Inflation and the stock-bond correlation relationship - the driver for asset allocation

The worst asset allocation situation for investors is when stocks and bonds are correlated, and both are heading down. The situation is especially disruptive if bonds are falling faster because fixed income is supposed to be the safe asset. This correlated scenario occurs when the economy is in a high and rising inflation environment. We have seen this bad inflation environment in 2022.  We are now in a high but falling inflation environment which also has a positive correlation, yet stocks and bonds are both moving higher. 

With the PCE core inflation showing sticky behavior at 4.6% YOY, the promise of lower inflation may not be as strong as suggested even two months ago. Investors must ask where they are  positioned within the inflation matrix and where may the market be in six months. This will provide answers to the correlation environment and what will be the diversification expected between the two major asset classes.

From the Man Institute

Inflation is not going away - So what do investors need to think about?

 

The core PCE YoY is falling, and the trend is lower, but the speed of the decline in not as fast as expected by many economists and investors. This number suggests that the Fed will still have to raise rates. A recession and falling prices are still expected at the end of the year, but investors still need to focus on balancing their inflation/deflation strategy.

The focus must still be on balancing strategies to account for inflation and hold exposure to dynamic strategies like trend-following, global macro, and commodities. Strategy diversification is still critical because the inflation story does not seem to be ending. While from an older piece of research from AQR, the story is the same, diversify. See Fire and Ice: Confronting the Twin Perils of Inflation and Deflation. 

A surprise decline in inflation will be good for both stocks and bonds but a surprise increase will be negative for both  main traditional asset classes. Commodities will give you protection if we have more inflation, but the decline in a falling inflation environment will be severe. Trend and macro momentum are two places where there is protection from either upside or downside inflation surprises. Given the amount of uncertainty, it is not too late to consider either strategy to reduce downside risk. The current gains in equities and bonds offer investors a chance to rebalance and prepare for any next move in inflation.

Short-term and long-term strategy skew

 

The skew of an investment strategy will change with the investment time horizon that you use. An interesting research piece from the folks at Quantica, the managed futures manager discusses the poor performance for many CTA during March. No trend-following manager was immune to the market reversal risk last month, but they also reported a more interesting nugget of information for investors.  

Quantica looked at the strategy skew for different time horizons from one day to 250. They found that trend-following has a strong negative skew in the short-run but then moves higher to a strong positive number which peaks at about the six-month mark. 

Trend-following, the capturing of market behavior that is moving higher or lower based on price behavior, will generate positive skew in the longer-run; however, over the short run, returns will be hurt by market reversals which may create negative skew. Long-only global equities will have strong negative skew in the short-run that will also improve, but the profile will stay negative regardless of the investment horizon.

There is pain when looking at the distribution of a trend strategy over a day, week, or month, but investors will be rewarded by sticking with the investment and allowing the cumulative price trends to take their course. Holding onto winner and selling losers will create positive skew, but regardless of the risk management, the chop and short-term reversal seen with trending markets over short horizons will cause a different skew profile. 

Reread "The Bankers' New Clothes" - Still a fresh look at banking

 

It is 10 years since The Bankers' New Clothes was written by two of the best bank finance professors. It was supposed to explain the risks with banks and what we can do to diminish the risk to the economy and the government, taxpayers, who provide an insurance backstop.  We wrote about it in  What is it about bankers' clothes?  The argument of Admati and Hellwig its simple, banks need more capital and less leverage. Banks are not special relative to any other firm that uses leverage to boost profits. If banks make bad investments with leverage, the pain is real. We can talk about risk management and supervision but the best and first line of defense should be more equity in the business. 

Look at all the bank failures this year. The problem is the same as any in the past. More investments that turn unprofitable and blow through all the equity. The threat of losing equity makes any lender or depositor want to exit. Increase equity the downside risk is limited. Of course, greater equity will impact lending and bank decision making, that may end up being a good thing for the economy.  This does not change the original sin of zero interest rates for over decade; however, the responsibility of managing assets still rests with the bankers. 

The meritocracy must be tempered with empathy

Adrian Wooldridge's provocative book, The Aristocracy of Talent: How Meritocracy Made the Modern World tells the interesting story of how the world moved from a system of privilege to one based on merit. We often forget that even less than 100 years ago your success was measured by your station and not your talent. 

The world adaptation to a merit-based system has been a boom for productivity, economic advancement, and success. Your success was not based on your name but on your actions.  Think of all who were talented but denied access to economic opportunities. A system based on intelligence and skill created a unique ladder for many to climb. 

We would not be as successful as a world without the focus on merit, yet the meritocracy system may have reached an extreme that has a dark side. A merit system focused on the wrong measures can lead to a new ruling elite based on credential that serve as new barriers to entry. IQ and other aptitude tests have created a barrier to entry. A world based on merit test scores can misallocate resources to score taking and not innovation or hard work. A world sorted between merit haves and have not can also be restrictive.  Hence, a world based on "talent" may be subject to problems seen in history that stifles creativity and innovation. A meritocracy is subject to corruption no different than other systems of privilege.

So how do we find a happy medium between merit, equity, and equality? The solution may be through redefining and rethinking merit with a movement away from one single measure of talent. Merit is not a test or a ticket from a school, but a broader measure based on hard work with a sense of empathy and equity for others. 

