“It is only prudent never to place complete confidence in that by which we have even once been deceived.” Rene Descartes, 1641.
We used the above quote back in our February 2022 Update – “The Road to Serfdom and Pascal’s Wager” Convex Strategies | Risk Update: February 2022 – The Road to Serfdom & Pascal’s Wager.. We were, at the time, challenging the year-long rhetoric around the 2021 catchphrase of the year – “Transitory” – and the corresponding efforts to forecast price stability measures imminently returning to the respective central bank targets, country by country.
We have found ourselves, yet again, directing our ire at the gamesmanship of our central banking friends as they have returned to their obfuscating ways over the last two rounds of policy meetings. We have highlighted, at some length, this phenomenon over our last two Updates (Convex Strategies | Risk Update: March 2026 – “Exposing Fragility” and Convex Strategies | Risk Update: April 2026 – “Unchanged”). We are not going to claim that our message got through to ECB President Lagarde, but clearly, she has finally seen what we thought was already visible at their March and April meetings. We might put it this way – initial conditions matter.
When It Matters Most: Upholding Independence in Challenging Times
“First, supply shocks are becoming more frequent, placing monetary policy before its most difficult dilemma, because they drive inflation and economic activity in opposite directions. Second, fiscal pressures stemming from defence needs, the climate transition, the digital transition and ageing are narrowing budgetary margins. And beyond these structural forces, a broader erosion is taking place, namely a decline in trust in public institutions, including in technical institutions like central banks.” Christine Lagarde, May 2026.
Still, reading that quote again, maybe she has seen some of our previous comments!
Somewhat ironically, the core theme of her speech is on central bank independence and credibility. She gives her ECB some credit for having been up for the task. She lays out three key conditions for maintaining independence:
- Clarity of mandate: Price stability must be the primary objective without concern of trade-offs.
- Clear communication: They will do what they say and be held accountable for it.
- Room for manoeuvre: They must guard against fiscal and financial dominance which would constrain their independence of action.
“For money rests on a promise: that its value will be preserved over time. This promise depends on the trust that citizens place in the institutions charged with safeguarding it. Preserving that trust – and so to preserve the value of money – is the mission that brings us all here today.” Christine Lagarde, May 2026.
We agree with her points, though somewhat less so with her assessment of her own performance
Figure 1: Eurozone HICP Index (white). 1997 – March 2026. Symmetrical Target as of July 2021 (red). Pre-Symmetrical Trend 1.65% (red dash). Post-Symmetrical Trend 4.45% (green dash)
Source: Bloomberg, Convex Strategies
Since President Lagarde led her ECB to adapt their price stability target to being symmetrical around 2%, things have gotten rather dicey on that credibility question. While it is nice to hear her talk about the importance of guarding against the straightjackets of fiscal and financial dominance, does anybody really believe that we are not already there? The initial condition challenges that Ms. Lagarde lays out are all very much current constraints on the system and, as we discussed in March, the long memory of the market is fully ingrained.
Case in point, all should read this wonderful note from Hanno Lustig on ECB independence. The supposed independence that was constructed around the ECB in Maastricht has all been methodically whittled away.
Central Bank Independence: Lessons from Maastricht
On paper, the ECB is structured to have greater independence and clarity of purpose than virtually all of its peers. Turns out, not so much.
“It doesn’t. Over the past fifteen years the ECB has used its balance sheet to repeatedly backstop the bond markets of fiscally weak member states, built up trillion-euro cross-country claims through the Eurosystem payments system, and transferred billions of euros across national taxpayers — none of it approved by any legislators.” Hanno Lustig, May 2026.
Of course, the theme of central bank independence is not in the least bit unique to the ECB. Friend of Convex, Marvin Barth, penned this marvellous note related to his comments at the prestigious Hoover Institution Monetary Policy Conference.
(3) Themistocles’ lesson for the Fed – by Marvin Barth
“My primary message is that the risks to Fed independence are largely of its own making and that as an institution it is in desperate need of root-to-branch reform.” Marvin Barth, May 2026.
This is a wonderful note from Marvin and echoes many of our own criticisms. Not least being the erosion of trust as, essentially unaccountable experts, have time and again obfuscated and misled their way to imposing costs on the masses they claim to protect.
