‘Game Of Chicken’: Why Do Markets Think They’re So Damn ‘Impervious’?

BofAML wants to talk about “games of chicken” on Monday.

A “game of chicken” is like a “Game of Thrones” – only with chickens:

(If you’re not a Gary Larson fan, you won’t get the joke – sorry)

No, but seriously, BofAML of course means game theory and what the bank set out to do on Monday is analyze political brinksmanship over tax reform and North Korea using a game-theoretic framework.

To be sure, there are pitfalls to this approach, but this is more thought experiment than anything else and for obvious reasons, it has applications in the current market environment.

One of the main worries for those who are concerned about persistently low cross-asset volatility is that markets are far too complacent in the face geopolitical/policy headwinds.

Indeed, the disconnect between geopolitical/policy uncertainty and measures of market angst has become something of an obsessions for quite a few commentators.

As BofAML notes, “Volatility across financial markets has collapsed in recent months.”

Here’s a quick summary for those who might not be up to speed on the extent to which it isn’t just equity vol. that’s suppressed:

Our MOVE index, which measures interest rate volatility across the US yield curve, is hovering just above the 52 level that represents the trough of the index since 1988. Only in 2007 and 2013 was the index lower, and only barely.

VIX has again dropped below 10. The only time it was lower since the inception of the index in 1990 was briefly in 1993.

3-month EUR/USD vol is now below 7. Since the inception of the euro, EUR/USD vol was only lower twice, in 2007 and 2014.

We aggregate these volatility measures by first taking z-scores of the individual measure and then taking an average of the three series. The results are shown in Chart 1. Our aggregate volatility measure is near its lowest level in twenty years.

Ok, so given that, the worry is that investors might not only be mispricing the trajectory of DM monetary policy normalization, but also the potential for geopolitical and/or policy event risk to come calling – an eventuality which would compound any volatility associated with central bank tightening. 

“If the market is underpricing the uncertainty with respect to the outlook of US monetary policy, we are even more concerned that it seems totally impervious to the risk of two potentially disruptive, if not dangerous, Games of Chicken likely to unfold in the summer and the beginning of the fall,” BofAML writes.

So what of these “chickens,” you ask? Well, BofAML is going to tell you. Below, find the bank’s take on the “Showdown In Washington.” We’ll bring you the North Korea breakdown later today…

Via BofAML

In our view, the risk is increasing that a Game of Chicken will be played out in Washington this September, with serious market consequences.

What we have in mind is a showdown over tax reform between the President and the Republican controlled Congress:

• The White House has repeatedly said that tax reform is the top priority of the administration. This is likely to be even more the case if the GOP fails to push through healthcare reform. The New York Times reported back in March, citing sources close to the President, that Trump regretted going along with doing healthcare reform before tax reform.
• Meanwhile, tax reform has been delayed again and again. There is no agreement between GOP House leadership and Senate leadership over how to pay for the proposed tax cuts.
• In September, Congress will have to reach an agreement over the fiscal year 2018 budget to avoid a shutdown. Around the same time, Congress will have to raise the debt ceiling to avoid a default by mid-October. A potential shutdown and/or default may be the only levers the President has over tax reform before it becomes too late.
• There are good reasons to think that the President has a strong enough incentive to enter into a Game of Chicken with the GOP. After all, it will be the GOP rather than Trump that will be facing re-election next year. There is a general consensus that without tax reform the GOP could lose their majority in the House.
• Last month Steve Mnuchin, the Secretary of Treasury, said during Congressional testimony that, “At times there could be a good shutdown, at times there may not be a good shutdown. There could be reasons at various times why this is the right outcome.” This echoes Trump’s tweet back in May: “Our country needs a good shutdown in September to fix mess.”

Set-up of the game

To illustrate the above dynamics, we have created the following hypothetical game between Trump and the GOP. The game has possible two stages. In the first stage, the GOP will decide whether to pass tax reform or not. If they do, the game is over. If they do not, in the second stage of the game the President will decide whether to force a shutdown of the government or not.

Exhibit 1 outlines this hypothetical game and the pay-offs for the two players in each of the three potential scenarios:

• The best scenario for the President is Scenario 3 (tax reform and no shutdown). We assume that he is indifferent between Scenario 1 (no tax reform and shutdown) and Scenario 2 (no tax reform and no shutdown). The former scenario would poison his relationship with the GOP while in the latter scenario he would lose credibility.
• The best scenario for the GOP is Scenario 2 (no tax reform and no shutdown). We assume that it trumps Scenario 3 (tax reform and no shutdown) because any tax reform is likely to be controversial and could be politically costly. The worst scenario for the GOP is Scenario 1 (no tax reform and a shutdown).

This game could be seen as a sequential Game of Chicken. It is quite similar to the decision tree faced by the US and the Soviet Union during the Cuban missile crisis. Whereas the Game of Chicken has two Nash equilibria, our modified Game of Chicken does not have any pure strategy Nash equilibrium at all:

• Given our assumption that Trump is indifferent between Scenario 1 and Scenario 2, the GOP cannot know for sure what the President will do if there is no tax reform (50:50).
• Assuming the GOP is risk neutral, this means that the GOP will be indifferent between passing and not passing tax reform (the expected payoff for both no tax reform and tax reform is the same at -5).

The only Nash equilibrium in this game involves mixed strategies whereby each player randomly selects a pure strategy.

BofAML’s advice:

Buy hedges before it is too late

This above game is meant to demonstrate the possibility of escalating tension as well as the high uncertainty around the outcome as we move into September. With volatility at two-decade low, the market has not priced in even a slight probability of this kind of upheaval, in our view.