Rewardless Risk

Faramir: Then farewell! But if I should return, think better of me.
Denethor: That depends on the manner of your return.

J.R.R. Tolkien “The Lord of the Rings” (1954)

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I’m going full-nerd with the “Lord of the Rings” introduction to today’s Epsilon Theory note, but I think this scene — where Denethor, the mad Steward of Gondor, orders his son Faramir to take on a suicide mission against Sauron’s overwhelming forces — is the perfect way to describe what the Bank of Japan did last Thursday with their announcement of negative interest rates. The BOJ (and the ECB, and … trust me … the Fed soon enough) is the insane Denethor. The banks are Faramir. The suicide mission is making loans into a corporate sector levered to global trade as the forces of global deflation rage uncontrollably.
Negative rates are an intentional effort to weaken your own country’s banks. Negative rates are a punitive command: go out there and make more bad loans where risk is entirely uncompensated, or we will, in effect, fine you. The more bad loans you don’t make, the bigger the fine. Negative rates are only a bit worrying in today’s sputtering economies of Europe, Japan, and the US because the credit cycle has yet to completely roll over. But it is rolling over (read anything by Jeff Gundlach if you don’t believe me), it is rolling over everywhere, and when it really starts rolling over, any country with negative rates will find it to be significantly destabilizing for their banking sector.

There’s a reason that the Fed kept paying interest on bank reserves even in the darkest, most deflationary days of the Great Recession. Yes, it’s the Fed’s job to support full employment. Yes it’s the Fed’s job to maintain price stability. But the Fed’s job #1 — the reason the Federal Reserve was created in the first place — is to maintain the stability of the banking system. Go ask a US moneycenter bank how things would have turned out in 2008 if the positive interest coming in on their reserves had been flipped to negative interest going out on their reserves. Go ask a US regional bank how things would have turned out if they had made even more rewardless risk loans in 2006 and 2007 under the pressure of negative rates.

Look, I get the “theory”. I understand that weakening the yen is an existential domestic political issue for Kuroda and Abe, just as weakening the euro is an existential domestic political issue for Draghi and Merkel, just as weakening the yuan is an existential domestic political issue for Zhou and Xi. And I understand that policy-addicted markets will respond exuberantly to anything that can be described as central bank support for financial asset price inflation. Hey, I’m an addict, too.

But what I’m concerned about is not the theory but the practice. What I’m concerned about is the intentional destabilization of the global financial system for domestic political purposes. What I’m concerned about is the Fed’s inevitable adoption of negative rates, something Alan Blinder pushed for in 2008 and Ben Bernanke is pushing for now.

When the ECB instituted negative rates, that was just a point. The BOJ’s move last Thursday makes a line. Now we have a pattern. Now we have a market that expects MOAR! Now we have a Fed that will undoubtedly implement negative rates when things get squirrely again, even if there are some in the Fed who I’m sure are shaking their heads at all this.

I’ve come to expect every elected politician or politician wannabe to rail against “the bankers” and the terrible mess they’ve made of the world with their “predatory lending” and “easy credit”, even though this is exactly what every politician in the world desires. But I didn’t expect central bankers to betray their own charges. I didn’t expect central bankers to throw their own domestic banks into a battle they can’t win.

You know what negative rates are? They are the final stripping away of the illusion that central bankers somehow exist above and separately from domestic politics, that they are wise and able stewards of financial stability. Nope. They’re Denethors.

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You Can Either Surf, or You Can Fight

Kilgore: Smell that? You smell that?
Lance: What?
Kilgore: Napalm, son.  Nothing else in the world smells like that.

– Apocalypse Now (1979)

Hello, hello, hello, how low? [x3]
– Nirvana, Smells Like Teen Spirit (1991)

Outside the bus the smell of sulfur hit Bond with sickening force.  It was a horrible smell, from somewhere down in the stomach of the world.
– Ian Fleming, Diamonds Are Forever (1956)

There’s more than a whiff of 2008 in the air. The sources of systemic financial sector risk are different this time (they always are), but China and the global industrial/commodity complex are even larger tectonic plates than the US housing market, and their shifts are no less destructive. There’s also more than a whiff of 1938 in the air (hat tip to Ray Dalio), as we have a Fed that is apparently hell-bent on raising rates even as a Category 5 deflationary hurricane heads our way, even as the yield curve continues to flatten.

What really stinks of 2008 to me is the dismissive, condescending manner of our market Missionaries (to use the game theory lingo), who insist that the US energy and manufacturing sectors are somehow a separate animal from the US economy, who proclaim that China and its monetary policy are “well contained” and pose little risk to US markets. Unfortunately, the role and influence of Missionaries is even greater today in this policy-driven market, and profoundly misleading media Narratives reverberate everywhere.