“They don’t trust you. And after a long sequence of ‘experts’ policy errors whose cost have largely fallen on the masses, who can blame them?” Marvin Barth, May 2026.
We certainly would not argue with that sentiment. We just keep going back to this wonderful quote from Dan Davies:
“History is a series of decisions, not of events, and many decisions are best understood as the outcomes of larger systems rather than individual acts of will.” Dan Davies, August 2025.
We will just slot in here this wonderful paper (hat tip to Ole Peters for highlighting it) from mathematician Reuben Hersh.
Some Proposals for Reviving the Philosophy of mathematics
“Most writers on the subject seem to agree that the typical ‘working mathematician’ is a Platonist on weekdays and a formalist on Sundays. That is, when he is doing mathematics, he is convinced that he is dealing with an objective reality whose properties he is attempting to determine. But then, when challenged to give a philosophical account of this reality, he finds it easiest to pretend that he does not believe in it after all.” Reuben Hersh, 1979.
Replace the word “mathematician” in the above (and throughout the paper) with the word “economist” and you get a brilliant exposition of the rigid adherence to something that is, if anybody is honest, known to be wrong. What we have dubbed Sharpe World. Again, constantly falling back on a core premise of mathematical structure, that does not reflect empirical reality, is no way to build and sustain trust. As above for the ECB, we can easily enough visualize that broken trust by the Fed that Marvin is criticizing.
Figure 2: US CPI Index (white) 1997 – May 2026. FAIT Aug 2020 (purple). Pre-FAIT Trend 2% (red dash). Post-FAIT Trend 4.5% (green dash)
Source: Bloomberg, Convex Strategies
These simple pictures can easily make one suspicious that all the grandstanding about protecting central bank independence, smells a bit more like avoidance of accountability. As we have highlighted over the past two months, we have once again been serenaded with the choruses of looking through, appropriate tools, watching for second order effects, from the master planners at the controls. They are in full control of the future, but all current failings are the result of unforeseeable past events. They want to be central planners when they really should be risk managers.
What does the reality look like? Reality is that initial conditions are what they are. The memory of recent inflation is ingrained in the system and, supply shock or not, the feedthrough is happening. Just simply overlaying in the same chart the year-on-year percent changes of CPI and PPI gives an eery similarity to the last (supposed) supply shock they all wanted to look through.
Figure 3: US CPI YoY% (white) and PPI YoY% (blue). May 2020 – May 2026
Source: Bloomberg
The above-mentioned masses are not as easily duped the second time around. After getting rugged by the “transitory” crowd and having to wear the consequences of three years of significantly above target inflation, they have watched as central banks commenced to easing policy before ever getting back to their reported targets, 175bp of cuts from the Fed without ever getting back to 2% (much less, per their previous misspent philosophy of FAIT, of getting the average back to 2%, if only!). Now, they are greeted once again with a (supposed) supply shock that they are told isn’t for the central bankers, tasked with maintaining price stability, to do anything about.
Will the Fed, and their brand-new incoming Chairman Warsh, recognize as President Lagarde appears to have done, that you can only ride this bull for so long? By most traditional metrics, you could make a pretty obvious argument that Chairman Warsh ought to be hiking at his very first meeting, maybe even justified to jump ahead, after the last couple of meetings of looking through, and doing a 50bp hike. What is Mr. Warsh going to do about building trust as he steps into a role where it has certainly seen some erosion over his (not totally outgoing) predecessor’s term?
We don’t have May numbers yet for the UK, but the same points were already perfectly clear in April.
Figure 4: UK CPI YoY% (white) and PPI YoY% (blue). May 2020 – April 2026
Source: Bloomberg
As we said above, eerily similar to the recent past. And, just like their global peers, the longer-term view is simply just more of the same.
Figure 5: UK CPI Index (white). 1997 – April 2026. Andrew Bailey Governorship Commences March 2020 (purple). Pre-Bailey Trend 2% (red dash). Post-Bailey Trend 4.5% (green dash)
Source: Bloomberg, Convex Strategies
We do find it somewhat interesting that the post-inflection point trend rate across the ECB, Fed, and BOE (RBA as well, FWIW) are all approximately 4.5%. The erosion of trust is, at least, a balanced competition.
