Excerpted from Artemis Capital Management letter to investors, [31]
Prisoner’s Dilemma describes when two purely rational entities may not cooperate even if it is in their best interests to do so, thereby replacing known risks for unknown risks. In an arms race when two superpowers possess the ability to destroy each other, the optimal solution is disarmament and peace. If the superpowers do not trust one another completely, the natural course of action is proliferation of conflict through nuclear armament despite great peril to all. This non-cooperation, selfishness, and conflict, ironically results in an equilibrium of peace, but with massive risk.
Global central banks are engaged in an arms race of devaluation resulting in suboptimal outcomes for all parties and greater systemic risk. In this year alone 49 central banks have cut rates or devalued their currencies to gain a competitive edge and since 2008 there have been over 600 rate cuts worldwide. Globally we have printed over 14 trillion dollars since the end of the financial crisis. The global economy did not de-leverage from the 2008 crash but instead doubled down as global debt has increased a staggering 40% since 2007. The pace of global growth is slowing with the World Bank lowering GDP projections from 3% to 2.5%, and emerging economies from China to Brazil are struggling. Global currency reserves outside the US have declined over $1 trillion USD from their peak in August 2014 as foreign central banks have sold dollars to offset the ill effects of capital flight and commodity declines.
The last time the world economy experienced declines in reserves of this magnitude was right before the crash of 2008. Cross-asset volatility is rising from the lowest levels in three decades yet markets remain complacent with the expectation that central banks will always support asset prices.
[32]
Volatility regime change is happening now and is a bad omen for a global recession and bear market.
[33]
As global central banks compete in an endless cycle of fiat devaluation an economic doomsday clock ticks closer and closer to midnight. The flames of volatility regime change and an emerging markets crisis ignited on the mere expectation of a minor increase in the US federal funds rate that never came to be. The negative global market reaction to this token removal of liquidity was remarkable.
Central banks are fearful and unwilling to normalize but artificially high valuations across asset classes cannot be sustained indefinitely absent fundamental global growth. Central banks are in a prison of their own design and we are trapped with them. The next great crash will occur when we collectively realize that the institutions that we trusted to remove risk are actually the source of it. The truth is that global central banks cannot remove extraordinary monetary accommodation without risking a complete collapse of the system, but the longer they wait the more they risk their own credibility, and the worse that inevitable collapse will be.
In the Prisoner’s Dilemma, global central banks have set up the greatest volatility trade in history.
Moral Hazard in the Prisoner’s Dilemma
A pre-emptive war describes a violent action designed to eliminate a perceived threat before it even materializes. Since 2012, the Federal Reserve have been engaged in a pre-emptive war against financial risk, and other central banks are forced to follow suit in a self-reinforcing cycle of devaluation and a mad game of Prisoner’s Dilemma. This unofficial, but clearly observable policy has the unintended consequence of socializing risk for private gain and introduces deep ‘shadow’ risks in the global economy.
Pre-emptive central banking is a very different concept than the popular idea of the “central bank put”. The classic “central bank put” refers to policy action employed in response to, but not prior to, the onset of a crisis. Rate cuts in 1987, 1998, 2007-2008, and Quantitative Easing I and II (“QE”) programs were a response to weak economic data, elevated financial stress, and large drawdowns in credit and equity markets. To differentiate, pre-emptive central banking refers to monetary action in anticipation of future financial stress to avert a market crash before it starts, even if markets appear healthy and volatility is low. In executing a pre-emptive strike on risk, policymakers rely on changes in faster moving market data (e.g. 5yr-5yr breakeven inflation) rather than slower moving fundamental economic data (e.g. CPI and unemployment). Although well intentioned, their actions have created dangerous self-reflexivity in markets by artificially suppressing volatility and encouraging rampant moral hazard. Central banks have exchanged ‘known unknowns’ for ‘unknown unknowns’ creating the potential for dangerous feedback loops.
