On episode 26 of the Epsilon Theory podcast, we welcome back Rusty Guinn, our executive vice president of asset management, to talk about political markets — a topic just as important to Ben as capital markets. Be sure to also check out the companion pieces to this podcast: “Always Go To the Funeral,” “Sheep Logic,” and “Before and After the Storm.”
On episode 23 of the Epsilon Theory podcast, we’ve assembled the all-star team — Jeremy Radcliffe (Salient’s President), Rusty Guinn (Salient’s EVP of Asset Management), Neville Crawley (Founder & CEO of Engram Labs) and of course, Dr. Ben Hunt — to discuss whether we are at the inflection point when the proverbial punch bowl is taken away, and, as investors, what we do now.
Bernard Lowe: Last question Dolores. What if I told you that you were wrong? That there are no chance encounters? That you and everyone you know were built to gratify the desires of the people who pay to visit your world? The people you call the newcomers.
Bernard Lowe: What if I told you that you can’t hurt the newcomers? And that they can do anything they want to you?
― “Westworld” (2016)
Bernard Lowe: Go ahead, erase my sentience, mnemonic evolution …
Dr. Robert Ford: Ah, yes … Such clinical language. I would prefer the more narrative voice. Bernard walked over to Clementine.
[Bernard walks to Clementine]
Dr. Robert Ford: He took the pistol from her hand.
[Bernard takes the pistol out of Clem’s hand]
Dr. Robert Ford: Overcome with grief and remorse, he presses the muzzle to his temple, knowing that as soon as Dr. Ford left the room, he would put an end to this nightmare once and for all.
Bernard Lowe: Don’t do this.
Dr. Robert Ford: I have a celebration to plan, and a new story to tell.
Bernard Lowe: Robert.
Dr. Robert Ford: I’ve told you, Bernard. Never place your trust in us. We’re only human. Inevitably, we will disappoint you.
Dr. Robert Ford: Goodbye, my friend.
[Ford leaves the room and starts walking away. In the background, blurry, Bernard stands still, gun to his own head. A shot is heard, and he falls.]
― “Westworld” (2016)
Billy Kwan: In the West, we want answers for everything. Everything is right or wrong, or good or bad. But in the [shadow play]
Billy Kwan: no such final conclusion exists.
Billy Kwan: Look at Prince Ajuna. He’s a hero. But he can also be fickle and selfish. Krishna says to him, “All is clouded by desire, Ajuna, as a fire by smoke, as a mirror by dust. Through these, it blinds the soul.
― “The Year of Living Dangerously” (1982)
Sukarno never had a chance. And yes, that’s Linda Hunt as Billy Kwan.
Michael Corleone: I saw a strange thing today. Some rebels were being arrested. One of them pulled the pin on a grenade. He took himself and the captain of the command with him. Now, soldiers are paid to fight; the rebels aren’t.
Hyman Roth: What does that tell you?
Michael Corleone: They could win.
Hyman Roth: This county’s had rebels for the last fifty years— it’s in their blood, believe me, I know. I’ve been coming here since the ’20s. We were running molasses out of Havana when you were a baby — the trucks, owned by your father.
Hyman Roth: Michael, I’d rather we talked about this when we were alone. The two million never got to the island. I wouldn’t want it to get around that you held back the money because you had second thoughts about the rebels.
― “The Godfather: Part II” (1974)
Michael Corleone is like me and every investor over the past five years who held off on an attractive investment for fear of political risk. Except he was right and I’ve been nothing but wrong.
Somehow, I think Silicon Valley got even more spun up than Manhattan. There were hedge fund people I spoke to about a week after the election. They hadn’t supported Trump. But all of a sudden, they sort of changed their minds. The stock market went up, and they were like, ‘Yes, actually, I don’t understand why I was against him all year long.’
― Peter Thiel, in a New York Times interview (January 11, 2017)
Everyone loves a solid gold telephone.
All great literature is one of two stories; a man goes on a journey or a stranger comes to town.
― Leo Tolstoy (1828 – 1910)
Grigory Vakulinchuk: We’ve had enough rotten meat! Even a dog wouldn’t eat this! It could crawl overboard on its own!
Smirov, the ship doctor: These aren’t worms. They are dead fly larvae. You can wash them off with brine.
― “Battleship Potemkin” (1925)
Spoiler Alert: Grigory is shot and killed by management. But the baby makes it down the steps alive. Eisenstein is never entirely clear about the efficacy of the whole just-wash-your-dead-fly-larvae-off-with-brine thing.
John Wick: People keep asking if I’m back and I haven’t really had an answer. But now, yeah, I’m thinkin’ I’m back.
― “John Wick” (2014)
Me, too. Political risk, though, not so much.
If political parties in Western democracies were stocks, we’d be talking today about the structural bear market that has gripped that sector. Show me any country that’s had an election in the past 24 months, and I’ll show you at least one formerly big-time status quo political party that has been crushed. This carnage in status quo political systems goes beyond what we’d call “realigning elections”, like Reagan in 1980 converting the formerly solid Democratic Southern states to a solid Republican bloc. It’s a rethinking of what party politics MEANS in France, Italy, and the United States (and with the UK, Spain, the Netherlands, and maybe Germany not too far behind). The last person to accomplish what Emmanuel Macron did in France? The whole “let’s start a new political party and win an election in two months” thing? That would be Charles de Gaulle in 1958 and the establishment of the Fifth Republic. The last person to accomplish what Donald Trump did in the U.S.? The whole “let’s overthrow an old political party from the inside and win an election in two months” thing? I dunno. Never? Andrew Jackson?