For example, we all know that it’s the overwhelming oil “glut” that’s driving oil prices down and wreaking havoc in capital markets, right? It’s all about OPEC versus US frackers, right?

Here’s a 5-year chart of the broad-weighted US dollar index (this is the index the Fed publishes, which – unlike the DXY index and its >50% Euro weighting – weights all US trading partners on a pro rata basis) versus the price of WTI crude oil. The red line marks Yellen’s announcement of the Fed’s current tightening bias in the summer of 2014.

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Source: Bloomberg, January 2016.

Ummm … this nearly perfect inverse relationship is not an accident. I’m not saying that supply and demand don’t matter. Of course they do. What I’m saying is that divergent monetary policy and its reflection in currency exchange rates matter even more. Where is the greatest monetary policy divergence in the world today? Between the US and China. What currency is the largest contributor to the Fed’s broad-weighted dollar index? The yuan (21.5%). THIS is what you need to pay attention to in order to understand what’s going on with oil. THIS is why the game of Chicken between the Fed and the PBOC is so much more relevant to markets than the game of Chicken between Saudi Arabia and Texas.

But wait, there’s more.

>My belief is that a garden variety, inventory-led recession emanating from the energy and manufacturing sectors is already here. Maybe I’m wrong about that. Maybe I spend too much time in Houston. Maybe low wage, easily fired service sector jobs are the new engine for US GDP growth, replacing the prior two engines – housing/construction 2004-2008 and energy/manufacturing 2010-2014. But I don’t see how you can look at the high yield credit market today or projections of Q4 GDP or any number of credit cycle indicators and not conclude that we are rolling into some sort of “mild” recession.

My fear is that in addition to this inventory-led recession or near-recession, we are about to be walloped by a new financial sector crisis coming out of Asia.

What do I mean? I mean that Chinese banks are not healthy. At all. I mean that China’s attempt to recapitalize heavily indebted state-owned enterprises through the equity market was an utter failure. I mean that China is going to need every penny of its $3 trillion reserves to recapitalize its banks when the day of reckoning comes. I mean that China’s dollar reserves were $4 trillion a year ago, and they’ve spent a trillion dollars already trying to manage a slow devaluation of the yuan. I mean that the flight of capital out of China (and emerging markets in general) is an overwhelming force. I mean that we could wake up any morning to read that China has devalued the yuan by 10-15%.

Look … the people running Asian banks aren’t idiots. They can see where things are clearly headed, and they are going to do what smart bankers always do in these circumstances: TRUST NO ONE. I believe that there is going to be a polar vortex of a credit freeze coming out of Asia that will look a lot like 1997. Put this on top of the deflationary impact of China’s devaluation. Put this on top of an inventory-led recession or near recession in the US, together with high yield credit stress. Put this on top of massive market complacency driven by an ill-placed faith in central banks to save the day. Put this on top of a potentially realigning election in the US this November. Put this on top of a Fed that is tighteningStorm warning, indeed.

So what’s to be done? As Col. Kilgore said in “Apocalypse Now”, you can either surf or you can fight. You can adopt strategies that can make money in this sort of environment (historically speaking, longer-term US Treasuries and trend-following strategies that can go short), or you can slog it out with a traditional equity-heavy portfolio.

Also, as some Epsilon Theory readers may know, I co-managed a long/short hedge fund that weathered the 2008 systemic storm successfully. There were trades available then that, in slightly different form, are just as available today. For example, it may surprise anyone who’s read or seen (or lived) “The Big Short” that the credit default swap (CDS) market is even larger today than it was in 2008. I’d welcome a conversation with anyone who’d like to discuss these systemic risk trades and how they might be implemented today.

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Actually Maybe Not So Excellent

Everything under heaven is in chaos; the situation is excellent.
― Mao Zedong (1893 – 1976)

A quick email on China’s currency devaluation last night. The news itself is big enough, but it’s the Narrative that’s developing around the devaluation that has my risk antennae quivering like crazy. What do I mean? I mean that initial media efforts to portray the devaluation as a one-time “adjustment” that’s in-line with prior policy have been overrun by stories of “shock” and disjuncture. This is true even within Rupert Murdoch’s various media microphones, which tend strongly to toe the Beijing party line. Moreover, the devaluation is not being described in Western media as Chinese “stimulus”, which it surely is and would send markets higher if portrayed in this light, but as Chinese “currency competition” and as a sign that the growth problems in China are more severe than Western central bankers would like to believe. Or more precisely, would like to have YOU believe.

