Risk Management In A Nonsense World

One of the myriad confounding factors in what’s been variously billed as the “Great Inflation Debate” is the difficulty in assessing the veracity of claims centered around the notion that Americans haven’t experienced a serious bout of inflation in decades.

Almost immediately, that assertion is met with the following protestations: “Oh, really? What about the cost of college tuition?” And then: “Oh, is that right? How about the cost of healthcare?”

When we can’t even agree on whether Americans have or haven’t experienced inflation since the 70s, it’s hard to make much headway.

But for our purposes here, let’s just assume that it has, in fact, been decades since the US has experienced anything like “problematic” inflation. That’s one aspect of any good “whistling past the graveyard” thesis.

“When something doesn’t occur for a long enough period, we simply forget about it,” Macro Risk Advisors’ Dean Curnutt wrote this week, adding that “in the process of writing it off, we adjust our behavior, becoming more emboldened to take on tail risks that we can no longer imagine surfacing.”

In markets, that tendency can lead to what, in hindsight, looks like poor risk management. “Risk management suffers from a failure of imagination,” Curnutt said, in the same piece.

But it’s important (or at least interesting) to note that if we didn’t embrace a similar tendency in everyday life, we’d quickly find ourselves unable to do very much.

For example, in 2016, when I was on my (literal) death bed, I apparently had a seizure in the hospital due to the systemic shock associated with depriving my body of scotch and bourbon for a three-day period, the longest such stretch in decades. Because the seizure occurred a few hours outside of the “normal” window for a seizure associated with alcohol withdrawals, I was required to get a neurologist and to refrain from driving a car for six months. Had the seizure happened just ~12 hours earlier, no such precautions would have been necessary, I was told. I found that to be a ridiculous distinction. I had no other health problems whatsoever, and no history of seizures. There was no question as to the proximate cause. But I almost never drove anyway and the neurology visits would only be twice per year, so it made no sense to protest — I wasn’t inconvenienced by it, and this was long before you had to worry about catching a deadly respiratory virus from your Uber driver.

Despite being alcohol free for half a decade, there’s still a chance, I’m told, that I could have another seizure out of the blue. And yet, I’m no longer required (not by law nor by “the science,” as we habitually refer to the medical profession in the post-pandemic world) to refrain from driving a vehicle. For all intents and purposes, I’ve forgotten about that seizure, adjusted my behavior and routinely take on the tail risk associated with driving. (Admittedly, that risk is mitigated by the island being just nine miles long and having only one road with a posted speed limit above 40.)

We can conjure countless examples of the same dynamic. Plane crashes happen. Unless you’re a bird, there’s a tail risk associated with traveling high above the ground at very high speeds. Presumably, the list of “little” things that can go wrong mechanically on a plane without the tail risk being realized is virtually endless. However (and this is why I don’t fly), in the extraordinarily unlikely event that one of the handful of things that absolutely can’t go wrong does go wrong, the chances of surviving may as well be zero. But because plane crashes are relatively rare events, we quickly revert to pre-crash behavior. That is, we get back on planes. In fact, we often justify that decision by reference to the crash that just happened. Something like this: “If the odds of me dying in a plane crash on a given day are XYZ, then the odds of me dying in a plane crash after 132 people died in one last week must be even lower.”

Why do we do this? Well, because we have to. I mean, we don’t have to. But if I don’t drive, I have to take an Uber to the farmer’s market and if you don’t fly, you’ll have to swim to London. And so on, and so forth.

The same is true for markets. Just prior to the implosion of the VIX ETP complex in February of 2018 (“Volpocalypse,” as it’s known to market participants), Deutsche Bank’s Aleksandar Kocic explained the situation as only he can. “Through their communication with the markets, central banks, and the Fed in particular, have become ‘good listeners’ with their decisions and actions made with markets’ consent,” he wrote, adding that,

After years of this dialogue, the markets have gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting. Not much of a choice, really. In this process, Central banks have reached a point of enormous power and control where market dissent is practically impossible. We believe that such levels of market control remain uncontested with anything we have seen in recent history and that the markets’ dynamics have never been further from that of the free-markets. Low volatility is a perfect testimony of that.

There was doubtlessly some “failure of imagination” for market participants who continued to engage in various manifestations of the short vol trade, but there was also an element of necessity. When the tail risk is all but unimaginable and refusing to take it on is punitive (e.g., underperformance in the market context or, in the real world, losing your job because you refuse to accept the tail risk associated with catapulting yourself across the Atlantic at 30,000 feet), “choice” is a misnomer.