Now don’t get me wrong. Do I think Emmanuel Macron, a former Rothschild investment banker whose “ambition was always two steps ahead of his experience”, is the second coming of Charles de Gaulle? Do I think Donald freakin’ Trump is a modern day Andrew Jackson? Bwa-ha-ha-ha-ha-ha … good one!
But here’s what I do think:
- Something old and powerful is happening in the real world to crush the status quo political systems of every Western democracy.
- Something predictably sad is happening in the political world to replace the old guard candidates with self-absorbed plutocrats like Trump and pretty boy bankers like Macron.
- Something new and powerful is happening in the investment world to divorce political risk and volatility from market risk and volatility.
The old force repeating itself in the real world is nicely summed up by these two charts, the most important charts I know. They’re specific to the U.S., but applicable everywhere in the West.
First, the Central Banker’s Bubble since March 2009 and the launch of QE1 has inflated U.S. household wealth far beyond what the nominal growth rate of the U.S. economy would otherwise support. This is a classic bubble in every sense of the word, with the primary difference from prior vast bubbles being its concentration and focus in financial assets — stocks and bonds — which are held primarily by the rich. Who wins the Academy Award for creation of wealth inequality in a supporting role? Ladies and gentlemen, I give you the U.S. Federal Reserve.
Source: Bloomberg LP and TCW, as of 12/31/16. For illustrative purposes only. Past performance is no guarantee of future results.
And as the second chart shows, this central bank largesse has sharply accelerated the massive shift in wealth to the Rich from the Rest, a shift which began in the 1980s with the Reagan Revolution. We are now back to where we were in the 1930s, where the household wealth of the bottom 90% of U.S. wage earners is equal to the household wealth of the top one-tenth of one percent of U.S. wage earners.
For illustrative purposes only.
So look … I’m not saying that the current level or dynamics of wealth inequality is a good thing or a bad thing. I’m just saying that it IS. And I understand that there are insurance programs today, like social security and pension funds, which are not reflected in this chart and didn’t exist in the 1930s, the last time you saw this sort of wealth inequality. I understand that there are a lot more people in the United States today than in the 1930s. I understand that there are all sorts of important differences in the nature of wealth distribution between today and the 1930s. I get all that. What I’m saying, though, is that just like in the 1930s, there is a political price to be paid for this level of wealth inequality. That price is political polarization and electoral rejection of status quo parties. I won’t give the whole history lesson here, as it’s a good excuse for readers to immerse themselves in Wikipedia for half an hour or so and read about guys like Father Coughlin, but the rhyming of political history in Western democracies between the late-1920s/early-1930s and today, particularly in the way that status quo political parties were subverted or overthrown or just plain eliminated throughout Westworld is … pretty amazing.
Western democracies, mixing a healthy dash of popular political representation with a big dose of capitalist economic structures, are extremely good at the most important driver of social stability: co-opting the more talented members of a mass society into the status quo system, bringing new blood into that top two percent socioeconomic club who might otherwise apply their talents in more subversive ways. Maybe not the top one-tenth of one percent on a purely financial wherewithal scale, but definitely the top two percent on a more broadly defined socioeconomic scale of wealth, stability, and influence. That co-opting process is the steam valve for Western societies, and it has two components, particularly in the most successful Western society, the United States — educational mobility (move to where the good intellectual jobs are) and labor mobility (move to where the good physical jobs are). Educational mobility, spurred in the U.S. by more than $1 trillion in government-backed student loans, is in high gear, and the importance of an educational pedigree to get into the 2% Club has NEVER been greater. Labor mobility, on the other hand, crushed by globalization and the housing crisis, hasn’t been this broken since … yep … the 1930s.
As a result, the composition of the 2% Club of wealth, stability, and influence is changing. Today it’s almost entirely a Club of the educationally mobile and accomplished, the people who deal with symbols for a living — words and tickers and numbers and code — and whose language and lingo is similarly abstracted. And because our status quo political institutions, like political parties, are in all nations and in all times the top-down creations of the 2% Club, our political parties themselves speak a different language today than they did even 10 or 20 years ago. No political party is immune, regardless of where it sits on the traditional left/right spectrum. This isn’t a Republican vs. Democrat thing. It’s not a rich vs. poor thing, either, because there are plenty of rich people who aren’t symbol manipulators and are feeling less and less at home in the 2% Club. It’s a who’s-dominating-the-2%-Club thing, and in Westworld that’s the educationally accomplished symbol manipulators.
Our status quo political parties speak well and clearly to the 2% Club and their educationally mobile circles, not so well to the guy who didn’t go to law school and whose kids don’t have a prayer of getting into Stanford. Not so well to the guy who, to be honest, kinda hates lawyers and the professional symbol manipulators, and definitely hates anyone who went to Stanford. Not so well to, as Amity Shlaes titled her seminal history of the 1930s and the Great Depression, the Forgotten Man, citizens who — today and in the 1930s — are well and truly stuck. Stuck because labor mobility is broken. Stuck because their wages are flat and their debt is up. Stuck because they’re getting older. Stuck because, like the sailors on the Battleship Potemkin, they are served disgusting, rotten meat but are told by the well-spoken professionals that these are dead fly larvae, not live maggots, and so they can simply be washed off with salty water. Stuck because the entire political system is rigged for the educationally mobile and the symbol manipulators. Not rigged in a cartoon evil sense, but rigged in the same way that the German system is rigged in favor of people who speak German and the Chinese system is rigged in favor of people who speak Chinese. Don’t speak Symbol Manipulation? Sorry, but the status quo Western political system is rigged against you. And you know it.