What’s the Truth with a capital T about Chinese growth, Fed intentions, and the future price of growth-sensitive assets like oil? I have no idea and neither does anyone else. Seriously. But what I do know is that the Common Knowledge about Chinese growth – what everyone thinks that everyone thinks about Chinese growth – is dramatically changed for the worse today, and it’s a change that will accelerate unless the Narrative shifts. That could happen. I still have nightmares about how the Narrative around the ECB’s OMT program shifted from “Draghi’s Blunder” to “Draghi’s Bold Move” within a single day in the pages of the Financial Times in the summer of 2012. But unless and until that Narrative shifts, the path forward for the Fed just got much more perilous. And that’s why the 10-year US Treasury is at 2.12% as I write this note. Unless and until that Narrative shifts, the path forward for oil and any other global growth-sensitive asset or security just got much more perilous. And that’s why oil is at $43 as I write this note.

One last point, focused on what’s next for China. As with everything else here in the Golden Age of the Central Banker, my crystal ball is broken. But I think that I’ve got the right lens for viewing China and its political dynamics, and you can read about it in two Epsilon Theory notes: “The Dude Abides: China in the Golden Age of the Central Banker” and “Rosebud”.

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“Suddenly, Last Summer”

A quick Epsilon Theory email and a quick announcement. Announcement first. I’ll be giving a 1-hour webcast on Risk Premia strategies next Tuesday, August 4th, along with Salient President Jeremy Radcliffe and Salient Portfolio Manager Rob Croce, who knows more about the guts of these strategies than anyone should. The webcast qualifies for CE credit if you care about such things (and who doesn’t!) and is hosted by our friends at RIA Database. The catch … you have to be a professional investor / financial advisor to sign up. Sorry. For more information or to register for the webcast, check out: “Alternative Return Streams in Challenging Markets”

epsilon-theory-suddenly-last-summer-july-29-2015-suddenly

Dr. Cukrowicz: Mrs. Venable, loving your niece as you do, you must know there’s great risk in this operation. Whenever you enter the brain with a foreign object …
Mrs. Venable: Yes.
Dr. Cukrowicz: Even a needle thin knife.
Mrs. Venable: Yes.
Dr. Cukrowicz: In the hands of the most skilled surgeon …
Mrs. Venable: Yes, yes.
Dr. Cukrowicz: There is a great deal of risk.
Mrs. Venable: But it does pacify them. I’ve read that … it quiets them down. It suddenly makes them peaceful.
Dr. Cukrowicz: Yes, that it does do, but …
Mrs. Venable: But what?
Dr. Cukrowicz: Well, it will be years before we know if the immediate benefits of the operation are lasting or maybe just passing or perhaps … there’s a strong possibility that the patient will always be limited. Relieved of acute anxiety, yes, but limited.
Mrs. Venable: But what a blessing, Doctor, to be just peaceful. To be just suddenly peaceful. After all that horror. After those nightmares. Just to be able to lift up their eyes to a sky not black with savage devouring birds.

“Suddenly, Last Summer” (1959)

I figure not one Epsilon Theory reader in a thousand has seen “Suddenly, Last Summer”, but let me tell you … it’s got everything. Katherine Hepburn in a phenomenal performance as bizarro Aunt Vi. Elizabeth Taylor cavorting in the surf. Montgomery Clift. Lobotomies. Pedophilia. Cannibalism. Honestly, it’s kind of what you would expect if Gore Vidal took a Tennessee Williams script and just went gonzo with it. Which, in fact, is exactly what happened.
The subtext, as with so much of Southern Gothic in general and Tennessee Williams in particular, is mendacity and its crushing psychological damage. I found this quote, where Katherine Hepburn is trying to convince Montgomery Clift to lobotomize Elizabeth Taylor so that she’d forget her former life and be less fearful and anxious … less volatile, in other words … to be an eerily apt description of what Central Bankers have tried to do with markets.
We endured an event last summer that, just as in the movie, ultimately brings all the mendacity out of the shadows and into the open. When Yellen declared last summer that the Fed had now firmly embraced a tightening bias, followed by the rest of the world declaring that they were doubling down on extraordinary monetary policy easing, the entire world was set on a path where all of the political fragmentation – all of the deep fissures within and between countries – would be inexorably revealed. Suddenly last summer, the mask of global monetary policy cooperation was ripped away, and the investment world will never be the same.
epsilon-theory-suddenly-last-summer-july-29-2015-bloomberg

Here are two Bloomberg charts that show what I mean. On the top is a 5-year chart of DXY – the trade-weighted dollar index. On the bottom is a 5-year chart of WTI crude oil spot prices. Does this look like an accidental relationship to you? Can we just stop with all the hand-wringing about how there’s suddenly too much oil in the world, or how the Saudis are trying to crush US shale production, or any of the other spurious supply-and-demand “explanations” for why oil prices have collapsed? Seriously. Can we just stop?