The more extreme the tail risk — the more “imagination” it takes to conceptualize it — the less sense it makes to hedge. This is the North Korea problem. Investing in South Korean or Japanese assets implicitly involves taking on the tail risk associated with the Kim dynasty. Strictly speaking, it’s difficult to “hedge” the possibility that Kim Jong-un or, eventually, Kim Yo-jong, decides to make an ash heap of Seoul or Tokyo. It’s both an unimaginable and eminently imaginable scenario. Prior to their infamous “summits,” Donald Trump and Kim were seemingly on the brink of nuclear confrontation every other day. We didn’t have to “imagine” it because Trump actually described it for us (“fire and fury”). At the same time, it was unimaginable to the extent waking up to a headline that South Korea had been nuked would mean Pyongyang was either already annihilated by a US strike or about to be. That, in turn, would likely lead to a declaration of war by China within 48 hours. From there, all bets are off. So, other than a few gyrations in the won and the occasional widening in South Korea CDS, we just pretended that tail risk didn’t exist.

In the piece cited here at the outset, MRA’s Curnutt drew a parallel between subprime (2007) and inflation (2021). I should note that Curnutt was explicit in noting that this isn’t a question of the US financial system collapsing. Rather, the parallel, as he sees it, is the Fed’s willingness to look past mounting evidence that may undermine their base case, along with the growing disconnect between asset prices and fundamentals (see the scatterplot below, for example).

Curnutt quoted Bernanke from 2007: “Given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited.'” Then, he quoted Powell from this year: “We will not raise interest rates preemptively because we fear the possible onset of inflation. We will wait for evidence of actual inflation or other imbalances.”

Asset prices only belatedly acknowledged rising subprime defaults in 2007. The implication is that we may be seeing a repeat in 2021 as bond yields are now so far out of touch with inflation that words like “disconnect” no longer make much sense. As Deutsche’s Kocic put it earlier this month, “the departure of rates from inflation has become so extreme that it is meaningless to talk about dislocations anymore.”

For Curnutt, this is “a function of the challenges we have in appreciating the change afoot.” He added that,

Embedded in much of the Fed’s commentary on inflation is a misunderstanding of the nature of the time series. Like the VIX, the vol of inflation rises as inflation rises. When the VIX gets to 30 or 40, the market is forced to assign much greater probability to the potential that it gets to 60. In a similar way, inflation isn’t the kind of asset that gets to 3 to 4% and happily treads along. The process of it reaching that level means that forces are at work that may push it higher still.

This is perhaps what separates the seizure example from plane crashes. Boeing notwithstanding, one plane crash doesn’t generally increase the odds that another will occur. I was told by my neurologist that having had one seizure, the odds of having a second at some point are greater than the odds of someone who’s never had a seizure experiencing their first.

That dynamic complicates things immeasurably. Inflation can become a self-fulfilling prophecy. Once it manifests, it needs to abate quickly. If it doesn’t, the repeated experience of paying ever higher prices for everyday goods and services will prompt consumers to act accordingly. If that behavior “goes viral” (so to speak), it can be difficult to short circuit. Many market participants believe Fed officials are currently underestimating that risk.

But the (implicit and often explicit) assertion that tail risks won’t be realized is a necessary fixture both of markets and life in general. For every tail risk realized, innumerable others aren’t. Trying to hedge them all sufficiently would lead to near paralysis in everyday life. In markets, you’d bleed out on several fronts.

None of that’s to say you shouldn’t hedge. While my audience has some obvious overlap with the type of folks who might be clients of Curnutt or Nomura’s Charlie McElligott, for example, I have to cast a wider net in order to appeal to as many people as possible. A big part of what I do entails contextualizing markets through anecdotes and often through tangential socioeconomic diatribes. That has little (if any) relevance for a PM who, while willing to give the Fed the benefit of the doubt, nevertheless fears she may have too much duration risk considering current macro trends (for example).

Still, I think we spend (more than) enough time trapped in our monitors every day. And even when we’re not literally at the desk, we’re still there mentally. If we never allow for an honest appraisal of what’s real and what isn’t, we’re hostage to our own fantasies and myths which, while necessary for societal cohesion and useful for pretending life’s worth living, are fantasies all the same.