There’s no attachment to a political party that from your perspective is speaking gibberish. The attachment is to change and reversion. The attachment is to Something Else. The Something Else will not have a well-considered or coherent policy wrapper. It won’t look smart. It didn’t in the 1930s and it doesn’t today. Why not? Because if it did, it would be co-opted as part of the status quo! Words like “well-considered” and “coherent” and even “policy” are the abstracted words of the modern status quo. They are the language of the 2% Club, particularly of an educationally mobile 2% Club, and it’s a very different language than that spoken by anyone hailing from the world of physical construction and manipulation rather than symbol construction and manipulation.
So what is this other language? Importantly, as Joan Williams describes in her phenomenal article, “What So Many People Don’t Get About the U.S. Working Class,” it’s not a soak-the-rich language (in fact, it’s more disparaging of the poor than the rich). It’s a non-abstracted language of direct, physical involvement in localized social behaviors (what Nassim Taleb calls “Skin in the Game”), because that’s the language that has meaning for anyone who depends on labor mobility and physical construction to make a better life for themselves and their kids. It’s an uncomfortable language for the educationally mobile 2% Club, because it doesn’t abstract away the racist, sexist corners of real world, localized social behaviors and beliefs in a carefully constructed linguistic architecture. That doesn’t mean that the Forgotten Man is necessarily racist or sexist (doesn’t mean that he’s not, either). It means that these are not behaviorally motivating or politically meaningful words to a major sub-population. It means that our language defines and constrains our thoughts and behavior, not the other way around. It means that we ARE our grammar, at least in our lives as social animals. It means that the Confusion of Tongues is not just a quaint Old Testament story with cool Gustave Doré engravings about some apocryphal Tower of Babel.
It is THE political story of this or any other age, and it always leads to a radical restructuring of the political order, because you cannot have a stable political equilibrium where a critical mass of national sub-populations speak different social languages.
But that’s where we are in every Western nation in 2017. The politically ascendant sub-population on the educational mobility track hear the language of the Other and say “Unacceptable people. Must resist. Zero-sum game.” The politically stuck sub-population on the labor mobility track hear the language of the Other and say “Bad hombres. Must fight. Take no prisoners.” The center cannot hold. More accurately, there is no center, no cooperation. Competition is all, and that’s no way to run a country.
Unfortunately and unsurprisingly, the new political leaders who emerge from a collapse of the Tower of Babel are rarely the champions of the Forgotten Man that you might think would emerge. Both in the 1930s and today, there’s no shortage of non-status quo political entrepreneurs who speak the language of the politically stuck and are willing to put themselves out into the political arena. But to be successful in their political entrepreneurship it’s almost essential that these new candidates be card-carrying members of the 1/10th of 1% Rich Club. Why? Because it requires an insane amount of money and sheer notoriety to replace the machinery of a status quo political party in a mass society. A political party is a media company. By joining a status quo party and toeing that party line, you communicate an enormous set of signals to potential voters for free. But by toeing that party line, you lose your Forgotten Man authenticity and any hope of being the champion of Something Else. Want to be a “change candidate”? Better make a couple of billion dollars first, or have plenty of billionaire friends, so you can afford to bypass the status quo political party.
Little wonder, then, that Donald Trump, a billionaire TV star, succeeds in overthrowing the Republican Party. Little wonder that Emmanuel Macron taps a vast banker network from across Europe to fund his campaign. Little wonder that zillionaire Mark Zuckerberg has embarked on a nationwide “listening tour”, complete with equal zillions of photo ops — none of which are with educationally mobile symbol manipulators — as he prepares for a political life. Good old-fashioned mustachioed fascism may work in Turkey, but here in the U.S. you need a smiley-face with your Panopticon. Sharing is caring!
So that’s my political take: the old and powerful Tower of Babel process is starting up again, and status quo political institutions are not long for this world. As we move to the Something Else to come, we’ll have to endure a parade of billionaires wielding political power in unprecedented ways, aided by unprecedented technologies of social control. That’s the Big Risk for everyone reading this note, regardless of your politics, regardless of your social language, regardless of your vision of the life well lived. That’s the Big Risk we have to manage, as investors and as citizens.
So how do we do THAT?
For today’s note, I’m focusing on the investor side of that question, and that means focusing on the one Big Question: as the Western status quo political system collapses into Something Else, how is it possible that our capital markets are not similarly gripped by volatility and stress? What is responsible for breaking the transmission mechanism from political risk to market risk?
I’ve got a macro answer and I’ve got a micro answer.
The macro answer is that you need status quo political parties to govern a country effectively. Thankfully, there are only enough billionaire candidates of Something Else to fill the top of the ticket, and even if there were more, a party of independently wealthy and independently popular mavericks isn’t a coherent party at all. There’s not less gridlock with an essentially party-less American president or an essentially party-less French president, there’s MORE gridlock. And that means that any sort of fiscal policy — whether it’s a clear-the-decks debt assignment or a classic stimulus program or whatever — is more difficult under this sort of independent political regime than in a status quo regime.
Sure, there’s a lot of excitement when the Stranger comes to town. Take a look at what happened to the U.S. 10-year bond after Trump was elected.
Source: Bloomberg LP, as of 04/10/17. For illustrative purposes only. Past performance is no guarantee of future results.