Monetary policy divergence manifests itself first in currencies, because currencies aren’t an asset class at all, but a political construction that represents and symbolizes monetary policy. Then the divergence manifests itself in those asset classes, like commodities, that have no internal dynamics or cash flows and are thus only slightly removed in their construction and meaning from however they’re priced in this currency or that. From there the divergence spreads like a cancer (or like a cure for cancer, depending on your perspective) into commodity-sensitive real-world companies and national economies. Eventually – and this is the Big Point – the divergence spreads into everything, everywhere. Some things will go up, and some things will go down. But the days of ALL financial assets inflating in lock-step … the days of everything, everywhere going up together … that’s over.

For a lot of active investment managers, this is great news. For a lot of politicians and central bankers – particularly the weaker ones, either in resources or in willpower (yes, I’m looking at you, Alexis Tsipras) – this is terrible news. For investors? Well, it’s a mixed bag. Certainly it’s a more difficult bag, where so many of the learned behaviors of the past five years that worked so well in an environment of monetary policy coordination will fail miserably in an environment of monetary policy competition. But it beats getting a lobotomy. I think. We’ll see.

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Ghost in the Machine, Part 1

  The way out is through the door. Why is it that no one will use this method?
― Confucius (551 – 479 BC)

Tanzan and Ekido were once traveling together down a muddy road. A heavy rain was still falling. Coming around a bend, they met a lovely girl in a silk kimono and sash, unable to cross the intersection.
“Come on, girl,” said Tanzan at once. Lifting her in his arms, he carried her over the mud.
Ekido did not speak again until that night when they reached a lodging temple. Then he could no longer restrain himself. “We monks don’t go near females,” he told Tanzan, “especially not young and lovely ones. It is dangerous. Why did you do that?”
“I left the girl there,” said Tanzan. “Are you still carrying her?”
― Nyogen Senzaki, “Zen Flesh, Zen Bones: A Collection of Zen and Pre-Zen Writings” (1957)

In 1995, David Justice had a superior batting average to Derek Jeter (.253 to .250)
In 1996, David Justice had a superior batting average to Derek Jeter (.321 to .314)
In 1997, David Justice had a superior batting average to Derek Jeter (.329 to .291)
Yet from 1995 – 1997, Derek Jeter had a superior batting average to David Justice (.300 to .298)
― example of Simpson’s Paradox, aka The Yule-Simpson Effect (1951)

A student says, “Master, please hand me the knife,” and he hands the student the knife, blade first. “Please give me the other end,” the student says. And the master replies, “What would you do with the other end?”
― Alan W. Watts, “What Is Zen?” (2000)

Such in outline is the official theory. I shall often speak of it, with deliberate abusiveness, as “the dogma of the Ghost in the Machine.” I hope to prove that it is entirely false, and false not in detail but in principle. It is not merely an assemblage of particular mistakes. It is one big mistake and a mistake of a special kind. It is, namely, a category mistake.
― Gilbert Ryle (1900 – 1976) 

The trouble with Oakland is that when you get there, there isn’t any there there.
― Gertrude Stein (1874 – 1946) 

Dr. Malcolm:     Yeah, yeah, but your scientists were so preoccupied with whether or not they could that they didn’t stop to think if they should.
― “Jurassic Park” (1993) 

It’s a big enough umbrella
But it’s always me that ends up getting wet.
― The Police, “Every Little Thing She Does is Magic” (1981)  

Everyone who lost money on the SNB’s decision to reverse course on their three and a half year policy to cap the exchange rate between the CHF and the Euro made a category error. And by everyone I mean everyone from Mrs. Watanabe trading forex from her living room in Tokyo to a CTA portfolio manager sitting in front of 6 Bloomberg monitors to a financial advisor answering a call from an angry client. It will take me a bit of verbiage to explain what I mean by a category error and why it’s such a powerful concept in logic and portfolio construction. But I think you’ll find it useful, not just for understanding what happened, but also (and more importantly) to protect yourself from it happening again. Because this won’t be the last time the markets will be buffeted by a forex storm here in the Golden Age of the Central Banker.

A year and a half ago, when I was just starting Epsilon Theory, I wrote a note called “The Tao of Portfolio Management.” It’s one of my less-downloaded notes, I think largely because its subject matter – problems of misunderstood logic and causality in portfolio construction – doesn’t exactly have the sexiness of a rant against Central Bank Narrative dominance, but it’s one of my personal favorites. That note was all about the ecological fallacy – a pervasive (but wrong-headed) human tendency to infer qualities about the individual from qualities of the group, and vice versa. Today I’ve got the chance to write once again about the logic of portfolio construction AND work in some of my favorite Zen quotes AND manage something of a Central Bank screed … a banner day!

