I continue to think the biggest risk from the wind down of ECB asset purchases (and I use that example to proxy for central bank normalization more generally simply because the Fed is already normalizing and the BoJ is some ways off, so the ECB is just the most relevant case) emanates from market participants (big and small) underappreciating the extent to which years of supply/demand distortions have served to effectively relegate price discovery to the dustbin of history.
That’s a simple concept. There’s nothing novel about it. Here’s a quick take from something I wrote a couple of weeks back for Dealbreaker that just kind of rehashes what’s going on:
I don’t know if you’re aware of this or not, but somewhere, buried beneath $15 trillion-ish in central bank liquidity and hiding under the distortions that liquidity has created by effectively forcing investors to knowingly misallocate mountains of capital, are actual markets.
To be sure, price discovery (where that entails the participation of price sensitive investors) hasn’t really a been a thing for the better part of the last decade.
In one way or another, all the bids are price insensitive these days, whether by definition (e.g., central banks), by choice (e.g., Norway’s SWF) or else by accident (e.g., retail investors not understanding that ETFs don’t generally contribute to price discovery). Everyone else is effectively forced to adopt a similarly “long hair don’t care”-ish strategy because what else are you going to?
When everything is indiscriminately bid to infinity and that dynamic traces its roots to policymakers with printing presses, well then you either harvest yourself some carry alongside everyone else or you go the fuck out of business. It converges on one trade. It’s a binary option: you either short vol. (explicitly or implicitly) or else you take it upon yourself to shriek “the emperor has no clothes!” and risk nobody being willing/brave enough to go along with you.
It is questionable whether markets can ever be completely reemancipated or even whether reemancipation is something people want.
Ok, so where I think a lot of people go wrong is implicitly (and sometimes explicitly) assuming that when it comes to appreciating just how distorted markets are, policymakers and Wall Street are somehow more sanguine about the outlook than traders, critics and investors.
I think that gets it backwards.
Investors and traders are the people being herded down the quality ladder in search of yield. To be sure, this isn’t by choice. It’s by sheer necessity. Unprecedented monetary accommodation has forced sophisticated investors to chase yield and adopt strategies that are implicitly or explicitly short vol. and these conditions have persisted for so long that the dynamics have optimized around themselves. That optimization creates the illusion that risk assets are bulletproof and that, in turn, pulls in retail investors. The Pavlovian reaction function for the retail crowd renders them unable to differentiate between “boy who cried wolf”/”chicken little” analysis and fact-based critiques of the current environment which all boil down to the simple assertion that the mad scramble down the quality ladder by definition leaves everything priced to perfection.
Ostensibly, everyone realizes (to a greater or lesser degree) that the past several years were too good to be true, but it’s gone on for so long that even if they outwardly profess to know it’s unsustainable, the real-life returns it generates understandably leave them inwardly skeptical of their own professed cynicism and thus predisposed to ignoring the risks. Outwardly: “This is obviously ridiculous and unsustainable, but I’m not going to be the guy/gal who doesn’t take advantage of it while it lasts.” But inwardly: “Maybe this isn’t unsustainable, because after all, the permabear contingent has been wrong for nine years and everyone said Bernanke would trigger hyperinflation, and how’s that worked out for the cynics?”
Meanwhile, it’s not always clear that the staunchest “cynics” and “skeptics” (some of whom belong in the “boy who cried wolf”/”chicken little” category) truly appreciate the risks here either. Assuming they have skin in the game and assuming they haven’t been burning premium for damn near a decade waiting on a collapse that never came, they are involved in the same yield hunt/short vol. trade too, even as they publicly rail against it.
If they don’t have skin in the game, well then there’s no readily discernible reason why they should care one way or another what happens and that kind of apathy shows up in slapdash “analysis” that only seems rigorous by virtue of the ostensibly (and needlessly) complex terms it’s couched in and by virtue of the fact that it’s sometimes copied wholesale from Wall Street without proper attribution (and I’m not talking to any bloggers in particular there, but if the shoe fits, then wear it).
Tangent: What category do I fall in? Well, that’s an interesting question. I’m pseudo-retired and my revenue streams are “diversified” (you can just write your own punchlines and create your own maybe true/maybe not Heisenberg fairy tales there). Given that, I am definitively not engaged in the hunt for yield nor am I short vol. in a market sense (although you could probably say I’m “short vol.” in some other respects). Why then, do I care? Why do my breathless posts betray a level of interest and intellectual rigor that is demonstrably out of step with my participation in markets? There a number of answers to that question (and it’s a question I get a lot) and I’m never going to make you an exhaustive list, but the simplest answer is that at heart, I’m a lifelong academic. I’m one of those people who actually enjoys peer-reviewed academic journal articles. And if you’ve ever read a peer-reviewed academic journal article, you know that sellside analyst notes are riveting by comparison. In short, I’m passionate about this because I’m passionate about analysis. I’m also passionate about money and although I’m not, as noted above, on board when it comes to riding this years-old carry gravy train by effectively dollar-cost averaging in the wrong direction, I know opportunities when I see them. So what I do is combine my passion for academic rigor and tedious analysis with my desire to identify sometimes esoteric opportunities to take calculated risks, package it in my trademark style, and out comes this blog. It also “helps” that this man is an island. Figuratively and literally.
