“The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.” Jerome Powell, Jackson Hole August 2024.
With that, Chair Powell declared the battle to restore price stability complete. The market, probably quite rightly, has taken his comments as a clear signal that the Federal Reserve (Fed) will commence rate cuts at their next FOMC meeting in September.
Speech by Chair Powell on the economic outlook – Federal Reserve Board
For the mature crowd, the concept of rate cuts commencing, even as financial conditions remain relatively loose (below the long-term average) and equity markets are at all-time highs, brings back memories of the Fed’s premature rate cuts in 1995, and the subsequent bubbles in Asian and EM markets that culminated with the ‘97/’98 Asian/EM crises.
Figure 1: Fed Chicago Financial Conditions Index (white) and its Average (yellow). Fed Funds Rate (blue). SPX Index (orange-log scale). Vertical Line July1995 (white) and Aug2024 (red). Sept1987-Aug2024
Source: Bloomberg
It has become a bit of a tradition here to comment on the annual Jackson Hole Economic Policy Symposium put on by the Federal Reserve Bank of Kansas City. This year, once again, did not disappoint in terms of relevant content.
Chair Powell headlined the production, giving the market, by way of the above quote, the red meat they were craving. Overall, however, the speech reads pretty much as what a basic prompter could pull out of any of today’s AI packages by simply asking “how would a central banker explain the recent period of inflation”.
Chair Powell (or whatever version of GPT his speech writers used) touches on all the usual points.
- Inflation was caused by the usual boogeymen of exogenous events: Covid pandemic, supply chains, Russia-Ukraine. As is often the representation from central bankers, it just arrived. “Enter inflation.”
- It made sense to assume it was “transitory”. “Standard thinking has long been that, as long as inflation expectations remain well anchored, it can be appropriate for central bankers to look through a temporary rise in inflation.”
- Their policy response has been responsible for bringing it back to target, or at least close enough. “Our restrictive monetary policy contributed to a moderation in aggregate demand, which combined with improvements in aggregate supply to reduce inflationary pressures while allowing growth to continue at a healthy pace.”
- All is well now, and their efforts will keep expectations anchored at target, which will keep inflation on target. “All told, the healing from pandemic distortions, our efforts to moderate aggregate demand, and the anchoring of expectations have worked together to put inflation on what increasingly appears to be a sustainable path to our 2 percent objective.”
The gist is, we can all rest assured that they have this price stability (aka inflation) problem, that they never saw coming and certainly had no role in causing, under control and they will shortly be turning their focus to the other leg of their dual mandate, employment. For those that may be unfamiliar with their definition of price stability, it looks like this.
Figure 2: US CPI Index Aug1987 – July2024 (white) and 5yr Projection at 2% yoy change (red dashed)
Source: Bloomberg, Convex Strategies
We will never get over how their own extreme policies of ZIRP, QE, FAIT, which were explicitly targeted at generating inflation, are never attributed as having a role in the subsequent inflation. And, yet their latest rounds of policies are given all the credit for doing away with something that they had dubbed as transitory, prior to deciding they better try to do something about it.
As ever, our fear goes back to one of our favourite Nassim Taleb adages – “without accountability, there can be no learning.” Reviewing Chair Powell’s speech, we have a tough time noting any sense of learning or humility, with the exception of one little self-deprecating quip:
“The good ship Transitory was a crowded one, with most mainstream analysts and advanced-economy central bankers on board.”
Those unfamiliar may wish to pop back and review our December 2021 Update – “Arthur Burns mea culpa” https://convex-strategies.com/2022/01/17/risk-update-december-2021/. Former Fed Chair Burns, admittedly after he was out of the job, gave a little more indication of having garnered some learning. We noted several quotes relevant right through to today. Here is a good example.