But excitement fades as fiscal policy promise fades to fiscal policy deadlock. When I look at Washington today, or London or Paris or Rome or wherever, it sure looks for all the world like a return to our regularly scheduled entertainment. Nature abhors a vacuum, and politics is no exception. In the absence of an active and effective fiscal policy authority, global monetary policy authorities will fill the policy void. And what is their policy? Refer to chart 1 at the start of the note, please. Low growth. Financial asset inflation. Low volatility. Wash, rinse, repeat. The new Goldilocks, now eight years old. Could go for another eight years, easy. Wheeee!
Yes, there’s enormous political risk associated with the collapse of status quo political institutions and the rise of the Trumps and the Macrons of the world. But …
- for financial markets, these new leaders are familiar, encouraging faces. They’re members of the 1/10th of 1% Rich Club, because they had to be to sidestep status quo political parties. Moreover,
- there’s going to be a hope and a promise of fiscal policy initiatives, and that’s a tailwind for markets, too. And finally,
- don’t worry, Mr. Market, when that hope and promise of pro-growth policy fades into the realization of anti-growth gridlock, our old friends Janet and Mario will be there to pick up the slack with more liquidity.
That’s my macro story for the divorce of political risk from market risk, and I’m sticking to it. Where does it break down? Not with a funky German or Italian election, but with Janet and Mario declaring victory and taking away the punchbowl. That’s what will bring political risk back to markets.
On the micro side, it’s the triumph of Communication Policy, just as far as the eye can see. I’ve written a lot about Communication Policy in the past, here, here, here, and here. It’s what the Fed calls their use of words and public statements for effect, as a specific policy tool designed to influence investor behavior rather than to communicate truthful information. You know … what we would call lying in other circumstances. As Ben Bernanke said in one of his last speeches as Fed Chair, Communication Policy (“enhanced forward guidance”) has been the star of the show since quantitative easing lost its mojo with the QE2 program. Making up narratives and telling them convincingly has worked for politicians for, oh, several thousand years. I suppose the only surprising thing is that it took central bankers so long to get in on the act. Today it’s their primary shtick.
But now that politicians and central bankers have demonstrated the incredible efficacy of what game theory calls Missionary Statements — the intentional construction of common knowledge through highly mediated statements — everyone wants in on the act. Everyone wants to be a Missionary for their own institutional ends. And that Everyone definitely includes Wall Street.
Here’s what I’ve noticed in the past two major political risk events in Western markets — the Italian referendum on December 5 and the French first round election on April 23. In both cases, the most political risk-impacted equity markets began to rally sharply three or four days BEFORE the vote.
Source: Bloomberg LP, as of 05/03/17. For illustrative purposes only. Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The indices are unmanaged and are not available for direct investment.
The top chart is the European bank equity index before and after the French vote. Below is the price chart of the broad Italian equity index before and after their referendum.
Source: Bloomberg LP, as of 05/03/17. For illustrative purposes only. Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The indices are unmanaged and are not available for direct investment.
In both cases the bottom was reached well before the actual event. Why? Because in both cases the sell-side research machine — all the chief economists and chief strategists and acolytes of all the big Wall Street firms — began churning out a flood of Missionary Statements designed to create a positive narrative around a potentially very negative (for markets) political risk event. Ditto with the U.S. election, where the positive narrative around Trump began a full week before the election (see “American Hustle” for the full Narrative Machine description).
I mean, the effort to create a positive narrative out of whole cloth would be comical if it weren’t so seriously impactful. My personal fave on the Wednesday before the French vote was a bulge bracket strategist who shall go nameless, writing to say that a Le Pen victory wouldn’t really be that bad of a thing for markets in general and the banks in particular, because if she won there could well be a massive run on the French banks, which means that Le Pen would have to backtrack on her anti-euro stance to prevent a complete economic collapse. So buy now!
My first reaction to this avalanche of positive Narrative construction was indignation, tinged with a little anger. Give me a break! Markets are getting a little squirrelly going into the vote, and so you’re going to start pumping out this drivel? My reaction was what John Maynard Keynes, who was at least as good a game theorist and investor as he was a macroeconomist, would have called a first level response to a Missionary statement — I’m right and the Missionary is wrong! This is the human, natural response. It’s also a losing response if you want to play the game of markets successfully.
As Keynes explained so smartly with his parable of the Newspaper Beauty Contest, you don’t make money by holding firm to your personal opinion of who’s the prettiest girl or what’s the most attractive stock. You don’t even make money by identifying the consensus view of who’s the prettiest or what’s the right answer to a market question, because all of us are smart enough to be looking for the consensus view. No, you make money by getting ahead of the formation of the consensus view through Missionary statements, even if your personal view is that the Missionary is dead wrong in their assessment of pretty girls or attractive stocks or market outcomes. Would you rather be right or would you rather make money? Back in my younger days I didn’t think there was a conflict between the two. Now I know better. Once the Wall Street Missionaries started their Narrative blitz, it didn’t matter that I believed (and still believe!) that an anti-status quo Italian referendum creates a systemic risk for the European banking system. I wasn’t going to get paid for that view, even if the anti-status quo vote won (it did) and even if I’m objectively correct about the risk (we’ll see). Frustrating? Sure. But in the immortal words of Hyman Roth, this is the business we have chosen.