“Don’t you miss people?”
“Lol. No.” pic.twitter.com/RCsv6ooQKJ
— Heisenberg Report (@heisenbergrpt) April 16, 2018
So if market participants are blind to this and the cynical/skeptical peanut gallery/doomsday blogger crowd doesn’t actually care and thus can’t really be taken seriously (digitally shrieking “the end is nigh” and cherrypicking charts doesn’t count when it comes to intellectual honest and rigorous skepticism), then who does understand the risks inherent in the wind down of ECB asset purchases and the normalization effort by DM central banks more generally?
Well, I would argue it’s the folks who are perpetually said to be blind to the risks or who are otherwise maligned as harboring an unjustifiably sanguine view. Namely: Wall Street and policymakers themselves.
Taking Wall Street first, it’s easy to get the impression there are only a handful of analysts who truly understand the extent to which the post-crisis policy response has distorted markets. It’s certainly true that some spend more time writing about it than others, but a couple of popular finance blogs and the mainstream financial news media have created the impression there’s some kind of clean divide between a select few analysts who persistently rail against these distortions and all the other analysts who don’t get it and think everything is going to be fine. That’s not true.
If you read credit strategy notes (for instance) from all the sellside shops you will discover that with few exceptions, everyone gets it. You’re not going to find any serious analysts who are willing to contend that CSPP hasn’t distorted € credit. That would be a wildly absurd thing to contend, which is why no one says it. There are disagreements as to the degree of distortion and as to whether those distortions will immediately be reversed once the “flow” effect of CSPP abates materially, but generally speaking, everyone is on the same page. That’s true across asset-class-level research. And look, unlike some other finance bloggers you might be reading, I actually talk to some of these analysts on a weekly basis and occasionally quote them anonymously (as opposed to just giving you the impression that I’m plugged in when, in reality, none of these analysts have ever spoken personally to me).
On policymakers (i.e., central bankers), the notion that this is a global cabal of bumbling idiots is absurd on its face. Inherent in the word “cabal” is some level of competency. This narrative where DM central bankers are morons but are simultaneously nefarious conspirators is inconsistent. Either they are engaged in a global mindfuck to manipulate markets and exacerbate inequality via financial repression or they are complete idiots who do not understand the consequences of their actions, but it damn sure can’t be both. My contention is, and has always been, that these are extremely smart people who have gone too far down the road towards attempting to make an inherently “soft” science (economics) into a “hard” science. It’s a misguided effort, primarily because it’s too ambitious. You cannot force a soft science to be a hard science. That’s impossible.
But (again unlike most finance bloggers and commentators outside of Wall Street), I’m plugged into the academic community and have been since childhood. Political scientists, sociologists, psychologists and economists are a lot of things, but they’re not morons (as a group, I mean – obviously every profession/field of study has its village idiots, including the hard sciences).
Tangent: This narrative that Nassim Taleb pushes about “pseudo-experts” has had a deleterious effect on the public’s perception of the soft sciences and of academia more generally. If you want to spot the “moron” in that ongoing debate, maybe point the finger at the guy who, despite being blessed with the type of mind that is clearly capable of making some kind of truly historic contribution to the The Western Canon, instead spends his time writing the same book over and over again, challenging peers to deadlifting contests on Twitter and conducting social media polls about whether he should shout at Scandinavians on the Metro North.
So no, economists are not morons. They’ve just chosen a soft science as a profession and it turns out that economics ends up informing policies that affect the economy (funny how that works). Soft sciences are imperfect and that imperfection manifests itself in the words and deeds of economists, accentuating the imperfections that come along with being human in the first place.
But to suggest that after a lifetime spent studying the intellectual underpinnings of the policies they are now foisting on markets, they somehow don’t understand what the likely fallout from those policies is, is to suggest that they’re just doing this shit for no reason. That makes no sense. Rather, it’s the exact opposite of that. In the 2008 crisis, they got an opportunity to conduct a real-life, global experiment using the most extreme versions of the economic orthodoxy to which they subscribe. I’m sorry, but you can hardly blame them for jumping at the opportunity. That would be like if an asteroid were on a collision course with Earth and for whatever reason, the only readily available option for possibly stopping it was to fire a rocket into space carrying a red roadster armed with an atomic weapon and expecting Elon Musk to be like “nah, I don’t think I’m interested in participating because after all, if something goes wrong, that nuke could accidentally detonate on liftoff and accidentally wipe out a city.”