“It therefore seemed only natural to federal officials charged with economic responsibilities to respond quickly to any slackening of economic activity ….. but to proceed very slowly and cautiously in responding to evidence of increasing pressure on the nation’s resources of labor and capital. Fear of immediate unemployment – rather than fear of current or eventual inflation – thus came to dominate economic policymaking.” Arthur Burns, 1979.
The only other head honcho to take the stage was Bank of England Governor Andrew Bailey. Governor Bailey titled his UK-GPT version of the same speech, “Reflecting on recent times”.
Reflecting on recent times – speech by Andrew Bailey | Bank of England
Governor Bailey’s AI prompter took the instructions, per blaming the failure to achieve their mandate on exogenous events, to a new level. Just a quick check on a word count for Covid, pandemic, Ukraine, Russia, shocks, comes in at no less than 50 instances! Just to be clear, it wasn’t their fault! But now, their policies have restored order and we all can rest easy, everything is back on path, and they are in total control.
“Inflation expectations appear to be better anchored, which I put down in good part to the presence of independent central banks with clear mandates and nominal anchors, usually in the form of inflation targets.”
Figure 3: UK CPI Index Aug1987 – July 2024 (white) and 5yr Projection at 2% yoy change (red dashed)
Source: Bloomberg, Convex Strategies
Again, there is no real perspective that their previous policy extremes played a role in the subsequent surge in prices. This despite the fact that, for whatever reasons, they felt the necessity over the previous 13 years to hold their policy rate significantly lower than the previously imposed low during the not moderate circumstances of the Great Depression and World War II.
Figure 4: 125 years of the UK Bank Rate
Source: Bloomberg
Governor Bailey does echo some past comments that we had previously noted from his crack Chief Economist Huw Pill in our June 2023 Update – “One Thing” https://convex-strategies.com/2023/07/13/risk-update-june-2023-one-thing/. In that note, we quote Mr. Pill from his presentation at the ECB Sintra Conference:
“As inflation moves away from target, the everything-else-equal assumption that allows us to break down the contributions to the drivers of inflation in a linear way tends to become unworkable. The likelihood of second round effects is much stronger when there is a tight labour market. The impact of the shocks is not additive to one another but has an important multiplicative moment. Which means linear models are not very successful.” Huw Pill. ECB Sintra Conference, June 2023.
Governor Bailey put it this way at Jackson Hole:
“A second feature of this tightening phase has been the size of the shocks we have witnessed and the potential non-linearities and asymmetries that have arisen in the monetary transmission mechanism. When we are dealing with relatively small shocks which stay within the locality around the inflation target where the linear approximations we normally make in our models hold, then these issues do not arise. That was the experience during much of the inflation targeting era.”
As we always say about Sharpe World, and part of what makes it so dangerous, it looks like it works a lot of the time, just not when it actually matters. This wonderous quote from Governor Bailey just begs us to once again show our visual proxy for Jensen’s Inequality. Approximating non-linear functions with linear models, based on appallingly small data sets taken over anomalous historical regimes, is a roadmap to nonsense. Amazingly, they seem rather well aware of this, just uninterested in doing anything about it.
Figure 5: Jensen’s Inequality: Hypothetical Payouts of Variance Swap (blue) vs Volatility Swap (red)
Source: Convex Strategies
Nassim, as ever, says it best. He outlines his concept of the Intellectual Yet Idiot (IYI) here in an excerpt from his book “Skin in the Game”.
The Intellectual Yet Idiot (nassimtaleb.org)
“Typically, the IYI get the first order logic right, but not the second-order (or higher) effects making him totally incompetent in complex domains.”
“The IYI has been wrong, historically, on Stalinism, Maoism, GMOs, Iraq, Libya, Syria, lobotomies, urban planning, low carbohydrate diets, gym machines, behaviorism, transfats, Freudianism, portfolio theory, linear regression, Gaussianism, Salafism, dynamic stochastic equilibrium modelling, housing projects, selfish gene, Bernie Madoff (pre-blowup) and p-values. But he is convinced that his current position is right.”
