Submitted by Guy Haselmann of Scotiabank
The Herd Mentality – The Left Tail Will Follow the Right Tail
Last Friday in NY, I attended a fabulous Monetary Policy Forum sponsored by the Initiative on Global Markets, a thought-leadership-medium set-up within the University of Chicago Booth School of Business. This annual event is increasingly being viewed as ‘Jackson Hole East’. Eight current members of the FOMC were in attendance including Stanley Fischer (not yet confirmed). Former Treasury Secretary Robert Rubin gave the keynote lunch address.
Each year the conference begins with a highly-topical report co-authored by a few economists and academics, and which serves as the basis for initial discussion. This year’s paper was entitled “Market Tantrums and Monetary Policy” (on website). The paper was successful at proving that there is the potential for financial instability even with subdued leverage in the banking system.
The authors drew five conclusions:
1) the absence of leverage in the banking system is not a sufficient reason for Monetary Policy to disregard concerns for financial stability
2) the usual macroprudential toolkit does not address instability driven by non-leveraged or non-bank investors;
3) forward guidance (like ZIRP – my words) can encourage risk taking that can lead to risk reversals;
4) financial instability need not be associated with insolvency of financial institutions; and
5) Tradeoffs for monetary policy are more difficult than portrayed.
The tradeoff is not the contemporaneous one between more versus less policy stimulus today, but is better understood as an intertemporal tradeoff between more stimulus today at the expense of more challenging and disruptive policy exit in the future.
The paper did not comment on how policy makers fundamentally assess and mollify the tradeoff between attempts at stimulating real economic activity and financial stability. I was surprised that Fed officials so openly admitted their policies cause moral hazard problems and power the ‘search for yield’. One interesting point is that Fed officials seem to tacitly admit that supervisory tools alone may be insufficient to protect markets against excessive risk-taking and that monetary tools may be required.
The word “tantrums” referenced in the title was the paper’s attempt to explain adverse market reactions, e.g., last year’s reaction from ‘taper-talk’. The authors stated that risk premiums can jump quickly, simply because non-bank market participants (read: mutual funds) are motivated by their peer performance rank. The authors had 3 subsequent conclusions:
1) the relative peerperformance race causes momentum in return;
2) return chasing can reverse sharply; and
3) changes in the stance of monetary policy can trigger heavy fund inflows and outflows.
These conclusions partially explain (empirically) the herd mentality and momentum in recent years behind tight credit spreads and elevated equity prices. Investors are so fearful of missing the upside and underperforming peers that they frantically scramble to remain ahead of them (i.e., seek risk). However, the conference and paper suggests that there is a threshold point during the Fed’s attempt to normalize policy where the tide reverses and investors join in a selloff in a race to avoid being left behind. This is why I’ve been calling it the greater fool theory.
The most surprising part of the conference was Rubin’s keynote speech. Most thought he said little, but I found the topic of his speech a bit startling. Rather than speak about Washington’s messy politics or such, he basically gave a speech that criticized and questioned Fed policy.
He began by saying that forecast models don’t work; particularly with the complexities of today’s modern world. He said that it was unwise to depend too much on models and that nothing can replace experience and intuition. He said, there is never perfect information and uncertainties always exist, so decisions must be made through judgment about the probabilities of potential outcomes. He suggested that anecdotal information was as helpful as quantitative analysis. As a case in point, he mentioned a recent dinner with 10 senior corporate executives who all unanimously said that business investment and growth were sluggish.
Rubin said the Eurozone is more vulnerable than most think, especially given EM exposures. He suggested there is great tail risk that is not properly reflected in market prices. He said tail risk always exists, but it can’t be ignored. He said the best way to deal with it today given high probabilities and low risk premiums is to reduce exposures.
The last part of his speech continued to criticize the Fed in his friendly and humble way, often saying that “you know more about this than me, but….”. He thought the risks to QE3 far outweigh the benefits. He blasted Fed policy for elevating moral hazard and encouraging excessive risk taking. He commented on the unpredictable market reaction from, and difficulties in, unwinding the balance sheet and trying to normalize policy. He said the ultimate effects cannot be ascertained by models (rub it in). He blasted forward guidance as having no validity saying that it is impossible to know what is going to happen in 6 months.
Cracks in the foundation are evident. Buy Volatility.
“Two roads diverged in a wood, and I – I took the one less traveled by, and that has made all the difference” – Robert Frost