I’ve titled this note “The Ghost in the Machine” because it starts with another pervasive (but wrong-headed) human tendency – the creation of a false dualism between mind and body. I know, I know … that sounds both really daunting and really boring, but bear with me. What I’m talking about is maybe the most important question of modern philosophy – is there a separate thing called “mind” or “consciousness” that humans possess, or is all of that just the artefact of a critical mass of neurons firing within our magnificent, but entirely physical, brains? I’m definitely in the “everything is explained by neurobiology” camp, which I’d say is probably the more widely accepted view (certainly the louder view) in academic philosophy today, but for most of the 19th and 20th centuries the dualist or Cartesian view was clearly dominant, and it was responsible for a vast edifice of thought, a beautiful cathedral of philosophical constructs that was … ultimately really disappointing and empty. It wasn’t until philosophers like Gilbert Ryle and Van Quine started questioning what Ryle called “the ghost in the machine” – this totally non-empirical but totally accepted belief that humans possessed some ghostly quality of mind that couldn’t be measured or observed but was responsible for driving the human machine – that the entire field of philosophy could be reconfigured and take a quantum leap forward by incorporating the insights of evolutionary biology, neurobiology, and linguistics.

Unfortunately, most economists and investors still believe in ghosts, and we are a long way from taking that same quantum leap. There is an edifice of mind that dominates modern economic practice… a beautiful cathedral where everything can be symbolized, where everything can be securitized, and where everything can be traded. We have come to treat these constructed symbols as the driver of the economic machine rather than as an incomplete reflection of the real world things and real world activities and real world humans that actually comprise the economy. We treat our investment symbols and thoughts as a reified end in themselves, and ultimately this beautiful edifice of symbols becomes a maze that traps us as investors, just as mid-20th century philosophers found themselves trapped within their gorgeous constructs of mind. We are like Ekido in the Zen koan of the muddy road, unable to stop carrying the pretty girl in our thoughts and trapped by that mental structure, long after the far more sensible monk Tanzan has carried the girl safely over the real world mud without consequence, symbolic or otherwise.

The answer to our overwrought edifice of mind is not complex. As Confucius wrote in The Analects, the door is right there in front of us. Exiting the maze and reducing uncompensated risk in our portfolios does not require an advanced degree in symbolic logic or some pretzel-like mathematical process. It requires only a ferocious commitment to call things by their proper names. That’s often not an easy task, of course, as the Missionaries of the Common Knowledge Game – politicians, central bankers, famous investors, famous economists, and famous journalists – are dead-set on giving things false names, knowing full well that we are hard-wired as social animals to respond in ant-like fashion to these communication pheromones. We are both evolved and trained to think in terms of symbols that often serve the purposes of others more than ourselves, to think of the handle rather than the blade when we ask for a knife. The meaning of a knife is the blade. The handle is not “the other end” of a knife; it is a separate thing with its own name and usefulness. The human animal conflates separate things constantly … maybe not a big deal in the kitchen, but a huge deal in our portfolios. Replace the word “knife” with “diversification” and you’ll get a sense of where I’m going with this.

Here’s what I mean by calling things by their proper names. The stock ticker “AAPL” or the currency ticker “CHF” are obviously symbols. Less obviously but more importantly, so are the shares of Apple stock and the quantities of Swiss francs that AAPL and CHF represent. Stocks and bonds and commodity futures and currencies are symbols, not real things at all, and we should never forget that. The most common category error that investors make (and “category error” is just a $10 phrase for calling something by the wrong name) is confusing the symbol for what it represents, and as a result we forget the meaning of the real world thing that’s been symbolized.

A share of stock in, say, Apple is a symbol. Of what? A limited liability fractional ownership position in the economic interests of Apple, particularly its free cash flows.

A futures contract in, say, copper is a symbol. Of what? A commitment to receive or deliver some amount of real-world copper at some price at some point in the future.

A bond issued by, say, Argentina is a symbol. Of what? A commitment by the Argentine government to repay some borrowed money over an agreed-upon period of time, plus interest.

A currency issued by, say, Switzerland is a symbol. Of what? Well, that’s an interesting question. There’s no real world commitment or ownership that a currency symbolizes, at least not in the same way that stocks, bonds, and commodity contracts symbolize an economic commitment or ownership stake. A currency symbolizes government permission. It is a license. It is an exclusive license (which makes it a requirement!) to use that currency as a medium for facilitating economic transactions within the borders of the issuing government, with terms that the government can impose or revoke at will for any reason at all. That’s it. There’s no economic claim or right inherent in a piece of money. As Gertrude Stein famously said of Oakland, there’s no there there.