Conveniently, some folks, under the umbrella of the NBER, decided to write a recent paper seeking to put some academic rigor behind Mr. Taleb’s assertions of IYIs in the fields of finance and economics.
f204525.pdf (nber.org) “High and Rising Institutional Concentration of Award-Winning Economists.”
The authors’ conclusion – “All fields, except for economics, exhibit a low and decreasing concentration, which suggests a trend toward decentralized knowledge production. Conversely, economics shows a high and rising concentration.”
The authors construct the below graph to show the concentration across institutions of academia for Nobel laureates in their respective fields. The y-axis, HHI (Herfindahl-Hirschman Index), is their measure of concentration by affiliations, both before and after year t, for a given award recipient.
Figure 6: Institutional concentration of Nobel laureates from 1950
Source: f204525.pdf (nber.org)
The high, and growing, concentration in the field of Economics quite clearly stands out. One could translate that as indicative of a certain amount of groupthink in that realm. They provide this breakdown of the Top 10 affiliations.
Figure 7: Economic Award Recipients: Top 10 Affiliations
Source: f204525.pdf (nber.org)
With that in mind, here is the link with the full agenda from the Jackson Hole event this year, with all the academic papers that were commissioned then, subsequently, presented and discussed at the symposium. You may note a fairly good weighting in the ranks of the above noted concentration.
We will touch briefly on two of the papers that dance around our ongoing theme of “who’s going to own the 40?” (the 40 in a ‘standard’ institutional 60% equity / 40% fixed income balanced portfolio), aka fiscal dominance, and “is Sharpe World closing?”, aka financial repression.
First up is an excellent piece from Hanno Lustig, et al, “Government Debt in Mature Economies. Safe or Risky?”
Hanno_Lustig_Paper_JH.pdf (kansascityfed.org)
This is a really nice paper. It constructs a model of two regimes around the risks and impacts of government spending increases. They evaluate the trade-off that governments and central banks must make, between protecting taxpayers versus protecting bondholders, against bearing the fiscal costs.
“Monetary dominance produces a safe debt regime, while fiscal dominance generates a risky debt regime. The safe debt regime rules out unfunded spending shocks because of the fiscal authority’s commitment to pay for surprise spending with future taxation.”
In the safe debt regime, taxpayers will pay back the cost of the additional spending. In the risky debt regime, bondholders will eat the cost in the form of inflation. Not surprisingly, their analysis concludes “that the risky debt regime is a better fit for the recent U.S. experience as well as the experience of other advanced economies.”
The implications are obvious.
“In a regime of fiscal dominance, bond returns largely absorb spending shocks. When large spending shocks occur in bad times, bonds become riskier, and their correlation with stocks increases.”
A sampling of some of their charts will look similar to what regular readers have seen in our pages before.
Figure 8: US Nominal and Real Bond Returns. Jan2020 – Oct2023
Source: Hanno_Lustig_Paper_JH.pdf (kansascityfed.org)
Very much to their point, the cost was passed to bondholders. Likewise, the hoped for, or statistically expected based on recent years, correlation benefits of holding bonds went bye-bye.
Figure 9: US Bond-Stock Correlation. Jan1926 – Dec2023
Source: Hanno_Lustig_Paper_JH.pdf (kansascityfed.org)
While primarily focusing on the fiscal dominance nature of the current state of play, the paper emphasizes how the Fed initially defended bondholders, at the expense of taxpayers, up until March 2022.
“The large-scale asset purchases destroyed value from the perspective of taxpayers… The central bank’s mark-to-market losses measure the cost to taxpayers… In this environment, large-scale asset purchases by central banks in response to large government spending increase have undesirable public finance implications. These purchases, which provide temporary price support, destroy value for taxpayers but subsidize bondholders.“
One could ponder from where exactly the Fed gets the authority to impose these costs on taxpayers. We could even wonder if the new Supreme Court ruling overturning the Chevron doctrine/deference might ever be redirected towards the Fed and some of their freewheeling, as unelected administrators, be constrained. Who knows? Maybe even the whole concept of self-defining price stability as a minimum 2% currency debasement, and the accompanying upward distribution of wealth, could be questioned as to whether that should be set by Congress, as opposed to a board of unelected administrators.