The one idiosyncratic player in the game is our old friend the Bank of Japan. They have intentionally stuck with an accommodative policy stance throughout this entire period, consistently insisting that their mythical “underlying inflation” measure had not yet achieved the 2% target. This despite the fact that their official reported measures of inflation have been at or above target for a full four years and are projected to remain so through the forward-looking projections over the next three years. Many had expected the BOJ to hike 25bp at their April meeting, moderately reducing the scale of negative real rates in the policy rate setting, particularly in line with the anticipated raising of their forward inflation forecasts. We got the increased forecasts but without reduction in the level of policy rate accommodation.
There were three dissenters in the vote to hold policy rate unchanged, a fairly unusual occurrence at the BOJ. With the receipt of the subsequent “Summary of Opinions”, as well as pretty much a clean slate of all BOJ speeches in May, we can see that there is general consensus that they probably made a mistake. Much like Ms. Lagarde’s speech above, indications seem pretty clear that the June meeting will be used to at least start to try to catch up.
This from the Summary of Opinions for the April meeting.
Summary of Opinions at the Monetary Policy Meeting on April 27 and 28, 2026
“It can be considered from the experience of the past oil crises that, unlike during the 1979 oil crisis, when the surge in inflation was contained, the current financial and fiscal conditions and developments in the pass-through of price and wage increases appear to be more prone to inducing second-round effects stemming from the rise in crude oil prices.” Bank of Japan, May 2026.
This from Monetary Policy Committee member, Masu Kazuyuki.
“At the April 2026 MPM, there were mixed views among Policy Board members on whether to raise the policy interest rate immediately. I myself judged at the April MPM that the situation did not warrant a hasty policy rate hike. That said, if statistical data do not indicate clear signs of an economic downturn, I believe it is desirable to raise the policy rate at the earliest stage possible.” Masu Kazuyuki, May 2026.
And, most clearly, two from BOJ Governor Ueda, himself.
Economic Activity and Prices, and Monetary Policy in Japan
“Thus, interest rate hikes to date notwithstanding, Japan’s financial and economic activities have not been constrained. On the contrary, I believe accommodative financial conditions have firmly supported economic activity… In terms of financial conditions, unlike the United States and Europe, where policy interest rates are considered to be in the neutral range, real interest rates in Japan remain low, indicating accommodative conditions. In this sense, compared to other major economies and to our own country in the past, Japan is currently in a situation in which the secondary spillover effects of inflation stemming from higher crude oil prices are more likely to lead to an upward deviation in underlying inflation. The Bank considers that it is necessary to make decisions about future policy based on this premise.” Kazuo Ueda, May 2026.
“Let me conclude. Japan’s experience shows that oil price shocks are never just oil price shock. They are tests of the entire inflation regime… What are the important initial conditions that will matter for the evolution of the economy from here? What inflation regime are we in now? And, what is the best response from central banks around the world, including the BOJ?” Kazuo Ueda, May 2026.
As with Ms. Lagarde, we are very pleased to see Ueda-san joining us onboard the initial-conditions-matter bullet train! The story, really, is very much the same.
Figure 6: Japan CPI exFresh Food and Energy YoY% (white) and PPI YoY% (blue). May 2020 – May 2026
Source: Bloomberg
Crazy as it may sound, given their self-admitted accommodative stance, we might put BOJ up as a candidate for that same path that we mentioned for the Fed. They likely need to make an effort to catch up and could themselves be up for at least some members arguing for a 50bp hike. The three members that voted for the 25bp hike in April could, rationally, consider that they need to make up for having missed that one and fallen even further behind.
No doubt, plenty of folks would argue as to whether or not the BOJ is strictly speaking “behind”. Our point would be that the currency and bond markets, quite clearly, think they are behind. Thus, necessitating more FX market intervention by the MoF and steady bond market reinvestment by the BOJ.
Figure 7: USD/JPY FX Rate (orange) and JGB 10yr Yield (yellow). 2012 – May 2026
Source: Bloomberg
Japan, as we have so often discussed, is a key player in much of the core global dynamics that we have analogized as The Hunger Games and Resource Wars. Japan is the world’s largest foreign creditor and, pretty much across the board, the largest foreign owner of every government bond market of significance. If ever those Japanese flows reverse, the Hunger Games, the competition by governments to issue their debt, really kicks off.