In other words, of course these economists understand the risks of what they’re doing. That’s the whole fucking point. The crisis handed them an excuse to unleash the type of policy experiment that makes for economist wet dreams and part of the reason they believe those types of policies are effective is through the wealth effect that by very definition involves inflating the value of financial assets. Well, inflating the value of financial assets comes with myriad risks. Again: they not only understand it, it’s part and parcel of the whole damn plan.
What’s not part and parcel of the whole plan (and this is the final dot to connect) is returning the developed world to a feudal system by ensuring that the rich get richer and the poor get poorer. Yes, the post-crisis policy response has exacerbated inequality, but that’s not some damn conspiracy, it’s just what mechanically happens when you inflate the value of the assets that are disproportionately concentrated in the hands of the wealthy. The effects of QE and accommodation more generally aren’t linear – they accrue exponentially, and of course central bankers understood that when they embarked on these policies. But what they also understood was that if someone didn’t “DO SOMETHING!” (to quote a guy who really is a moron), it might very well be the case that the entire U.S. financial system would collapse leading to a scenario where the most advanced economy on the planet was suddenly thrust back into a soup line situation. With apologies to creative destruction proponents, that was a non-starter. Americans wouldn’t have stood for it (figuratively and also literally – they wouldn’t have “stood” in soup lines). So DM central banks chose what they viewed as the lesser of two evils: they decided to implement a set of policies where the only predictable outcomes were bubbles and more inequality in order to prevent bank runs and outright chaos.
Coming full circle, the people who are going to be surprised when the distortions created by the post-crisis policy regime are unwound won’t be Wall Street and central bankers. They’re acutely aware of the risks and are actively trying to mitigate them, although obviously, Wall Street is happy to take each and every opportunity to capitalize along the way.
Rather, the people who are going to be surprised are market participants who, despite having outwardly professed to understand the situation, became so accustomed to the free ride that the reversal will act as a cold, hard slap in the face.
Also, paradoxically, the doomsday crowd will be ill-prepared because they’ve become so cartoonish in their pursuit of producing clickbait that they forgot to actually engage with the research along the way and will thus be unprepared to do anything other than produce downward sloping charts with big red, dashed lines on them, if and when shit hits the fan. I’m not sure that’s going to be very helpful – unless of course you like having salt rubbed in your wounds.
Food stamps are the bitcoin of soup lines.
H
Mmm. I do love your stuff. I am one of those getting that free ride. I read you to try to stay far enough of that slap in the face that it won’t be ice cold. My own conceit is that I like to think I am far enough ahead — lucky to be there — that when the slap comes I’ll still have enough left to finish the ride. If not, it’s too late now.
As to economists. Well, I’ve always thought, as you point out, that they suffer most from “physics envy.” They seem to “get” marginal this and marginal that, but they don’t really understand either business or people. We swallow the meme that since business is the central part of the economy and they are economists they must get business. But they don’t because they don’t really seem to get the idea of profit, in either a macro or micro sense. They assume away all the messy naughty bits associated with human participation in their precious economic system. So when they mess with the system and people don’t like it they just don’t understand. I had an economist for a dean once. He was actually a successful entrepreneur but he didn’t “get” other people. He once instituted some silly new procedural change that was going to cause most of his faculty to lose either time or money or both, while the “college” would benefit at their expense. He sincerely couldn’t understand why his faculty were unhappy with the change. He asked me why they were unhappy. After all, the college would gain. I had to remind him that these folks had families. They like food and clothing and the odd night out. They didn’t really care what happened to the college “system.” That just didn’t fit his system view. To him their behavior was not rational in the context of the good of the “system” and they should understand this.
I think this topic, in particular, highlights the gap between markets and physics. If markets were like physics, QE would be analogous to an inertial reference frame and relativity would apply, which would mean that none of the distortions being discussed here would happen. But they obviously do happen.
I think the issue is that it IS Physics but it is also Neuroscience AND Human Culture. The basic landscape is physics but all the roomba’s have human firmware and they are grouped into different code sets by culture. Predicting what they’ll do with simple mathematical formula’s is a bit cart before the horse to put it mildly. It’s hard to even understand what domains they apply in or what the underlying assumptions are.
Far and a way, this is the best essay I’ve read that you have produced. The fun part is to finally get a glimpse of your mainspring. I do hope you edit and submit to SA.
