“The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. Based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission, it is now appropriate to moderate the degree of monetary policy restriction after nine months of holding rates steady.” ECB Policy Statement, 6 June 2024.
The ECB went ahead with a 25bp rate cute at their most recent policy meeting, despite raising the forecast for their 2024 price stability measure (HICP) from 2.3%, the March 2024 projection, to a revised 2.5% (remember, their forecast for the year is for the average monthly yoy% change over the calendar year). The official statement seemed to not necessarily align with their actions.
“We are determined to ensure that inflation returns to our two per cent medium-term target in a timely manner. We will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim.” ECB Policy Statement, 6 June 2024.
Figure 1: Eurozone HICP yoy% (white) and ECB Deposit Rate (blue)
Source: Bloomberg
As we have seen from the ECB before (readers may enjoy our October 2021 Update – “We really looked and deeply tested our analysis” https://convex-strategies.com/2021/11/19/risk-update-october-2021/), they prefer to direct our attention to their own forecasting, cum guidance, into the future. As with all central bank forecasters, regardless of their methodology or policy settings, the measure always returns to target.
Figure 2: Eurozone HICP yoy% (dark blue) and ECB Quarterly Projection Paths (various colors)
Source: ECB Website, Convex Strategies
“I think the second element that we took very much into account was the reliability and the strength of our projections.” Christine Lagarde, ECB Press Conference, 6 June 2024.
Of course, it was precisely this mentality that produced one of our most frequently used quotes from ECB President Lagarde (and the namesake of our October 2021 Monthly):
“We really looked and very deeply tested our analysis of the drivers of inflation, and we are confident that our anticipation and our analysis is actually correct.” Christine Lagarde, ECB Press Conference, 28 October 2021.
As we all now know, with hindsight, she could not have been more wrong, whether you think they were indeed ‘forecasting’ or whether you think they were ‘guiding’ expectations.
Again, back in the October 2021 press conference, President Lagarde was openly critical of market pricing relative to the guidance being provided by the puppet masters.
“Our analysis certainly does not support that the conditions of our forward guidance are satisfied at the time of lift-off as expected by markets, nor anytime soon thereafter.” Christine Lagarde, ECB Press Conference, 28 October 2021.
In the most recent press conference, when asked about her views of current market pricing which continues to price in 2-3 additional 25bp cuts in 2024, as opposed to her verbal guidance that no such cuts are currently being signaled, she gave a much more laissez faire response. Maybe there has been some learning?
“….. markets do what markets have to do, and we do what we have to do.” Christine Lagarde, ECB Press Conference, 6 June 2024.
To the everyday consumer, the enthusiasm of the ECB for their success in curtailing ‘inflation’, is not particularly shared. Ms. Lagarde mentioned multiple times in her responses that they have now twice “divided inflation by half”, with their rate hikes bringing it from its annualized peak of 10.6% down to 5.2%, then subsequently through holding rates steady at restrictive levels halving it again to 2.6%. We can’t help but note their own acclaim that it was their policy that is restoring price stability, but it was not as a result of their policies that price stability was previously destroyed. Back to the everyday consumer, far less concerned about the niceties of yoy% changes smoothed and averaged over time, and their view of things tracking the persistent increase in their cost of living. Hard to convince them that it all amounts to a job well done.
Figure 3: Eurozone HICP Index
Source: Bloomberg
We, and presumably a few others out there, can’t help but wonder why they wouldn’t leave policy rates unchanged and not raise the 2024 inflation projection to better align with their statement that they are committed to returning to their price stability target. We shall likely never know.
This all follows along with the themes we have been writing about over recent months/years. We titled our March 2024 Update “Divergence” https://convex-strategies.com/2024/04/16/risk-update-march-2024-divergence/ and pondered the implications of diverging policy requirements from the leading global central banks.
We used this wonderfully clear illustration of risk in last month’s Update – “Wittgenstein’s Ruler” https://convex-strategies.com/2024/05/15/risk-update-april-2024-wittgensteins-ruler/, using the pricing of the EUR/USD FX 25delta Butterfly to visualize how endogenous risk builds, then reflexively unwinds.
Figure 4: EUR/USD 25delta 9mth Butterfly
Source: Bloomberg, Convex Strategies
What might trigger the potential reflexive unwind of this accumulated risk? Could it be divergence in monetary policy? Or a ‘policy mistake’ by one of the respective central banks? Could it be an escalation of the war raging adjacent to their borders? Could it be a negative response/pushback from the everyday consumer and the impaired quality of life imposed by the persistent increase in price levels?
We put it this way last month:
“We would, of course, argue that the actual risk is indicated by the red circles. It is the fragility in the accumulation of snow ahead of the avalanche. It is the fragility in the buildup of combustible material on the forest floor ahead of the wildfire. It is the compression of risk premium through the application of leverage in the procyclical risk and accounting ecosystem of Sharpe World. The unwinds, while arguably triggered by or at least explained away by an exogenous spark, are the results of the reflexivity potential that has built up as the combustible material agglomerates in the system.”