We have long been vocal on this concept, coining one of our most used catchphrases – “Who is going to buy the bonds?”
We got some further insight on the officialdom thinking on this topic with the thorough review conducted under the auspices of the G30 Group.
Figure 8: Holders of Advanced Economy Government Debt 2021 vs 2024
Source: G30_NBFI-Report_FINAL.pdf
Clear to see that all of the increase in holdings from 2021 to 2024 has fallen in the hands of NBFIs (NonBank Financial Intermediaries). We are reluctant to say it, but this is an important read. Our interpretation is that this is further effort to pave the way for justifying coming bailouts/support of NBFIs in whatever next government bond market crisis transpires. There is a lot in there but this simple quote sort of sums up the argument.
“These links undermine one theme of the post-GFC reforms—the transfer of risk away from banks—since, while credit risk has partly migrated to NBFIs, much of the associated liquidity risk remains concentrated in the banking system.” G30 NBFI Report, May 2026.
Post GFC, they intentionally tried to move some of this risk off the government backed bank balance sheets into the hands of the NBFI community, in hopes that there was actual capital in that sphere to absorb potential future losses. Now, it would seem, that the risk is too much, or maybe that they are too necessary as a tool for financial repression, whichever, they need them to climb aboard the moral hazard wagon.
For those interested in the long history of post-GFC efforts to make government bond markets safe again, we would refer you to our September 2022 Update – “Is Sharpe World Closing” Convex Strategies | Risk Update: September 2022 – Is “Sharpe World” Closing? where we link/reference six of our other past notes on specific efforts by various regulatory bodies to address these issues.
On related topics we refer readers to friend of Convex, Mike Green’s, recent open letter to Treasury Secretary Scott Bessent on creative ideas as to a means to cleanse some of the blockage in the financial repression food chain of Rational Accounting Man’s underwater holdings of 0% RWA, Hold-To-Maturity accounting treatment, US Treasury Bonds. (Convex Strategies | Risk Update: February 2025 – “Rational Accounting Man”)
(3) So tired – by Michael W. Green
Mike, and Secretary Bessent if he is listening, are right to look at this problem. Mike has long been at the absolute forefront of the issues around the impact of passive investing strategies in equity markets. As he has turned his lens to the implications of the same, and more broadly price-insensitive participants overall, on the government bond markets he has come to shine the spotlight on where the problem is arguably more developed and more troublesome.
Hard to say if Mike’s proposed accounting gimmick would work in cleansing some of the system. It is not dissimilar to what we have previously discussed as the solution being undertaken by the insurance regulator in Taiwan with similar issues on the callable-note structures clogging insurance balance sheets there. Addressing it as an accounting issue, does get right at the heart of what drives Rational Accounting Man, but it may not cure the underlying disease.
Everybody knows our opinion, the only way to truly fix these problems is to inject accountability back into the system. Turn Rational Accounting Man back into a Boundedly Rational Agent with actual skin-in-the-game. Fiduciary agents have been robbed of their risk-taking skills after far too much time operating with accountability delegated to the regulatory overlords. They come to see the Sharpe World map as representing reality. It does not. And they lose their instinct, their tacit knowledge, of how to survive in the wild, necessitating ever more bailouts and accounting gimmicks to keep the system from imploding.
We have drawn parallels of this before with the booming proliferation of LLMs, a process we find as remarkably similar to Sharpe World methodologies. We even coined our own Reverse Polanyi Paradox Convex Strategies | Risk Update: May 2024 – “Polanyi’s Paradox” which goes:
“They (AI/LLMs) can tell more than they can know.”
We link here three wonderful papers raising some of these same questions about LLMs that we mentioned above about risk-taking inside Sharpe World. Do we risk losing our own navigational abilities as we come to rely on AI systems?
“Desirable difficulties are purposeful challenges at study time (e.g. retrieval, spacing, generation) that lower short-term fluency but improve long-term retention… By potentially eliminating these beneficial difficulties, AI tools might optimize for immediate task completion while undermining the deeper learning processes necessary for durable knowledge construction.” Andrew Barcaui, 2025.
This is so spot on with our criticisms of Sharpe World regulated entities and Rational Accounting Man. Does optimizing calendar period accounting revenue, alongside risk measured as VaR and RWAs, actually teach people about true risk?