Why is this examination of underlying real world meaning so important? It’s important because there is no positive long-term expected return from trading one country’s economic license for another country’s economic license. There is a positive long-term expected return from trading money for stock. There is a positive long-term expected return from trading money for bonds. There is a positive long-term expected return from trading money for commodities and other real assets. But there is no positive long-term expected return from trading money for money.

Unfortunately, we’ve been trained and encouraged – often under the linguistic rubric of “science” – to think of ANY new trading vehicle or security, particularly one that taps into as huge a market as foreign exchange, as a good thing for our portfolios. We are deluged with the usual narratives that alternatively seek to tempt us and embarrass us into participation. On an individual level we are told stories of savvy investors who look and act like we want to look and act, taking bold advantage of the technological wizardry (look! it’s a heat map! that changes color while I’m watching it!) and insanely great trade financing now at our fingertips in this, the best of all possible worlds. On an institutional level we are told stories of liquidity and non-correlation (what? you don’t understand what an efficient portfolio frontier is? and you call yourself a professional?), both good and necessary things, to be sure. But not sufficient things, at least not to cast the powerful magic that is diversification.

There are only a few sure things in investing. First, taxes and fees are bad. Second, compound growth is a beautiful thing. Third, portfolio diversification works. At Salient we spend a lot of time thinking about what makes diversification work more or less well for different types of investors, and if you’re interested in questions like “what’s the difference between de-risking and diversification?” I heartily recommend our latest white paper (“The Free Lunch Effect”) to you. One thing we don’t do at Salient is include currency trading within our systematic asset allocation or trend-following strategies. Why not? Because Rule #1 for tapping into the power of portfolio diversification is that you don’t include things that lack a long-term positive expected return. Just because we can trade currency pairs easily and efficiently doesn’t mean that we should trade currency pairs easily and efficiently, any more than cloning dinosaurs because they could was a good idea for the Jurassic Park guys. The point of adding things to your portfolio for diversification should be to create a more effective umbrella, not just a bigger umbrella. I like a big umbrella just as much as the next guy, but not if I’m going to get wet every time a forex storm whips up.

So if not for diversification, why do smart people engage in currency trading? There’s a good answer and a not-as-good answer to that question.

The good answer is that you have an alpha-driven (i.e. private information-driven) divergent view on the terms of the government license embedded within any modern currency. This is why Stanley Druckenmiller is an investing god, and it’s why anyone who put money with him before, during, and after he and George Soros “broke the Bank of England” in 1992 has been rewarded many times over.

The not-as-good answer is that you have identified a predictive pattern in the symbols themselves. I say that it’s not as good of an answer, but I’m not denying that there is meaning in the pattern of market symbols. On the contrary, I think there is real information regarding internal market behaviors to be found in the inductive study of symbolic patterns. This information is alpha, maybe the only consistent source of alpha left in the world today, and acting on these patterns is what good traders DO. But because it’s inductively derived, anyone else can find your special pattern, too. Or if they can’t, it’s because you’ve carved out a nice little parasitic niche for yourself that’s unlikely to scale well. More corrosively, the natural human tendency is to ascribe meaning to these patterns beyond the internal workings of the market, something that makes no more sense than to say that goose entrails have meaning beyond the internal workings of the goose. The meaning of the Swiss franc didn’t change just because you had a consistent pattern of market behavior around the EURCHF cross. Deviation in the expected value of the Swiss franc in Euro terms did not become normally distributed just because you can apply statistical methodology to the historical exchange rate data. I get so annoyed when I read things like “this wasn’t just the greatest shock in the history of forex, it was the greatest shock in the history of traded securities! a 30 standard deviation event!” Please. Stop it. Just because you can impose a normal distribution on the EURCHF cross doesn’t mean that you should. And if you’re making investment decisions because you think that this normal distribution and the internal market stability it implies is somehow “real” or has somehow changed the fundamental nature of what a currency IS … well, eventually that category error will wipe you out. Sorry, but it will.

I don’t mean to be snide about any of this (although sometimes I can’t help myself). The truth is that an aggregation of highly probabilistic entities will always surprise you, whether you’re building a baseball team or an investment portfolio. Portfolio construction – the aggregation of symbols and symbols of symbols, all of which are ultimately based on massive amounts of real world activities that may have vastly different meanings and underlying probabilistic natures – is a really difficult task under the best of circumstances for a social animal that evolved on the African savanna for an entirely different set of challenges. And these are not the best of circumstances. No, the rules always change as the Golden Age of the Central Banker begins to fade. The SNB decision was a wake-up call, whether or not you were directly impacted, to re-examine portfolios and investment behavior for category errors. We all have them. It’s only human. The question, as always, is whether we’re prepared to do anything about it.