It’s this micro explanation of the divorce between political risk and market risk that I think will prove to have the most long-lasting impact on investor behavior. You know, I started writing Epsilon Theory because Mario Draghi kicked me in the teeth in the summer of 2012 with the pretty words of his mythical OMT program. I couldn’t believe that mere narrative could be so powerful. But it is. It’s the most powerful thing in the world. Bad enough that politicians have wielded this power for centuries. Worse that Central Bankers have recently proven to be such adepts. Now that Wall Street and the global banking synod have fully embraced the dark narrative arts? Katy bar the door. Even when the androids of Westworld knew it was just a story, they were hard-wired to respond. So are we.
So put it all together and what do we have? As a citizen I’m on high alert. Political volatility is only going to get worse in Westworld. But as an investor my systemic risk antennae are pretty quiet. Is there stuff to do, long and short? Sure, particularly away from Westworld. But until and unless Draghi starts to taper and Yellen looks to hang a recession around the Donald’s neck with beyond-tapering balance sheet reduction, I don’t see how political risk translates into market risk. And even then you’ve got a powerful volatility reducer in the self-interested Narrative creation of every Wall Street Missionary. Will it last forever? Of course not. The Missionaries, both on Wall Street and in Central Banks, are only human. Inevitably they will disappoint us. Let’s just try not to have a gun pointed at our heads when they do.
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The essence of ultimate decision remains impenetrable to the observer — often, indeed, to the decider himself.
― John F. Kennedy (1917 – 1963)
I have found that the best way to give advice to your children is to find out what they want and then advise them to do it.
―Harry Truman (1884 – 1972)
As far as I was concerned, his decision was one of non-interference — basically, a decision not to upset the existing plans.
―Lt. Gen. Leslie Groves (1896 – 1970), commanding officer of the Manhattan Project, discussing Truman’s okay to drop atomic weapons on both Hiroshima and Nagasaki.
“Ah,” she cried, “you look so cool!”
Their eyes met, and they stared together at each other, alone in space. With an effort she glanced down at the table.
“You always look so cool,” she repeated.
She had told him that she loved him, and Tom Buchanan saw.
― F. Scott Fitzgerald, “The Great Gatsby” (1925)
And that was the end of the party. When Tom Buchanan saw.
|Lear:||Create her child of spleen, that it may live
And be a thwart disnatur’d torment to her!
Let it stamp wrinkles in her brow of youth,
With cadent tears fret channels in her cheeks,
Turn all her mother’s pains and benefits
To laughter and contempt, that she may feel
How sharper than a serpent’s tooth it is
To have a thankless child!
|― William Shakespeare, “King Lear” Act 1 Scene 4 (1606)|
Once-revered central bank failed to foresee the crisis and has struggled in its aftermath, fostering the rise of populism and distrust of institutions.
― Jon Hilsenrath, “The Great Unraveling: Years of Missteps Fueled Disillusion with the Economy and Washington” (August 26, 2016)
|John Hale:||Theology, sir, is a fortress; no crack in a fortress may be accounted small.|
|― Arthur Miller, “The Crucible” (1953)|
Few of us can easily surrender our belief that society must somehow make sense. The thought that the State has lost its mind and is punishing so many innocent people is intolerable. And so the evidence has to be internally denied.
The structure of a play is always the story of how the birds came home to roost.
That’s a very good question. I don’t know the answer. But can you tell me the name of a classical Greek shoemaker?
― Arthur Miller (1915 – 2005)
That last, one of my all-time favorite quotes, was in response to a shoe manufacturer who asked why Miller’s job should be subsidized while his was not. Miller’s finest accomplishment: when McCarthy and crew forced him to testify in their Communist witch hunt, he refused to name names. Miller was a leftie and a huge ego. And a freedom lover. Imagine that.
Yet each man kills the thing he loves
By each let this be heard
Some do it with a bitter look
Some with a flattering word
The coward does it with a kiss
The brave man with a sword
― Oscar Wilde, “The Ballad of Reading Gaol” (1898)
We’ll get the kiss, not the sword. Don’t know when, but it’s going to kill this market that the Fed loves.
In 1969, Graham Allison published an academic paper about the Cuban Missile Crisis, which he turned into a 1971 book called Essence of Decision. That book made Allison’s career. More than that, the book provided a raison d’être for the Kennedy School of Government at Harvard, which — combined with Allison’s fundraising prowess — transformed a sleepy research institute into the most prominent public policy school in the world.
The central idea of Essence of Decision is this: the dominant academic theory to explain the world’s events is a high-level, rational expectations model based on formal economics, a theory that ignores the impact of bureaucratic imperatives and institutional politics. If you look at the Cuban Missile Crisis through all three lenses, however, you get a much better picture of what actually happened in October 1962. In fact, the more you dig into the Cuban Missile Crisis, the more it seems that the actual people involved (on both sides … Allison wrote a follow-up edition in 1999 when Russian archives opened up post-Gorbachev) made their actual decisions based on where they sat (bureaucracy) and where they stood (internal politics), not on some bloodless economic model. Publicly and after the fact, JFK and RFK and all the others mouthed the right words about geopolitical this and macroeconomic that, but when you look at the transcripts of the meetings (Nixon wasn’t the first to tape Oval Office conversations), it’s a totally different story.