As a bit of final emphasis, the authors close out linking the Fed’s actions to the subsequent fiscal dominance state in the final paragraph of the conclusion.
“These purchases may also distort the incentives of governments and impair the price discovery in government bond markets. It is not inconceivable that governments in some mature economies have overestimated their true fiscal capacity as a result of these large-scale asset purchases.”
We would very much agree that it is not “inconceivable”.
The second paper we would like to direct attention towards is from Anil Kashyap, “Monetary Policy Implications of Market Maker of Last Resort”.
Anil_Kashyap_Remarks_JH.pdf (kansascityfed.org)
This presentation runs through the actions and implications of the asset purchases by central banks during and after the Covid Pandemic, what the author terms as their role as “market maker of last resort”.
Recalibration of shocks in the interest rate risk in the banking book standard (bis.org)
The author tries to justify the support of bond markets in the name of financial stability but warns against some of the risks of using it for other purposes, eg. monetization of debt or monetary accommodation purposes.
“Of course, if the government bond rates simply reflect concerns about the fiscal responsibility of the government, then there is nothing the central bank can do to remedy that problem. Whether or not the central bank tries to assert a financial stability motive for any purchases, bond purchases will ultimately lead to inflation if they wind up merely monetizing the debt.”
To his credit, the author, using language from various successive FOMC meetings, lays out the transition from the initial financial stability rationale, through to the intermingling with monetary policy objectives and, finally, fully to a monetary policy transmission mandate.
“There was no definition offered for how to tell when the smooth functioning of markets would be deemed to have been restored…. Thus, almost immediately, the financial stability rationale and monetary policy objectives were intermingled…. The increase in the balance sheet was now in part needed to help ‘foster accommodative financial conditions’.”
“The initial purchases were undoubtedly merited on financial stability grounds, I believe that justification was long gone by the summer.”
On a couple of occasions, the author realizes that his support of the market maker of last resort function inevitably drifts into the realm of moral hazard but, as tends to be the case within IYI type crowds, second order effects are broadly brushed aside.
“If market participants know that a facility will be available and understand how it will operate, that information alone may help promote stability and reduce the need to activate the tool. Though conversations about a private securities facility could be double-edged because they could encourage more risk-taking.”
“Sherlock, any thoughts here….?”
What the IYIs of Sharpe World never seem to understand is that it is the leverage, and the regulations that allow fiduciaries, without the tacit knowledge of skin in the game, to own securities with insufficient capital to absorb losses. The disfunction of markets doesn’t simply magically materialize, any more so than Chair Powell’s “Enter inflation”. It is the result of the accumulated fingers of fragility built up through the self-organizing dynamics of complex systems. The risk is endogenous.
Chaos Theory legend, Doyne Farmer, wrote a wonderful paper on just this topic: “Leverage Causes Fat Tails and Clustered Volatility”.
Doyne and his colleagues build a simple computational model that compares market behaviour across different levels of leverage-use by market participants. The implications of their results are what we would class as common sense and, unsurprisingly, align with real world outcomes.
“When funds do not borrow, the price fluctuations of the asset are normally distributed and uncorrelated across time… As leverage increases price fluctuations become heavy tailed and display clustered volatility, similar to what is observed in real markets… The resulting nonlinear feedback amplifies large downward price movements. At the extreme this causes crashes, but the effect is seen at every time scale, producing a power law of price disturbances.”
“The mechanism we develop here supports the hypothesis that they {fat tails and clustered volatility} are caused by endogenous dynamics of the market rather than the nature of information itself – in our model information is normally distributed and IID {independent and identically distributed}, but when leverage is used, the resulting prices are not.”