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Going Gray

epsilon-theory-going-gray-october-1-2014-chinese-officials

Everything under the sun is in chaos. The situation is excellent.

– Mao Zedong (1893 – 1976)

Forget it, Jake. It’s Chinatown.

– Chinatown (1974)

Language is conceived in sin and science is its redemption.

– W.V.O. Quine (1908 – 2000)

I am, as I am; whether hideous, or handsome, depends upon who is made judge.

– Herman Melville (1819 – 1891)

All -ism’s end up in schisms.

– Huston Smith (b. 1919)

What Asians value may not necessarily be what Americans or Europeans value. Westerners value the freedoms and liberties of the individual. As an Asian of Chinese cultural background, my values are for a government which is honest, effective and efficient.

– Lee Kuan Yew (b. 1923)

Two years ago, the new seven-member Standing Committee of the Chinese Communist Party Politburo – the most powerful political entity in the country – was introduced to great fanfare. All seven men walked on stage wearing a dark suit and a red tie, but to me the most striking aspect of their appearance was their hair. Yes, their hair. Their dark, immaculately coifed, powerful hair. Despite an average age of 65, not one of these men has EVER been seen in public without sporting a mane that would make their grandsons proud.

On the other hand, consider this handsome man, Bo Xilai. Once the princeling of princelings, the son of a Long March vet, Bo was enormously popular for his Redder-than-Thou politics and enormously rich from his mayoral “crackdown” on organized crime in Chongqing, a municipality with about the same urban population as New York City. To put Bo Xilai in a US context, he was richer than Michael Bloomberg and more politically ambitious than Rudy Giuliani, if either of those two qualities can be imagined. And of course, this 65 year old politician had the luxurious jet-black hair as befits a man of his position.

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But alas, Bo’s political reach exceeded his political grasp. Undone publicly for abuse of office and a murder conspiracy, privately for his creation of a top-notch intelligence operation that spied on his fellow Politburo princelings (again to put in a US context, imagine if a mega-billionaire mayor of New York City created his own electronic FBI that could monitor everyone’s market activities … crazy, right?), Bo found himself on the wrong end of a show trial and is currently living out the rest of his days in a Madoff-style cell. How do we know that Bo is gone for good, that he has lost whatever political support he formerly commanded? Because they took away his hair dye. He’s “gone gray”, as they say in the Chinese political lingo, portrayed to the world as a frail old man who not only lost his freedom but much more importantly lost his mojo.

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Patrick Henry famously said, “Give me liberty or give me death!”, a sentiment that makes sense in Western political culture but is met with puzzled looks in the East. Personal liberty is, in an important sense, everything in Western political culture. In Chinese political culture … not so much.  On the other hand, signifiers of personal potency – like maintaining dark hair – have enormous meaning in China and, at times, a diametrically opposed meaning in the West.

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Okay, Ben, kinda interesting in a cultural anthropology sort of way, but what in the world does this have to do with investing? Simply this, and it’s a core Epsilon Theory tenetthe meaning of events and market signals differ hugely from country to country, tribe to tribe, generation to generation. Ferguson does not mean the same thing as Hong Kong. Hong Kong does not mean the same thing as Tahrir Square or even Tiananmen Square. Monetary policy does not mean the same thing in Beijing as monetary policy means in Washington, which in turn does not mean the same thing as monetary policy in Paris or Rome. But we have an innate tendency to act as if these signals DO mean the same thing, and we can totally wrong-foot our investments as a result.

The biggest thing happening in the world today is the growing divergence between US monetary policy and everyone else’s monetary policy. There is a schism in the High Church of Bernanke, with His US acolytes ending the QE experiment in no uncertain terms, and His European and Japanese prelates looking to keep the faith by continued balance sheet expansion. That divergence plays out mostly in exchange rates, and it has three HUGE implications, one for investment strategy selection, one for global growth, and one for … (gulp!) gold.

First, this is great news for global macro strategies and their low-cost, populist cousins, so-called “alternative beta” strategies. Global macro performance has been absolutely atrocious over the past five years, driven primarily by a coordinated global monetary policy regime that squeezed out the historical patterns of difference between geographies and asset classes. Now that monetary policy is uncoordinated, with every major economic region essentially fending for itself, global macro and alternative beta strategies have “room” to work. To be sure, some of these strategies will still be confounded by an investment regime where monetary policy trumps economic fundamentals at every turn, but the sine qua non for ANY active investment strategy is distinction and dispersion. For the first time in more than five years, we can see this sort of distinction and dispersion in regional macroeconomic policies, giving traditional global macro strategies at least a chance of success. Vive la difference!