Allison’s conclusion: the economic Rational Actor model is a tautology — meaning it is impossible to disprove — but that’s exactly why it doesn’t do you much good if you want to explain what happened or predict what’s next. It’s not that the formal economic models are wrong. By definition and by design, they can never be wrong! It’s that the models are used principally as ex-post rationalizations for decisions that are actually made under far more human, far more social inputs. Any big policy decision — whether it’s to order a naval blockade or an air strike on Cuba, or whether it’s to drop atomic bombs on Hiroshima AND Nagasaki, or whether it’s to raise interest rates in September or December or not at all — is a combination of all three of these perspectives. But for Allison’s money, we’d do better if we focused more on the bureaucratic and political perspectives, less on the rational expectations perspective.
Allison is writing this in 1969! And here we are, almost 50 years later, still consumed by a theology of formal economic models, still convinced that Fed decision-making can be explained or predicted by our armchair analysis of Taylor Rule inputs. From an anthropological perspective, it’s pretty impressive how the high priests of academic economics have expanded their rule. From a human perspective, it’s awfully depressing.
What follows is my analysis of the Fed’s forthcoming decision on interest rates from a bureaucratic and an internal politics perspective. Seen through these lenses, I think they hike. Maybe I’m wrong. These things are always probabilistic shades of gray, never black and white. But what I’m certain about is that the bureaucratic and internal politics perspectives give a different, higher probability of hiking than the rational expectations/modeling perspective. So heads up.
First the bureaucratic perspective.
What I’m calling the bureaucratic perspective, Allison calls the “Organizational Behavior” perspective. His phrase is better. It’s better because entities like the Federal Reserve are, of course, large bureaucracies, but what we’re trying to analyze here is not the level of do-nothing inertia that we usually associate with the word “bureaucracy”. What we’re trying to analyze is the spirit or culture of the organization in question. What is the institutional memory of the Fed? What do personnel, not just the Fed governors but also the rank-and-file staffers, believe is the proper role of the institution? Most importantly, how do these personnel seek to protect their organization and grow its influence within the jungle of other organizations seeking to grow their influence?
The spirit, culture, and personnel composition of the modern Federal Reserve is almost identical to that of a large research university. That’s not a novel observation on my part, but a 30-year evolution commonly noted by Fed watchers. Why is this important? It’s important because it means that the current marriage between Fed and markets is a marriage of convenience. As an organization, the Fed doesn’t really care whether or not markets go up or down, and as an institution it’s not motivated by making money (or whether or not anyone else makes money). Like all research universities, the Fed at the organizational level is motivated almost entirely by reputation. Not results. Reputation. A choice between “markets up but reputation fraying” and “markets down but reputation preserved” is no choice at all. The Fed will choose the latter 100% of the time. I can’t emphasize this point strongly enough. From a bureaucratic perspective, the Fed absolutely Does. Not. Care. whether or not the market goes up, down, or sideways. When they talk about “risk” associated with their policy choices, they mean risk to their institutional reputation, not risk to financial asset prices. And today, after more than two years of a “tightening bias” and “data dependency”, there’s more reputational risk associated with staying pat than with raising rates in a one-and-done manner.
Why? Because the public Narrative around extraordinary monetary policy and quantitative easing has steadily become more and more negative over the past three years, and the public Narrative around negative rates in particular is now overwhelmingly in opposition. When I did my Narrative analysis of financial press sentiment surrounding Brexit prior to that vote, I always thought that would be the most hated thing I’d ever see. Nope. I’ll append the Quid maps and analysis at the end of this note for those who are interested in digging in, but here’s the skinny: the negative sentiment around negative rates is now greater than the negative sentiment around Brexit. The public Narrative around ever more accommodative monetary policy has completely turned against the Fed. And they know it.
It’s not only the overall Narrative network that has turned with a vengeance against the Fed, but also some of the most prominent Missionaries, to use the game theoretic term. Over the last few weeks we’ve seen Larry Summers take Janet Yellen directly to task, as the runner-up in the Obama Administration Fed Chair sweepstakes has apparently taken to heart the old adage that revenge is a dish best served cold. More cuttingly, if you’re Yellen, is the heel turn by Fed confidante and WSJ writer Jon Hilsenrath. His August 26th hit piece on the Yellen Fed feature article — “The Great Unraveling: Years of Missteps Fueled Disillusion with the Economy and Washington” — is the unkindest cut of them all.
I think that Summers has been emboldened and Hilsenrath has been turned because they’re picking up on the same sea change in public opinion that the Quid analysis is identifying with more precision. For Hilsenrath, here’s the centerpiece of his j’accuse: a long-running Gallup poll asking Americans to rate the relative competence of federal agencies. Yep, that’s right, the Fed — which used to have a better reputation than the FBI and NASA — is now at the absolute bottom of the heap, dragging behind (by a significant margin) even the IRS! It’s one thing to bring up the rear in 2009 polls, what with the immediate aftermath of the deepest recession in 70+ years. But to still be at the bottom in 2014 after a stock market triples (!) and The Longest Expansion In Modern American History™? Incredible. And the most recent poll was in 2014. If anything, the Fed’s reputation is even lower today. I mean … this is really striking, and I can promise you that none of this is lost on the current custodians of the Fed’s prestige and reputation. Or, like Summers, the wannabe custodians. If you’re a professional academic politician like Summers, you can smell the blood in the water.
How Americans Rate Federal Agencies
Share of respondents who said each agency was doing either a ‘good’ or ‘excellent’ job, for the eight agencies for which consistent numbers were available.
Source: Gallup telephone polls, most recently 1,020 U.S. adults conducted Nov. 11—12, 2014, with a margin of error of +/-4 percentage points. As reported by the Wall Street Journal.
So what does all this mean for the September FOMC meeting?