[34]
A central bank reaction function is now fully embedded in risk premiums. Markets are pricing the supportive policy response before action is even taken. Bad news is good news and vice versa because the intervention is more important than fundamentals. Pre-emptive strikes on risk are contributing to the massive growth and popularity of any asset or strategy with a short convexity or mean reversion return profile. The unintended consequences of this massive short convexity complex will be born from phantom liquidity, shadow gamma, and self-reflexivity. In the past year alone, we have experienced 10+ sigma movements in the CBOE VIX index, US Treasury Yields, German Bunds, Oil, Chinese Equity Markets, and the Swiss Franc. Markets continue to exhibit bi-polar behavior as they struggle to gauge the level of anticipated forward invention by central banks against declining global growth.
[35]
The market has ceased to become an expression of the economy… it is the economy. The purpose of a pre-emptive strike on financial risk is to manipulate market psychology to affect fundamental reality. The global shift toward pre-emptive central banking occurred in the summer 2012: first with Mario Draghi’s pledge to do “whatever it takes” to save the Euro on July 26th; and followed thereafter by Bernanke’s QE3 speech at Jackson Hole on August 30th. At the time, risk assets had completely rebounded from the 2008 crisis and the VIX was in the mid-teens. Despite calm financial markets and falling financial stress, central banks on both sides of the pond added new doses of radical monetary policy. Since the summer of 2012, every period of rising financial stress has resulted in either direct monetary action by a major central bank or dovish commentary by a key official (see chart above). The result has been one of the best three-year volatility-adjusted performances for stocks in over 200 years of data!
[36]
Moral hazard is institutionalized in the price of risk. A new generation of traders has learned to buy every stock market dip, short every volatility spike, and re-leverage at the mere hint of government intervention. Yield starved investors are forced to chase the expectation of government response rather than fundamental returns and good business models. If central banks are constantly reacting to market conditions rather than economic conditions the net effect is to crowd out value investors (please see Kaleidoscope Capital’s excellent thought piece “The Fed is the New Value Investor” for more on this topic) [37]. It explains why great value investors like David Einhorn are experiencing their worst months since the 2008 crisis as value underperforms momentum; and why great contrarian investors like Hugh Hendry have been chasing leveraged beta in whichever market central banks are most actively propping up and making good returns doing it. Most importantly, it explains why the top 1% of income earning households that are most exposed to the market economy are dramatically outperforming the remaining 99% that are exposed to the real economy.
Pre-emptive central banking is analogous to Bush Doctrine foreign policy. The US foreign policy response to the 9/11 terror attacks involved a pre-emptive war against Iraq to prevent future terrorism. The Iraq war appeared successful at first, but soon after the fall of Baghdad dangerous ‘unknown unknowns’ emerged. In the aftermath of 2003 invasion, a rising insurgency and sectarian war led to a continuous and costly occupation and the deaths of 4.5k American soldiers and an estimated 500k Iraqi combatants and civilians. The cost of the war ballooned to $2 trillion and this limited our ability to respond fiscally to the 2008 recession. President Obama, who started as an underdog candidate in the primaries, was victorious over Clinton and then McCain largely because he was credible in his opposition to the war. By 2011 Obama made good on a promise to withdraw US troops from Iraq. The chaos of a failed state led to the rise of ISIS, a terror group even more brutal than Al Qaida, which now operates with impunity over large portions of Iraq and Syria. As ISIS fights Assad and the Kurds in Syria the civil war has resulted in largest refugee crisis in Europe since World War II with an estimated 4 million Syrians fleeing violence in their country and another 12 million in need humanitarian assistance. With no strategic buffer in the region and a shared enemy in ISIS, the US has controversially sought to strengthen diplomatic ties with Iran - an original member of Bush’s “axis of evil”. Whether you believe the Iraq war was just or not the point is that nobody predicted this extreme range of outcomes back in 2003. In similar fashion, global central banks are severely underestimating the unknown unknowns from their unprecedented policies today.