Great post, Mr. H, and thank you for giving as but a glimpse into your mental constructs. I have noticed that lately it seems your writing is lending to the fact that you’re tiring of the those that keep saying you’re simply a permabear and chicken little drum beater. I hope that everyone who reads you daily, or only comes across your writing every so often, is able to see this article and understands what you actually stand for. Please keep up your great work and know that the “haters” are just that and they’re simply noise around your signal that we hear, and (mostly) understand, loud and clear.
H- while soup lines might of been one of the outcomes, there would have been a backlash to the greed and unfettered leveraging. There would have been consequences. Would we have a Donald Trump president? Now, as have been mentioned, will the next GFC be even worse due to the even larger bubbles bursting? I would like you to peer into your crystal ball and let us know what you see the Great Experiment will bring!
“… a set of policies where the only predictable outcomes were bubbles and more inequality in order to prevent bank runs and outright chaos”, so WHY NOW is QE being eased? I understand econ is a soft science, but after all that number porn/quant porn that economics shows to the outside observer, there must be a reason why the end of QE was timed with the moron Trumpf? What’s different between 2016 (markets were still UP) and 2017 (new era of making Am. Great).? All those press conferences, all those senate hearings by Central bank, and we j u s t d o n ‘ t k n o w. But i tell you, it doesn’t smell of Central Bank “independence”.
and to the point of the bit in quotes above (which i led with, but which i forgot to address), what IMPROVED in the intervening 10 years?
H this piece is gold. I hope you port it to SA.
I think the price discovery distortions make QE and the unwinding process a “news and events” that is capable of affecting equity indices. I say this because unlike sporadic news and events, QE has been and is a very long term macroeconomic disturbance that has changed market psychology significantly. There are many that say that equity market fluctuations and valuations are determined purely by investor sentiment and not by news and events. I think that’s true to a very significant degree, but what they fail to recognize is that long term macroeconomic disturbances over time ( these are significant “news and events”) change the investor behavioral response to risk assets, and this of course affects both short and long term vol. in many different financial markets, most markedly in equity markets. This in turn affects market valuations.
One has to think about what happens when the behavioral response, that has been firmly encoded into the investor psyche via lack of price discovery, is turned completely upside down during an unwind. Sentiment will change. And as you mentioned,it goes beyond QE. Massive volumetric mutual fund stock aggregation has further obscured price discovery at the individual asset level.
Regarding QE, One also needs to ask three very basic quesruons
1.should we unwind?
The academic literature on this is a clear yes. The long term ramifications of prolonged QE and restrictive interest rate monetary policy are now very well understood. It goes far beyond the “debt trap” and the loss of risk quantification that is embedded in market determined interest rates. Long term QE paradoxically slows real economic growth and productivity in the long term,
The equity investor has little regard for the system (economy) as a whole. The equity investor has a family to feed. Insofar as the “should we” question, the equity investor would answer a firm no. (Despite realizing that future economic growth and productivity will be stunted for decades, and despite not realizing it. Reasoning doesn’t matter). The quick “here and now” realization of profit supersedes any and all future drawbacks.
2.can we unwind?
Globally, this will be very difficult. Accumulated leverage and policy divergence.
3.will the US continue to unwind and at what rate?
If we knew the answer to this we would know what the equity markets would do in the next critical 18 months. The Fed truly does understand the ramifications of prolonged QE and they do understand the dynamics of burgeoning inflation. As you mentioned they are very very intelligent. However, there are political forces (political being used very loosely) that are pulling in the opposite direction, making it difficult to sustain an unwind , as the equity market destabizes very reapidly with rapid normalization. There are very very wealthy and powerful people that have much to lose in a flailing equity market. This isn’t a conspiracy theory, it’s a fact. Combined with global monetary policy divergence (which you’ve explained very well) , normalization will be all the more challenging. I don’t know if there will ever be a complete follow through on global QE unwind. The only way that the unwind will be stubbornly pushed along in the US is through firm inflationary pressure that forces the hand of then Fed, despite any ramifications on equity markets. At this point the rate of normalization will increase and the rate is critical in determining its affect on risk asset valuations and risk markets.
I’m very grated for the academics at the Fed, because I know that they realize the issues with prolonged QE, and I know that they understand how quickly inflationary pressure can accelerate. They provide some sanity to the long term dynamics of the markets that are incessantly and relentlessly inflated by investor greed. They understand the importance of true market price discovery, asset bubbles, and how truly distorted markets have become.
Nice piece… the irony though is the economists who pursued QE are the doomers. If they weren’t they would not have done it. Don’t forget poverty is measure of government intervention.