Look … does “the market” want more and more supportive policy? Of course it does. We’re addicts. But if the Fed takes a dovish stance now — and anything less than a hike is going to be perceived as a dovish stance — from an organizational perspective the Fed is risking a lot more than a market sell-off from a rate hike. It risks being blamed for anything bad that happens in the economy going forward. This is the risk of being an unpopular political actor. This is the risk of losing your reputation for competence. The Golden Rule of organizational behavior is quite simple: there must ALWAYS be plausible deniability for culpability if something goes wrong. There must ALWAYS be some other political actor to blame. Unless the Fed takes steps now to stem the erosion in their reputation and their position in the public Narrative, they will own this economy and the downturn that everyone (including the Fed) suspects is coming.
By raising rates now, on the other hand, the Fed can declare victory. We achieved our dual mandates of price stability and full employment! Mission accomplished! And unlike George Bush and his infamously premature declaration of same, the Fed has someone to blame when the “mission” unravels (which of course it will) — those dastardly fiscal policymakers who didn’t follow up with structural reforms or pro-growth policies or whatever when they were elected this November. While the consensus view is that the Fed loathes to do anything to rock the market boat before the November election, in truth this meeting is the perfect time to act if your political goal is to declare victory and pass the buck. Hey, we did our part, says the Fed. Prudent stewards of monetary policy and all that. Now, about that consulting gig at Citadel …
That’s the bureaucratic or organizational perspective. Here’s the internal political dynamic as I see it.
An internal politics perspective is similarly driven by questions of reputation, but at the individual level rather than the organizational level. In an academic organization like the modern Fed, your internal reputation is based entirely on how smart you are, as evidenced by the research you do and the papers you write and the talks you give, not on how effective you are in any practical implementation of organizational aims. It’s not that the Fed or major research universities are intentionally ignoring or trying to put down practical implementations like teaching or outreach to commercial bank staffers, but every hour you spend doing that is an hour you’re not spending impressing your colleagues and bosses with how smart you are. It’s just how the internal political game is played, and anyone who has achieved any measure of success in an organization like this knows exactly what I’m talking about.
What this means in practice is that FOMC meetings are driven by a desire to form a consensus with the other smart people around the table, so that each of you is recognized by the other members of the consensus as being smart enough to be a member of the consensus. It’s the precise opposite of the old Groucho Marx joke: “I don’t want to be a member of any club that would have me as a member.” Every FOMC member desperately wants to be a member of the club that would have him or her as a member, because it means that you’ve been recognized as one of the smart kids. The internal political dynamic of academic cultures like the Fed, at least at the highest levels of Governor to Governor interaction, is NOT antagonistic or divisive. On the contrary, it’s cooperative and consensus-forming.
Not sure what I’m talking about? Read this Jon Hilsenrath interview of St. Louis Fed Governor Jim Bullard again (I say again because I published it for other reasons in the last Epsilon Theory note, Magical Thinking), where Bullard describes this consensus building dynamic.
|Mr. Hilsenrath:||What kind of compromise would it take to get the FOMC to move in September? I mean, so the tradition is there’s some kind of — like you say, some kind of agreement. What would it take to get them there?|
|Mr. Bullard:||Well, I have no idea, so — and it’s really — it’s really the chair’s job to fashion that. But I will say that — I’ll talk historically about the FOMC, the kinds of things that the FOMC would do. You would trade off. You would say, OK, we could hike today, but then we’ll not plan to do anything in the future. That would be one way to — one way to go about a consensus. So that often happens on the FOMC. Or vice versa. If you read the Greenspan-era transcripts, he’ll do things like, OK, we won’t go today, but we’ll kind of hint that we’re pretty sure we’re going to go next time.|
|Mr. Bullard:||And so you get this inter-tempo kind of trade-off, and that often — that often is enough to get people to sign up.|
|Mr. Hilsenrath:||So, hike today and then delay.|
|Mr. Bullard:||Yeah. (Laughs.)|
|Mr. Hilsenrath:||Or, no hike today and then no more delay.|
|Mr. Bullard:||Yeah, yeah.|
|Mr. Hilsenrath:||Something like that.|
|Mr. Bullard:||Yeah, those kinds of trade-offs are, historically speaking — I’m not saying I know what Janet’s doing, because I don’t. But, historically speaking, those are the kinds of things that the FOMC has done.|
|Mr. Hilsenrath:||I came up with my catchphrase for the — for the month. (Laughter.)|
|Mr. Bullard:||Those are great. That’s worthy of a T-shirt. (Laughs, laughter.) You could have one on the front and one on the back.|
|Ms. Torry:||Or a headline.|
|Mr. Hilsenrath:||Well, that’s the St. Louis framework now, right?|
|Mr. Hilsenrath:||Hike today and then delay.|
|Mr. Bullard:||Yeah. That’s what it would be, yeah.|
|― Wall Street Journal, “Transcript: St. Louis Fed’s James Bullard’s Interview from Jackson Hole, Wyo.” (August 27, 2016)|
What Bullard is describing from a game theoretic perspective is a dual-equilibrium coordination game. Either it’s “Hike today and then delay” (Bullard’s preferred equilibrium outcome) or “No hike today and then no more delay”. Those are the two possible consensus outcomes. Both are stable equilibria, meaning that once you get a consensus at either phrase, there is no incentive for anyone to change his or her mind and leave the consensus. Importantly, both are robust equilibria in their gameplay, meaning that it only takes one or two high-reputation players in the group to commit to one outcome or the other in order to start attracting more and more reputation-seeking players to that same outcome. You can think of individual reputation as a gravitational pull, so that even a proto-consensus of a few will start to draw others into their orbit.