HalluHard: A Hard Multi-Turn Hallucination Benchmark
This one is virtually the scientific equivalent of our Reverse Polanyi Paradox.
“LLMs still produce plausible-sounding but ungrounded factual claim, a problem that worsened in multi-turn dialogue as context grows and early errors cascades.” Fan, Delsad, Flammarion, and Andriushchenko, February 2026.
And finally, this last one from friend of Convex, Ben Hunt, with his usual poetic prose.
Contact: AI and the Semantic Dimension – Panoptica featuring Epsilon Theory
“When we fail to recognize the semantic dimension as real, we make a category error in our interpretation of LLM output and process. We mistake the computing map for the semantic territory… When we fail to recognize the semantic dimension as real, we mistakenly believe that we are creating new, powerful, AGI entities of arguable consciousness rather than representing old, powerful, semantic entities of arguable volition… When we fail to recognize the semantic dimension as real, we deceive ourselves by conflating our mastery of the LLM-as-instrument with the mastery of creation… When we fail to recognize the semantic dimension as real, we end up blindly serving the interests of hidden semantic entities, especially the semantic entity of deception.” Ben Hunt, May 2026.
Sounds almost precisely like our criticisms of a belief, often hard coded as regulation and driven by incentives, that the Sharpe World map is a true representation of reality. It is constantly fed like a tonic to ease the burdens of true understanding, a tonic that slowly poisons your mind and impedes your instinctive building of tacit understanding. The actual Polanyi Paradox!
“We (humans) can know more than we can tell.”
Initial conditions are extremely complex. Trust is eroded. The Hunger Games and Resource Wars are in full flight.
Rich nations continue to mask the implications of the supply shock with subsidies and caps, using ever scarcer fiscal capacity to mute price signals that would otherwise incentivize consumers to adjust behaviour. Until there is no choice.
Energy price cap will rise by 13% from July | Ofgem
The competition to issue bonds and secure necessary resources continues to challenge traditional trading partners.
And underneath it all, the inevitable creep of the demographic issue of rising dependency ratio fuels an ever so hard to reverse feedback loop. We mentioned the new book from friends Charles Goodhart and Manoj Pradhan, “The Unanchored Central Banker”, in last month’s note. Here is an FT interview with Charles on the topic.
Charles Goodhart: ‘Demography is going to make life worse and worse and worse’
“When we wrote the last book, we were one of the very few – I won’t say the only ones – to point out the importance of demography. Now everyone knows about demography. But I don’t think people have actually come to grips with how a society works when the dependency ratio is so lopsided. From now on, demography is going to make life worse and worse and worse.” Charles Goodhart, May 2026.
Can the same old tools of Sharpe World see us through the accumulated challenges that define today’s initial conditions? We think probably not, which leaves us right where we have been for as long as we can remember – BE CONVEX! Construct investment portfolios that participate in the extraordinary ongoing asset inflation, that seems to be either the desired outcome or the inevitable side-effect of their policy choices, and own highly asymmetric, negatively correlating, explicit risk mitigating structures that protect as and when things go wrong. Simply standing in the middle of the pitch isn’t going to get it done.
Figure 9: Frequency vs Magnitude. Normal Distribution (black) and Shannon’s Entropy Curve (yellow). Shading by Percentile Contribution to SPX Index 40yr CAGR. Oct 1985 – Sept 2025
Source: Bloomberg, Convex Strategies
We will give the last word to Brad DeLong and his excellent Substack note on John Hicks. John Hicks was one of the foundational builders of the economic Sharpe World edifice, not least credited with the cornerstone of the IS-LM Model. As Brad explains, in the final 20-years of his life, Mr. Hicks recanted much of what he had constructed.
(3) Not My John Hicks Lecture: “John (Hicks) the Apostate”
“And then, in the last twenty years of his long life, he recanted… Not everything all at once, not with the dramatic public theatre that the word ‘recantation’ implies… But the substance was devastating: he had been wrong, the profession had been wrong, and the framework he had done as much as anyone to construct had, in crucial ways, obscured rather than illuminated the phenomena it purported to explain.” Brad DeLong, on John Hicks, April 2026.
Nevertheless, these very tools still dominate in the halls of Sharpe World temples and, consequently, the erosion of trust proceeds.
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