Inflation is upon us; 60/40 is dead”, as relates to our view of Bitcoin as a barometer.

https://convex-strategies.com/2021/01/22/risk-update-december-2020/

We simply put it this way back then: “We like to think of this chart as the report card for central bank competence (it is, of course, on an inverse scale). They should look at this every morning and consider how the world is judging their policies.” This is what the chart looked like then.

Figure 9: XBT/USD (Bitcoin) Dec 2019 – Dec 2020

Source: Bloomberg

Bitcoin performed extraordinarily well while all the talk of transitory was going on and the overshoot was to be tolerated in line with the new Flexible Average Inflation Targeting (FAIT) framework that was hardcoded into policy in Q3 2020. Then, performed not so well, as first rhetoric, then action, shifted to fighting inflation. Then found a bottom just as the October 2022 PIVOT!™ took hold and is now accelerating as belief in the imminent recession solidifies.

FAIT is also something that we wrote about a little bit at the time. Our August 2020 Update, which we titled “Average Inflation Targeting; the beginning of the end”, took note of the broad fanfare at the time of its FAIT’s inclusion into formal “Statement on Longer-Run Goals and Monetary Policy Strategy”, the first update since January 2012.

https://convex-strategies.com/2020/09/21/risk-update-august-2020/

“Explanations of the new framework drowned the airwaves as the senior Fed mouthpieces put the word out, of course, led by Chair Powell himself virtually at the Jackson Hole event, backed up by both Vice Chair Clarida and Governor Brainard.”

There us been no update to the “Statement” since that August 2020 change, but we most certainly do not hear much about FAIT anymore. Like our discussion above per Philip Lane’s speech on central bank balance sheet, we are truly curious if anybody is discussing a review of this part of the Fed’s formal policy framework? Are they going to throw it out and say it was a mistake? Are they going to just ignore it as the problem of achieving their target is fought from above, not from below? Or are they still going to adhere to it? We virtually never hear this discussed. Certainly not by any Fed officials.

We know now, with the benefit of hindsight, that the Fed was most certainly willing to “let it run hot”, in line with their FAIT policy, once measures of inflation picked up. Will they now be willing to “let it run cold” to push the average back down to target? It seems very unlikely.

Figure 10: US PCE Core yoy% (white) and 5yr Moving Average (green) vs Fed Funds Rate (blue). 2% Inflation Target (red dash)

Source: Bloomberg

Just for some perspective, we’ve drawn in the 5yr Moving Average with the PCE Core Index yoy% change (the Fed’s designated preferred index). Back in August 2020, when FAIT was officially encoded to policy, the 5yr Moving Average of the PCE Core yoy% change was running at circa 1.6%, 0.40% below target. Today, that 5yr Moving Average is running at 3.15%, or 1.15% above target. Not reading anything into it, but the Fed dropped their ‘transitory’ talk at roughly the same time that the 5yr Moving Average crossed above 2%.

We would really love to hear them address this issue. If they are going to adhere to it, the anticipated near-term rate cuts might be a little aggressive. If they aren’t going to adhere to it, they should formally remove it from the “Statement” and might want to throw in a – “my bad” – modest apology.

As we hinted above, the one place that has not adjusted policy rates and has not seen a significant decline in their yoy% change of their price indices is, almost needless to say, Japan.

Figure 11: JGB 2yr Yield (white). BOJ Assets (purple-LHS inverted). Tokyo CPI ex-Fresh Food and Energy yoy% (orange). Japan Unemployment Rate (yellow-inverted)

Source: Bloomberg

The Japanese institutions in charge are still, generally, going with the “let it run hot” rhetoric, still claiming they have yet to ‘sustainably’ achieve their 2% target. This gets ever more difficult to deliver with a straight face as their various measures all persist well above 2% and increasingly their own forward forecasts rise to that level and above. It could, again, be worth paying attention come their December 19^th policy meeting.

All of this leaves us steady as ever in our views around risk and investment management. Be convex! Build portfolios that participate and benefit in uniquely good markets, like we saw in November, but are protected from the worst of the scariness of the previous couple of months. Fight to escape the compounding destruction imposed by the traditional Sharpe World methodologies.

For those that may want a refresher, go back and read our September 2021 Update – “The Challenge of Measurement”, or our July 2022 Update – “The Pointlessness of Forecasting”, or our January 2023 Update – “Understanding is a Poor Substitute for Convexity”, or our June 2023 Update – “One Thing”.

https://convex-strategies.com/2021/10/19/risk-update-september-2021/

https://convex-strategies.com/2022/08/16/risk-update-july-2022/

https://convex-strategies.com/2023/02/16/risk-update-january-2023-understanding-is-a-poor-substitute-for-convexity/

https://convex-strategies.com/2023/07/13/risk-update-june-2023-one-thing/

Throughout these pages we point out the flaws inherent in the simplified assumptions of traditional risk and investment practices and discuss the means by which we can replace the Sharpe World blinders with new convexity goggles. The answer lies not with predictions, the predictable makes little difference over time. It is the divergences from the expectation where opportunities exist. Investment portfolios should be constructed to be resilient/robust to the divergences, not fragile to them. Put good brakes on your race car so that you can, confidently, drive faster. Compounding paths are about time-averages along a non-ergodic track, not mythical parallel universes operating on a single slice of time.

A quick run through of some examples provides a very clear visualization. We will go with our standard Barbell Racer, the old reliable, hypothetical Always Good Weather Portfolio (AGW) of 40% in an SPX Total Return Index (SPXT Index), 40% in an NDX Total Return Index (XNDX Index), and 40% (20% 2x levered) in the CBOE Long Volatility Index (EHFI451 Index). We’ve chosen what we like to call the Bull Market Period commencing in March of 2009, now through November 2023. We’ve drawn up visuals that show the scattergram of each strategy’s monthly performance over the period and traced in the parabola represented by the dots, alongside the return distributions. Then, we’ve tracked the respective compounding paths and finally the ratio between the two NAVs. All of the below strategies assume annual rebalancing.

As always, the convex, braking-efficient, Barbell Racer, AGW is in blue and the traditional investment, Balanced Racer, strategies are in red. We have simply selected, for this run of Sharpe World based strategies, three well known Balanced Racers; 1) Risk Parity, 2) 60/40 Portfolio, 3) The Endowment Index. We threw in a bonus 4^th strategy, the Put Write Index, to make what should be an obvious point. For all of the Balanced Racer strategies we have reduced risk to roughly match the Max Drawdown of the hypothetical AGW portfolio over the time period to circa -17.6%. So Risk Parity becomes 90% in the S&P 10vol Risk Parity Index and 10% in Short Term US Tsy Total Return Index (LT12TRUU Index) aka “Cash”. The 60/40 Balanced Portfolio becomes 45/55, with just 45% in the SPX Total Return Index and 55% in the US Treasury Total Return Index (LUATTRUU Index). The Endowment portfolio is 70% in the Endowment Index (ENDOW Index) and 30% in “Cash”. And the Put Write portfolio is 85% in the CBOE Put Write Index (PUT Index) and 15% in “Cash”.

Figure 12: Barbell Racer AGW 40/40/40 (blue) vs Balanced Racer Risk Parity (red). March’09-Nov’23. Scattergram and Return Distribution