There’s a dark side to transparency.
Ostensibly, incessant policymaker communication with markets creates trust, fosters predictability and reduces the chances that a “surprise” introduces instability. Forward guidance, speaking engagements, and trial balloons floated via interviews or leaks to the press are tantamount to policymakers consulting the market. They put an idea out there and the market either approves or it doesn’t. The market’s response becomes an input in policymakers’ reaction function. Markets are thus a co-author of the policy script. The audience is now a part of the play, which by virtue of the two-way communication channel, is no longer a self-contained narrative with a preset course.
This is how central banks have chosen to manage the risk associated with their exit from the post-crisis policy regime.
There are any number of problems implicit in this arrangement, not the least of which is that it transforms policy into a referendum. There are no clearly identifiable anchors. The goal posts aren’t fixed. Or, as Deutsche Bank’s Aleksandar Kocic put it in his September note on the dark side of transparency, there’s an absence of “rigid reference point[s], like a well specified reaction function, objectives, and triggers.”
So this is just a kind of rolling plebiscite. Clearly, that creates substantial risks in terms of encouraging mass myopia. Thanks to near-daily speeches and media appearances by Fed officials, this is quite literally a real-time information exchange between markets and policymakers. No one can see outside of this information exchange and if you’re a trader, there’s really no utility in trying.
In this way, transparency introduces risk in a paradoxical way. As Kocic wrote more than two months ago, “transparency as a way of stabilizing the markets has become a tool of suboptimal control, one that reinforces the future risk in order to diffuse it – it is a tactics of delaying, rather than reducing risk.”
Everything thus becomes short-term. Taking a long-term view of the Fed (or of the ECB for that matter), is effectively impossible. You can try – you can “do the right thing”, as it were – but you will be drowned out. The status quo cannot change unless you are joined in your dissent by others. If you are alone in your rebellion, your efforts will almost invariably result in foregone carry and underperformance. Thus, change becomes for all intents and purposes impossible.
This is the controlling dynamic for volatility. This, as we put it a few weeks, is why things are the way they are.
In his year-ahead outlook piece, the above-mentioned Kocic reiterates and refines his framework as summarized and paraphrased above. “As much as predictable monetary policy and carry environment have a calming effect on the market, their persistence forces people to take more risk in order to get a fixed return,” he writes, adding that “calm encourages bad behavior and destabilizes the system in the long run, leading to misallocation of capital, one-sided positioning, and buildup of tail risk.”
That “bad behavior” entails sticking with the consensus – remaining in “the swarm” – chasing yield – embracing carry trades – selling vol. as a yield enhancement strategy. Here’s Kocic:
People, in general, face fixed long-term liabilities and, to match those liabilities, they have to find a source of return in the meantime. In order to remain in the game, however, one is forced to adhere to the consensus trade — the dissent is prohibitively expensive. As a result, investors are caught in the gap between factually constrained paralysis and an imperative of finding a source of return in the short-run.
Of course someone has to take the other side of those trades and that must be hedged. But dealer hedging only further optimizes around the existing dynamic:
Local stability is thus reinforced further making dissent even more inconsequential. The result: time itself becomes collateral damage. To wit, from Kocic:
Short-term survival dictates complacency, which inspires persistent volatility selling and, through monetization of time decay, disrupts the flow of time and contracts horizons. This places focus on the present losing sight of the future. The future is degrading into an optimized present, and totalization of the present inhibits actions that give time. This becomes a behavioral problem — people who have lost sight of the future behave differently. In this way, the factual constraint (Sachzwang) is transformed into a behavioral constraint that defines a new code of self-conduct, which becomes a source of both convexity supply and market vulnerability at the same time.
We are effectively optimizing around a dynamic that facilitates short-term stability and rewards myopia at the expense of our long-run survival.
For the vol. longs out there remember: even a broken clock is right at least two times a day.