Again, the risk is endogenous. As the most aggressive funds attract more investment during stable markets, more leverage builds in the system. Eventually, this will lead to sufficient fragility such that there will be a crash, a fat tailed event, preferentially harming those utilizing the leverage, until leverage in the system resets to a lower, more stable, level. Lather, rinse, repeat.
Another luminary in the world of Chaos and complex systems is the mathematical physicist (that comes nowhere close to describing him) Stephen Wolfram. We love his concepts of the ruliad and computational irreducibility as an analogy for the unknowability of markets and economies. He very quickly explains his premise in this short Ted Talk.
“Can one predict what will happen? No. There is what I call computational irreducibility, in which, in effect the passage of time corresponds to an irreducible computation that we have to run in order to work out how it will turn out.”
Stephen recently wrote a note at his website commemorating his 65th birthday. It is not a short note, but it is an important one and, maybe for mature audiences, the most inspirational thing we have ever read.
Five Most Productive Years: What Happened and What’s Next—Stephen Wolfram Writings
In the note, Stephen recounts over the various projects that he decided to pursue/undertake upon the occasion of his 60th birthday, five years previous. Calling it inspirational doesn’t do it justice.
He discusses his development of the concept of the ruliad. His theory of everything, trying to push beyond Relativity, Quantum Mechanics, the Second Law of Thermodynamics. Not small ambitions.
“But what if instead of just applying a given rule in all possible ways, we applied all possible rules in all possible ways?… The ruliad… The ruliad is the biggest computational thing there can be: it’s the entangled limit of all possible computations. It’s abstract and it’s unique – and it’s as inevitable in its structure as 2+2=4. It encompasses everything computational – including us. So what then is physics? Well, it’s a description of how observers like us embedded in the ruliad perceive the ruliad.”
We are all both observers and participants within the ruliad. It is naïve to think that, within the de minimis fraction of time and space that we occupy and can measure, we can somehow perceive and model the true complexity of the universe. Again, such a great analogy for how we (and Hayek, Mandelbrot, Taleb, Farmer, Peters) think about economies and markets. The whole is unknowable.
One of Stephen’s many contributions is the creation of a computational language, Wolfram Language. We love this concept. The rooted language of Sharpe World, based on all of its flawed assumptions of normality and linearity, needs to be shoved aside and replaced with language that has actual meaning in the real-world environments of complexity. As Stephen says in his birthday blog, we need new abstractions along those lines of what Shannon brought us with Information Theory.
“If we look at a microprocessor, it’s not very useful to describe it as “containing a gas of electrons”. And similarly, it’s not useful to describe a biological cell as “being liquid inside”. But just what kind of theory is needed to have a more useful description we don’t know. And my guess is that there’ll be some new level of abstraction that’s needed to think about this (perhaps a bit like the new abstraction that was needed to formulate information theory).”
This note is truly what we hope to aspire to over our next five years. Climbing on the shoulders of the aforementioned giants and advancing the understanding of what appropriate risk management should be. Think of this as our call to arms to chip away at the forces of Sharpe World. In practice. In academia. In regulation. If any readers share our passion, please do contact us and join us down this path.
The unknowable is unknowable. In an investment strategy targeted at an appropriate objective of geometric compounding through time, the answer is convexity. As we borrowed from Nassim Taleb for the title of our January 2023 Update – “Understanding is a Poor Substitute for Convexity”.
We linked to Nassim’s such titled note and quoted him as thus:
UNDERSTANDING IS A POOR SUBSTITUTE FOR CONVEXITY (ANTIFRAGILITY) | Edge.org
“Optionality frees us from the straightjacket of direction, predictions, plans and narratives.”
In a recently recorded interview at the AIM Summit in London, Nassim imparts us with numerous pearls of wisdom.