Central to appraisals of various disconnects like the one shown above, is the notion that, as Curnutt put it, “if markets are to make any sense, price and value must have some relationship.” He included a caveat: “The meme stock craze notwithstanding.”

I’ve been derisive towards the meme stock mania, but maybe I should be thanking all those involved. They exposed, albeit inadvertently, the unreality of markets. The absence of a relationship between price and value for names like GameStop and AMC wasn’t the death knell for the charade. It wasn’t GameStop at $350 that proved markets are a figment of our imagination. Rather, it was the subsequent resurrection of mostly dead businesses by sheer force of retail trader will that exposed the truth. Did GameStop and AMC really become that much more viable as businesses over the past six months? Of course not. Reddit came to realize that companies and the securities they issue need not have any relationship whatsoever to the underlying value of the business. If enough people bid up the shares, the company can raise more capital, pay down debt and even win upgrades from ratings agencies despite no material change in the underlying prospects for the business.

We’re led to believe these “aberrations” can’t exist in perpetuity. But they’re not properly “aberrations.” They’re just deviations from the way we’ve normally behaved in the course of assigning a price to assets which only exist in our minds. The same is true of Treasurys and inflation. Sure, common sense appears to dictate that ~1.3% on 10s is positively ludicrous if inflation is running at 6%. But the fact that such a conjuncture exists in the first place proves, beyond a shadow of a doubt, that there isn’t anything “natural” about any of this. An apple that drops from a tree and remains suspended in mid-air is an impossibility. That’s just not how things work in the real world. In the make-believe world of financial assets, by contrast, relationships aren’t fixed — not in the near-term (obviously), not in the medium-term and not necessarily in the long-term either.

Curnutt wrote that “because a relatively straight line between cause and effect is a must have for market participants, new valuation frameworks are conjured that satisfy the ‘why’ of prices.” That’s undoubtedly true. We make up all kinds of excuses on the way to explaining purported “disconnects” and “anomalies.” We think we need to explain the “Why?”

What we’ll never say, though, is that there’s no such thing as a “disconnect” or an “anomaly.” Prices for financial assets are always wholly arbitrary. It can’t be otherwise. There’s no “natural” or “fair” price for a 10-year US Treasury because a 10-year US Treasury isn’t something that’s real.

Of course, these aren’t popular notions for market participants. Even those who find them interesting will tell you they’re not very useful. And maybe they’re not.

Then again, the more extreme the anomalies become (whether it’s bond yields detached from inflation or some meme stock trading at an infinity multiple based solely on a 90s nostalgia premium that’s impossible to model), the more we’re compelled to question the very idea of “markets” as things that “make sense,” as Curnutt put it.

My argument is (and has always been) that they don’t make sense. Or at least not in the way almost all market participants believe they do. Curnutt wrote that,

Periods when [price and value] stray far from one another are important because the process by which they become reacquainted can lead to significant asset repricing. The market confronts its mistakes, each time at a different speed and along a different path, but a reckoning does occur as the notion that ‘this time is different’ gets tucked away, surely to be called upon again at a future date.

The idea, in the context of inflation, is simply that one way or another, the tail risk might be mispriced. There are all manner of ways a “reckoning” could manifest, some of which are mutually exclusive, others not.

But I wonder about all of this. We only remember the tail risks that are realized, which we then cite as confirmatory when we mock anyone currently parroting some version of a “this time is different” narrative. And we only bother worrying about tail risks we think we can hedge or those we can hedge without putting ourselves out of business waiting on some disaster that never happens.

This past year taught us that the “correct” way to trade a pandemic is to buy every risk asset you can get your hands on even as people drop dead by the millions and long before vaccine success is assured.

If markets only make sense when price and value have some connection, and if the reality of that connection is now being questioned not just by people prone to hopelessly long-winded philosophical musings, but by millions of retail investors who figured out, among other things, how to weaponize options dynamics to turn their trades into self-fulfilling prophecies, then how can we be any semblance of confident that an effective way to hedge, say, an inflation overshoot, is by betting that price and value will converge (e.g., through a closing of the disconnect between bond yields and inflation) so that markets make sense again? That’s an exercise in question-begging.

The better question to ask may be this: How do you hedge for a given tail risk (or set of tail risks) in a world where markets don’t make sense?

If we want risk management to be truly “imaginative,” we may want to ask what it means to manage risk in markets where we can no longer assume that disconnects between price and value must eventually correct.

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