Having discussed Gerd Gigerenzer’s concepts of heuristic decision-making in our February 2024 Update – “Where’s the Risk?” https://convex-strategies.com/2024/03/15/risk-update-february2024-wheres-the-risk/, and then Ludwig Wittgenstein principles of context-specific language in the April 2024 Update – “Wittgenstein’s Ruler”, a handful of readers correctly predicted that we would follow on to the works of Michael Polanyi on the topic of tacit knowledge. (https://en.wikipedia.org/wiki/Michael_Polanyi)
Coincidentally, and very much to our pleasure, we were able to attend a dinner last month where the keynote address was delivered by none other than MIT labor economist David Autor. For those not aware, Mr. Autor is credited with coining the name Polanyi’s paradox (https://en.wikipedia.org/wiki/Polanyi%27s_paradox).
“We can know more than we can tell.” Polanyi’s paradox.
This aligns directly with Polanyi’s premise of tacit knowledge from his 1958 works “Personal Knowledge”. Tacit knowledge are things that we, as humans, can know but aren’t able to explicitly explain.
Mr. Autor gave a wonderful presentation on the implications of automation, and more particularly AI, on the labour force. Referencing Polanyi’s paradox, Mr. Autor noted its implication as “we cannot ‘computerize’ tasks that we don’t explicitly understand”.
We have taken it upon ourselves to coin our own adaptation of Polanyi’s paradox as relates to the current versions (eg. LLMs) of AI. Please feel free to suggest naming alternatives!
Convex AI version of Polanyi’s paradox: “It can tell more than it can know.”
How do we get to this? It goes back again to our oft discussed probability vs possibility dilemma (See March 2023 Update – “Probability vs Possibility” https://convex-strategies.com/2023/04/14/risk-update-march-2023-probability-vs-possibility/). In fact, speaking literally, AI LLMs don’t actually ‘know’ anything. They are merely amalgamating all of the historical usage (at least that which it has access to in its given data universe) of a given word/phrase/sentence and returning the average of its usage as an answer. There is no tacit knowledge because there is no skin-in-the-game and, as such, no actual learning. Hopefully readers can see how this parallels our criticisms of the foundational premises of the mathematics behind the modern-day soft sciences of economics and finance, what we term “Sharpe World”. As Claude Shannon, the father of Information Theory, might put it; ‘there is no information in the expected outcome’.
Thus, we can now add Polanyi’s tacit knowledge to our list of things that differentiate between dealing with measurable risk and true uncertainty. Worth laying out the various renditions:
- Convex Strategies: Probability vs Possibility
- Frank Knight: Analysis vs Thought
- GLS Shackle: Imagination
- Pippa Malmgren: Dry Brain vs Wet Brain
- Per Bak: Critical State
- Ludwig Wittgenstein: Context
- Gerd Gigerenzer: Large Worlds
- Claude Shannon: Information Entropy
- Michael Polanyi: Tacit Knowledge
Polanyi has a series of lectures that you can find on YouTube. They are fantastic listens. Below we link the first one in a series of four lectures where he discusses precisely this point all the way back in 1962!
Michael Polanyi. “The Destruction of Reality”.
We have picked a couple of killer quotes from near the end of this lecture that perfectly align with our criticisms of models, AI or Sharpe World finance/economic related, that focus on the mean/average:
“Such universal knowledge will tell us absolutely nothing that we are interested in.”
“Actually, a state of complete ignorance.”
Beautiful! Very in sync with our views on the “reliability and strength” of the ECB’s projections.
Maybe the ECB made their decision to cut rates while raising inflation projection because, like we have discussed so often, they too are stuck with a fiscal dominance issue. The issue continues to garner much attention. Another example is a paper from widely respected Stanford-based economist John F. Cochrane titled “Expectations and the neutrality of interest rates”.
Expectations and the neutrality of interest rates – ScienceDirect
This is a somewhat Sharpe World-ish economic note that is a bit of an homage, while actually debunking to some extent, the 1995 Nobel Prize winning efforts by Robert E. Lucas as generally presented in his own paper titled “Expectations and the neutrality of money”. If you can dig through econo-speak, the Cochrane paper is a fun read as he debunks many of the consensus economic models of recent times, basically by pointing out how some combination of their assumptions and their results don’t reflect empirical evidence. He then presents his own model, what he dubs “fiscal theory with rational expectations”, still Sharpe World in its construct but with the key intention of tying it to actual reality. Odd that that is a novel approach.
“Adding fiscal theory of the price level to an interest rate target with rational expectations, we obtain a fully economic model that is at least not glaringly inconsistent with current institutions.”
The key conclusion of Cochrane’s model, getting back to the fiscal dominance point, is that an interest rate rise alone will not lower inflation unless it is accompanied by a fiscal tightening.