Second, this divergence in regional monetary policy creates enormous strains on the tectonic plates of modern international trade – currency exchange rates. In the absence of a re-convergence of monetary policy I don’t see any compelling reason why recent dollar appreciation should slow down, much less reverse itself, with the obvious consequences for US S&P 500 earnings (negative), commodity prices and commodity-related securities (negative), most EM markets (negative), and European and Japanese earnings (positive). But the greatest risk for global economic stability from a dollar on steroids is, for my money, China. Why? Because as I’ve tried to point out in prior Epsilon Theory notes (herehere, and here), China’s political stability depends on economic growth – it’s the mojo of the Party just as surely as jet-black hair is the mojo of Party leaders – and Chinese growth depends on exports.So long as the yuan is effectively tethered to the dollar, a stronger dollar means a stronger yuan, which means weaker exports to Europe, Japan, and EM’s. Sure, it’s cheaper now to buy more iron ore and copper, so I suppose you could build another ghost city or two to keep the growth train on track, but the Politburo’s only serious answer to the politically existential question of growth is to sell more advanced products to more people, most of whom don’t live in China. That means selling medical devices to Japan and telecom equipment to Germany, tasks made much more difficult by a stronger dollar/yuan. To be clear, I do NOT see some imminent economic collapse in China. But growth is much less certainin China today, and that’s a political problem that the Politburo will stop at nothing to fix. I expect the 180-degree shift in Chinese monetary policy that began this January and paused this summer to accelerate again, which in turn will accelerate political tensions abroad with the US and Japan, as well as political tensions domestically with the mega-rich princeling families. And speaking of domestic political tensions …

Look, I don’t think the meaning of Hong Kong – even to the participants – is some pro-democracy uprising a la the Arab Spring or any of the “color revolutions” our media is so quick to christen. Maybe if we start to see fewer English-language signs and fewer teenagers lifting their smartphone “candles” I’ll change my mind, but right now it seems a lot more like a tepid expression of political identity than a determined effort by determined citizens to change the political system at a fundamental level. This isn’t a release-the-hounds moment like Deng believed Tiananmen Square to be, and it looks like the Gang of Seven in Beijing have decided as much with new orders to pull the police back and let the protesters block traffic and annoy everyone in the city who just wants to get back to business.

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But I do think there’s a deeper implication of the Hong Kong protests, one likely to be missed by Western investors who want to project a Western meaning on the events taking place. I think the most important lesson that mainland leaders in the CCP and PLA will take away from the Hong Kong protests is not that the population must be brought to heel, but that they can’t be trusted, that they’re not really one of us. And that’s okay to a certain degree … the potential of “contagion” from Hong Kong to, say, Chongqing seems really remote given the State’s control over media and information flow … but it’s not okay if the “transmission wires” of Hong Kong’s financial system can’t be trusted. Hong Kong is an indispensable financial intermediary for the Chinese State, and I have zero doubt that Beijing will move to cement their control over the sinews of real power here, by any means necessary. One of those sinews of real power is the Hong Kong dollar, which means that Hong Kong monetary policy and the Hong Kong Currency Board – already reduced to a semi-independent satrap – is about to make the transition to full-fledged puppet. This lesson won’t be lost on the mega-rich Chinese princelings, either. The days of parking your mainland wealth in Hong Kong are now over, as it’s no longer a safe haven from the long arm of the CCP. Let the capital flight begin, and watch out below for the Hong Kong dollar.

As for my third point – the implications of monetary policy divergence on gold – I’m always reticent to write about gold because it incites such passion (and I don’t just mean the gold bug camp … poke pretty much any academically-trained economist and you will unleash a furious anti-gold tirade). To be clear, I believe that the meaning of gold today is NOT as a store of value but as an insurance policy against central banks losing control. With market faith in the Narrative of Central Bank Omnipotence at an asymptotic top, the price of that insurance policy – call it $1,200/oz – is as low as it’s going to go. And now with a schism in the High Church of Bernanke, monetary policy divergence, and growing pressures on the tectonic plates of exchange rates we have catalysts for both a generic and geographically specific central bank loss of control. Now I understand that gold means different things to different people, and to the degree that gold trades as a commodity or a dollar-denominated store of value it can trade cheaper as the dollar advances. I get that. But I don’t think that’s been the principal meaning of gold for the past 5+ years, and if you think as I do that this is the beginning of the end for the Golden Age of the Central Banker (or at least the end of the beginning), gold is pretty interesting here.

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