Rise up this mornin’ Smiled with the risin’ sun Three little birds Pitch by my doorstep Singin’ sweet songs Of melodies pure and true Sayin’, “This is my message to you-ou-ou:” Singin’: “Don’t worry about a thing, worry about a thing, oh! Every little thing gonna be all right. Don’t […]
Long Tail Alpha, July 20, 2021
Rise up this mornin’
Smiled with the risin’ sun
Three little birds
Pitch by my doorstep
Singin’ sweet songs
Of melodies pure and true
Sayin’, “This is my message to you-ou-ou:”
Singin’: “Don’t worry about a thing, worry about a thing, oh!
Every little thing gonna be all right. Don’t worry!”
Singin’: “Don’t worry about a thing” – I won’t worry!
“‘Cause every little thing gonna be all right”
– Bob Marley & The Wailers
Jay Powell, Christine Lagarde and Haruhiko Kuroda are the three little birds of central banking singing sweet songs of unlimited money. They want you to believe there is nothing to worry about when it comes to inflation or the stock market. Powell is the Chair of the US Fed, Lagarde is the President of the European Central Bank, and Haruhiko Kuroda is the Governor of the Bank of Japan. Importantly, they are our most important economic policy makers but are professional lawyers (Kuroda is actually both a lawyer and an economist), and for the first time it seems that a PhD in economics is less important for economic policy making than a doctorate in law (by the way William Miller, Fed Chair from 1979-1980 who is held partly responsible for highly inflationary policies at the time was also a lawyer). Between the three of them, they have authorized trillions worth of asset purchases over the last few years, and have essentially funded the operation of highly levered governments, and they would like to persuade you that this is still the right course of action. Hearing Powell speak to other lawmakers in his recent testimony, we could see the obvious advantage of a lawyer persuasively speaking to other lawyers.
Market participants are, however, quite worried as they see inflation statistics spiking. The recent CPI (consumer price index) was over 5% and PPI (producer price index) was over 7% year over year (Source: Bloomberg). Inflation certainly does not seem to be transitory. Stocks, bonds and housing markets are at record high prices. The leaders of the central banks are clearly engaged in persuading the public that “economic facts” justify these actions.
I have many lawyers in my own family, and growing up in a family full of lawyers, I have a view on how lawyers establish and use “facts”. My grandfather was a lawyer, so was my father, three of my aunts, one uncle, and my wife. I am the black sheep of the family as a law-school dropout of sorts (I went for a little over a year late in evening school at Chapman University before going on permanent leave to run my business). So I have rookie training in persuasive arguments and how to tilt them to sell my point of view.
Law Professor Roberta Mann, in her paper “Economists are from Mercury, Policymakers are from Saturn: The Tax Policy Implications of Communication Failure,” illustrates the communication divide between economists and lawyers which includes interpretation of data. In the context of the central banks, where the staff is primarily PhD economists, a quote from her paper is relevant: “Sometimes policymakers rely on economic analysis to make decisions. Sometimes policymakers use economic analysis to support decisions already made.” The decision to keep buying bonds and keep interest rates at zero and negative is a case of using economic analysis to support commitments already made, which is why there is increasing central bank fixation on one or two elusive numerical targets (“eight million jobs lost”, “2% inflation target” etc.). In his 2010 book “Proofiness”, Charles Seife calls this use of numbers the “dark art of mathematical deception.”
As my readers know, I am a physicist by training. The difference between scientific arguments and legal arguments is that scientific arguments are primarily “informative” while legal arguments are primarily “persuasive”. The lawyer’s goal is to weave the “facts” together for the benefit of his or her client and to persuade the judge or jury. In mock court, I had a chance to practice both sides of the argument using the same facts, which shows how facts can be interpreted to serve the client’s objective. Same facts, different sides of the argument.
Persuasive speech, which Powell, Lagarde and Kuroda, as lawyers, are adept at, consist of three classic elements: logos, pathos and ethos. Next time you listen to a testimony or press Q&A, pay attention to these. Logos refers to making logical arguments, and why, given the information and set of logical arguments, supplemented by “proofy” numbers, the conclusion must be true. Pathos refers to the emotional appeal to make the listener feel a certain way, so that they will accept the argument. Finally ethos refers to the establishment of credibility with the audience, which is easy to lose if one sticks to an invalid argument. It is well known that moderate amounts of repetition can result in persuasive arguments becoming stronger. But a very frequent, unvariegated repetition creates aversion to the repeated term. I sense that the market is close to the point where the word “transitory” has been used so many times by Powell and others that the market is no longer persuaded that the Fed knows much about actual inflation dynamics and evolution.
Why would the Fed and other central banks want to persuade the rest of the world that interest rates need to remain low and assets still need to be purchased, even in the light of booming markets? The simplest answer is that the size of the debt load is so large, that they just don’t have a choice. In order to keep debt servicing costs manageable in the short run, interest rates and bond yields have to stay extremely low. As inflation spikes up, keeping nominal yields low to keep debt servicing costs low means that real yields (real yields equal nominal yields minus inflation) are forced into deeply negative territory. For example, with ten year notes in the US yielding about 1.3%, and inflation running at 5.4%, the effective real yield is minus 4.1%! The actual real yield on the ten year TIPS is minus 1% because the Fed has been buying up most of the TIPS, forcing real yields low. Investors who are buying the nominal ten year note at 1.3% are being forced to lose over 4% a year of value – talk about being slowly boiled alive. And when real yields on bonds are negative, they drive money out of safety into risk-seeking assets, like stocks, to make up the lost yield in increased prices.
So if we agree that we are being persuaded to buy one view of the data from the three little birds/lawyers/central bank heads, what are we supposed to do?
I think the simplest answer is probably the best one. Whichever way I look at it, more asset purchases are in the cards because we are trapped in debt. Tightening policy now would mean that markets would crater, which would lead to another round of asset purchases and easy policy; whereas no tightening means a further rise in asset prices and then a subsequent decline in the asset prices mainly due to the force of gravity, which would again result in asset purchases and easy policy. In other words, either way the next step for the central banks is to do another round of asset purchases. In economics terms, the asset purchase strategy “stochastically dominates” all other strategies. Bubble or no bubble, it is better to keep purchasing assets today than to not purchase them and have to purchase them later! Which is why the central banks are so persuasive in justifying continued asset purchases.
Second, if debt sustainability requires governments to borrow more money to keep interest rates low, investors should rationally do just as the government does because sovereigns have a printing press. Investors should also borrow for the long term and buy assets along with the central banks, but control exposure so that a serious shock to the borrowing rates does not force them to liquidate. Astute corporations are already doing this. The borrowed money can be used to buy more assets, or perhaps used as precautionary savings, or simply used to spend. Companies are buying back their stock or other companies with the elevated stock values using stock as currency as mergers and acquisitions start heading into record territory again. Recent news (“Buy, Borrow, Die: How Rich Americans Live Off Their Paper Wealth”) show that this is exactly what many wealthy investors are also doing; instead of selling their assets and incurring tax liabilities, they are borrowing from banks to indulge their spending.
Of course this path of asset gorging is not riskless. If the central banks change their mind, and pivot again, the outcome for the market might be very different. The lawyers in charge of the central banks think they know how to pivot smoothly, but that is really the risk to taking their assurances at face value.
Given how inexpensive it is to hedge market risks today, entrusting the three little birds entirely with your financial welfare might not be the best idea. And a good reading of economics and scientific decision making might also be recommended for policymakers and investors alike.