Nassim Nicholas Taleb on Investment, Hedging, and Mishedging | AIM Summit London 2024 – YouTube
2:09 “If you are a professional investor and your portfolio doesn’t have a tail hedge, it’s not a portfolio.”
3:00 “When you have someone judged by her or his performance and working, say for a family office or something, then they get upset about the p/l and that’s why they blow up the owners of the capital.”
4:00 “When I want to talk about investments, you always go to the owners of the capital…. They think healthily, instead of some intermediary who is judged unfairly on a portion of return, not the whole package.”
Fortunately, some of the largest investors in the world are coming around to the Nassim’s concept of “the whole package”. A growing theme amongst some of the big boys in the space is what is being dubbed the “Total Portfolio Approach”. It is, in theory, what the title implies – investments should be considered, not on a standalone basis, but on their contribution to the total portfolio. The fact that this is considered new and innovative is obviously a little concerning, much like the Farmer paper above showing that leverage leads to fat tails and volatility clusters, but we should take heart that things are moving in the right direction.
Here is a paper pulled together by CAIA with the leading advocates; Australia’s Future Fund, CPP Investments, New Zealand Superannuation Fund, and Singapore’s Government Investment Corporation (GIC).
The Rise of Total Portfolio Approach (nxtbook.com)
An even more comprehensive piece has been put out by GIC in cooperation with JP Morgan Asset Management (JPMAM) and is available at GIC’s website.
GIC-ThinkSpace-Building-A-Hedge-Fund-Allocation.pdf
What GIC/JPMAM found, when applying the principles of the Total Portfolio Approach to an evaluation of Hedge Fund contributions to the portfolio, was that the key contribution is what they classed as “Loss Mitigation”, ie. negative correlation and, in particular, during significant market drawdowns.
Figure 10: GIC/JPMAM Analysis of Hedge Fund Performance during MSCI World Drawdowns. Jan2011 – Dec2023
Source: JPMAM, GIC, HFR, Pivotalpath. GIC-ThinkSpace-Building-A-Hedge-Fund-Allocation.pdf
Sounds familiar!
The focus of the piece is breaking out the types of contribution their various classes of Hedge Funds make to the portfolio into these four sub-groups:
- Equity Substitute
- Equity Complement
- Equity Diversifier
- Loss Mitigation
They then generate two different optimized portfolios:
- Standalone hedge fund allocation
- Hedge fund allocation integrated within a 60/40 portfolio (HF allocation capped at 20%)
Regular followers will know where this is going.
For Portfolio A, 59% goes to Loss Mitigation strategies with the balance split to Equity Diversifying and Equity Complement.
For Portfolio B, the entire 20% constraint goes into Loss Mitigation strategies, fully funded by reduction in the bond allocation. The reduced volatility, and total portfolio drawdown, allows an even further reduction in the bond allocation with increased allocation to equity.
“The total portfolio allocates 20% to hedge funds, which was the maximum allowable limit set, and funds this entirely from bonds. The hedge fund portfolio consists entirely of Loss Mitigation (20%) to limit the total portfolio drawdown and volatility, which results in more effective compounding.”
“Given the reduced volatility, the total portfolio allocates more to equities, which increases overall returns.”
Hallelujah!
The obvious question to be asked, given the conclusions from this decent piece of research, is why didn’t they include an additional category called something like “Explicit Loss Mitigation” and include Long Volatility strategies? Strategies that, per all of their various measures, would have greater negative correlation, larger positive returns during drawdowns, higher percentage of generating positive returns during drawdowns?
If anybody wants to discuss what this presentation might look like with the addition of “Explicit Loss Mitigation” and evaluated on more appropriate metrics than the Wittgenstein ruler of Sharpe Ratios, please send us a note.
“Patience is waiting. Not passively waiting. That is laziness. But to keep going when the going is hard and slow – that is patience. The two most powerful warriors are patience and time.” Tolstoy
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