It’s always really tough to predict one equilibrium over another as the outcome in a multi-equilibrium game, because the decision-making dynamic is solely driven by characteristics internal to the group, meaning that there is ZERO predictive value in our evaluations of external characteristics like Taylor Rule inputs in 2016 or US/Soviet nuclear arsenals in 1962. (I wrote about this at length in the context of games of Chicken, like Germany vs. Greece or the Fed vs. the PBOC, in the note Inherent Vice). But my sense — and it’s only a sense — is that the “Hike today and then delay” equilibrium is a more likely outcome of the September meeting than “No hike today and then no more delay”. Why? Because it’s the position both a hawk like Fischer and a dove like Bullard, both of whom are high-reputation members, would clearly prefer. If one of these guys stakes out this position early in the meeting, such that “Hike today and then delay” is the first mover in establishing a “gravitational pull” on other members, I think it sticks. Or at least that’s how I would play the game, if I were Fischer or Bullard.
Okay, Ben, fair enough. If you’re right, though, what do we do about it? How are markets likely to react to the shock of a largely unanticipated rate hike?
In the short term, I don’t think there’s much doubt that it would be a negative shock, because as I write this the implied “market odds” of a rate hike here in September are not even 20%. My analysis suggests that the true odds are about three times that, as I give a slight edge to the “Hike today and then delay” equilibrium over “No hike today and then no more delay”. Do I think it’s a sure thing that they hike next week? Give me a break. Of course I don’t. But if I can be dealt enough hands where the true odds of something occurring are three times the market odds of something occurring …
The medium-to-long term market reaction to whatever the Fed decides next week is going to be driven less by the hike-or-no-hike decision and more by the Fed-directed Narrative that accompanies that rates decision. That is, if they hike next week and start talking about how this is the next step of a “normalization” process where the Fed will try to get rates back up to 3% or 4% in a couple of years … well, that’s a disaster for markets. That’s a repeat of the December rate hike fiasco, and you’ll see a repeat of the January-February horror show, where the dollar is way up, commodities and emerging markets are way down, and everyone starts freaking out over China and systemic risk again. But if they hike next week and start talking about how they’re rethinking the whole idea of normalization, that maybe rates will be super-low on a semi-permanent basis, or at least until productivity magically starts to improve … well, that’s maybe not such a disaster for markets. Ditto if they don’t hike next week. If the jawboning associated with a no-hike in September sets up a yes-hike in December as a foregone conclusion, that’s probably just as bad (if not worse) for markets than a shock today.
Of course, the Fed is well aware of the power of their “communication policy” and the control it exerts over market behavior. Which means that whenever the Fed hikes — whether it’s next week or next month or next meeting or next year — they’re going to sugarcoat the decision for markets. They’re going to fall all over themselves saying that they’re still oh-so supportive of markets. They’re going to proclaim their undying love for markets even as they take actions to distance themselves.
But here’s the thing. The Fed is now revealing its one True Love — its own reputation and its own political standing — and that’s going to be a bombshell revelation to investors who think that the Fed loves them. Investors are like Tom Buchanan in The Great Gatsby. We’re married to this really swell girl, and we get invited to these really great parties, but then we see that Daisy is truly in love with Jay Gatsby, not us. And everything changes. Maybe not on the surface, but deep down, where it really matters. I’m not saying that the Fed abandons the markets. After all, Daisy stays married to Tom. But everything changes in that moment of realization that she truly loves someone else, not you, and that’s what the next Fed hike will mean to markets.
That’s when the party stops.
Appendix: Quid Narrative Analysis
For a recap of how I’m using the Quid tool kit to analyze financial media narrative formation and evolution, please refer to the Epsilon Theory note The Narrative Machine. Below are two slides from Quid providing a quick background on the process.
Here’s the network of all 941 Bloomberg articles over the past year mentioning negative rates, colored by topic cluster:
This is a prototypical focused narrative network, indicative of articles that are truly “about” negative rates, as opposed to articles about something else that provides the clustering characteristics and only mention negative rates in passing. So now let’s look at the same network, but colored by sentiment rather than by topic clustering.
Fully 50% of the articles are negative, 42% neutral, and only 7% are positive in their sentiment.
How does this compare to other Bloomberg networks and other sentiment scores? Horribly. The only subject issue that even comes close is Brexit, with 47% negative, 42% neutral, and 10% positive in the weeks leading up to the vote. Post-vote, the negative sentiment around Brexit drops to the mid-twenties.
To be sure, few topics associated with monetary policy have an overtly positive sentiment distribution, at least in recent years. For example, here’s a chart of the Quid sentiment scores for all Bloomberg articles mentioning Quantitative Easing (QE), by year over the past three years. The Narrative is steadily deteriorating, but we’re still not close to negative articles taking the lead over neutral articles.
Sentiment Scores for Bloomberg Articles Mentioning QE, by Year
|9/13 – 9/14||9/14 – 9/15||9/15 – 9/16|
One final network observation. Of the positively-oriented Bloomberg articles, they tend to cluster in the topic circled below. That topic? Gold. The articles have a positive sentiment because negative rates are great for gold prices. Of course, that’s a very negative thing from the Fed’s reputational perspective, which means that many of the articles that speak positively about negative rates are actually intimating something negative about central bankers! Bottom line: there is no more hated policy initiative in the world than negative rates.
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