“Successful historical disinflations have typically combined fiscal and monetary policy reforms. The hoped-for negative effect on interest rates acting alone may not be there…..Assuming that fiscal policy will always tighten to pay these costs is dangerous, as the assumed fiscal tightening may not happen. In the current environment of large debts and structural deficits, fiscal authorities may not wish to or be able to raise surpluses.”
In other words, in Mr. Cochrane’s opinion, fiscal dominance is real and the recent efforts of many a central bank to restore price stability is being undermined by the ongoing fiscal debt and deficit excesses.
“While belief in a powerful negative and direct effect of higher interest rates on inflation is strong, particularly in central banks and policy circles, the actual evidence for such an effect is weak….Rational expectations and fiscal underpinnings of monetary policy imply that inflation is stable and determinate in the long run. Those features imply that pegs are possible, and that higher interest rates, without a change in fiscal policy, eventually raise inflation.”
We can’t help but perceive a certain amount of common sense.
The picture we used last month of the historical sizes of the US Treasury 5yr bond auctions shows very simply what Mr. Cochrane is concerned about.
Figure 5: US 5yr Treasury Auction Allotment. 2004-April 2024
Source: Bloomberg, Convex Strategies
It all leaves us very much in that same old space, namely that bonds, in the current environment, seem unlikely to be useful portfolio complements to equities or other such growth assets. Bonds, as has been the case for quite some time, seem unlikely to either participate or protect. Maybe that mindset can be reconsidered as and when governments start to shrink deficits, per Mr. Cochrane’s above analysis, but, other than some fringe examples like Argentina, there hasn’t been too much of that going around.
Indeed, the whole Sharp World premise of foregoing upside to (probabilistically) reduce downside, as well as (foolish) reliance on stable correlations and volatilities, are truly the key drivers of foregone compounding in long term investment paths. It accounts for what we often refer to as the two killers of compounded wealth: 1) bearishness (forever driving slowly, relying on timing to avoid unforeseen dangers), and 2) poor risk mitigation (getting the time wrong, getting let down on historical based assumptions of correlation). Forever under participating on the upside and under protecting on the downside. Negative convexity.
The answer, as always, is better brakes. Fuller participation with the knowledge of better and explicit risk mitigation which delivers superior portfolio acceleration and deceleration. Positive convexity.
We can play around with various simplified hypothetical examples and visualize the point. In figure 6 below we compare CAGRs on the Y-axis and the ratio of Upside Beta/Downside Beta on the X-axis of various performance tracks. The bubble size represents terminal capital values. We have chosen what we call the ‘bull market period’, commencing from March 2009 through May 2024.
The starting point is the basic Balanced 60/40 which is comprised of 60% SPX Total Return Index (SPXT Index) and 40% US Treasury Bond Total Return Index (LUATTRUU Index), the bog standard for targeting ‘average lap speed’ in the investment F1 race. We also include three of the leading practitioners of the Sharpe World orthodoxy – Risk Parity represented by the S&P Risk Parity Index 10%Vol (SPRP10T Index), Endowment model represented by the Endowment Index (ENDOW Index), and HedgeFund represented by the Eurekahedge Hedge Fund Index (EHFI251 Index). The final contestant is a hypothetical version of our convexity adjusted Always Good Weather (AGW) portfolio constructed, in this case, by keeping the 60% allocation in SPXT Index then splitting the 40% allocation in bonds to equal weightings of 20% in Nasdaq 100 Total Return (XNDX Index), for more explicit participation/upside acceleration, and 20% into the CBOE Eurekahedge Long Volatility Index (EHFI451 Index), for more explicit protection/downside deceleration.
Figure 6: CAGR (Y-Axis vs Upside/Downside Beta Ratio. March2009 – May2024. Balanced 60/40, Risk Parity Index, Endowment Index, Hedge Fund Index and Hypothetical Always Good Weather Portfolio
Source: Bloomberg, Eurekahedge, Convex Strategies
It is easy to see that the advanced Sharpe World strategies impede compounding relative to the simple Kelly Criterion based, drive slowly, standard of the Balanced 60/40 model. That is the inevitable result of targeting as your measuring device the ultimate of Witggenstein’s ruler’s – the Sharpe Ratio. You will be optimizing to the mean of expectations and all divergences will be deleterious to your compounding path, optimizing for expected returns and impeding actual returns. The simple enhancement to a moderately more positively convex portfolio, where explicit risk mitigation/brakes allow more upside participation/acceleration, creates an eye-poppingly superior hypothetical CAGR and thus greater terminal capital. Both are far superior objectives than annual arithmetic returns.
For anybody with skin-in-the-game, this is just tacit knowledge. Any actual driver of a car knows that he will drive with far greater confidence knowing that he has effective brakes on the car and will be far less likely to succumb to the siren-song of the bearish doomsayer’s verse.
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