Does the macro-announcement premium exist?

There has been found a macro-announcement premium associated with equity markets. There are high returns on announcement days relative to all other days which suggests that there is a risk premium associated with these special news days, yet a close look finds that the conditional return volatility does not drop after announcements. This stability with volatility is odd given the concept of an announcement risk premium. 

A new paper "Is There a Macro-announcement Premium?" funds that the average announcement return is associated with monetary policy surprises and small-sample problem. The announcement effect does not really exist for employment and inflation days. After monetary announcements and sampling are accounted for, there is little macro announcement premium.

This is very useful research since it answers some of the questions surrounding this announcement premium effect that has been found by other researchers. First, a careful review of the announcements shows the focus is on monetary announcements and not on other key announcements. Second, if we account for the sample of announcements, there is a significant change in the results. Overall, there is not a strong premium associated with macro-announcements. 

However, there is still a strong monetary policy announcement effect and the change in macro regime will have a big difference on the reaction to a given macro announcement. There are still high returns relative to risk, but the return pattern changes over time for those macro-announcements not associated with monetary policy.

Old school Chicago machine politics

The Council dean, Alderman Ed Burke, closed his last Chicago  city council assembly by repeating one of his favorite quotes: “In politics, there are no permanent enemies and no permanent friends. Only permanent interests.”

The quote is an interesting commentary on old school Chicago politics. Ed Burke served as alderman in Chicago City Council from 1969 through 2022, and is charged with corruption and will go to trial in November 2023. He was well known for his Chicago power politics.

Macro sensitivities can be found in equity portfolios

There has been an explosion of research work on factor risks within equity portfolios. The go to analysis is to describe a portfolio through factor exposures like momentum, size, quality, value, or volatility to name a few; however, a key driver is still macroeconomic factors. A recent paper "Targeting Macroeconomic Exposures in Equity Portfolios: A Firm-Level Measurement Approach for Out-of-Sample Robustness" provides useful insights on macro risks that are different than factor premium and have out-of-sample robustness. 

Macroeconomic risks have a real effect on portfolio returns and can be picked up through cross sectional exposures that are sensitive to these macro exposures. While most macro exposures are gained through differences in asset class allocations, equity specific portfolio exposures can also create macro risk exposures. 

These macro exposures can be obtained through focusing on market-based proxies for macro risks which can be obtained daily and are based on the aggregate behavior of investors. The authors look at short rates, the term premium, the credit premium, and inflation breakevens as good forward estimates of key macro risks. Rates provide information on monetary policy and economic growth. The term premium is viewed as an important indicator on future growth. The credit premium provides insights on growth, and inflation breakevens tell us something about future inflation. The change in these variables can serve as a surprise estimate of expectations. 

The authors form equity portfolios that have strong positive and negative exposure to macro risks. The results show that strong macro sensitive portfolios can be formed. The table also shows that factor exposures are not sensitive macro risks.  Sector allocation exposures are also sensitive to macro risks, more so than factor portfolios. 

These macro portfolios can be formed to be either positively or negatively sensitive to macro surprises. 

Equities can be classified by their sensitivity to macro exposures that are associated with well-known market expectation data. This macro framework can allow investors to choose their desired macro sensitivity without moving exposures to other asset classes.

Finding scalability - The key to implementing ideas into practice

 

John List's The Voltage Effect: How to Make Good Ideas Great and Great Ideas Scale is another good book on the practical application of microeconomics. The powerful title on a voltage effect is just a way to introduce the key concept of scalability. Every business firm wants to gain economies of scale, but the concept can also be applied to any idea as well to production practices. Scaling of ideas is much harder than most people think. Marginal benefits often decline.  For List, gaining scalability is the voltage effect. 

List describes how much of human behavior is not scalable. What makes sense and works with a small group does not often work when applied to larger groups or is attempted to be replicated. This problem goes back to the fundamental issue that incentives matter. If you focus on the wrong incentives, most projects will not scale. The book focuses on many fundamental microeconomic issues: 

• Any research work especially with field experiments is subject to false positives.
• Know the subject audience and whether your subjects drive the results.
• Is the desired effect driven by the chef or the ingredients employed.
• Are there spillover effects, the problem of externalities. 
• What are the costs of gaining scale and when do you quit.

Microeconomics has been viewed by many as a dry subject, but List turns the dismal science into a tool for extracting unique answers to complex problems. The challenge for all who want to find scalable answers is to do conduct good experiments in a complex world that is not within a laboratory.

As said on the first page - 

"Scalable ideas are all alike; 

every unscalable idea is unscalable in its own way."

China - US relationship founded on false narratives?

Stephen Roach is a long-time Wall Street economist who was the chairman of Morgan Stanley Asia for several years and a current fellow at Yale University. He has been commented on China-US relations for decades through his varied experiences. His new book, Accidental Conflict: America, China, and the Clash of False Narratives, is an attempt to address the key problem of how to get the two major powers of the world to candidly talk with each other in a construction manner. 

Roach covers ground that many have already explored. There is a shared history. There is a strong codependency with China having high excess savings and the US engaged in excessive spending. The savings imbalance links both countries in a close relationship whether anyone likes it. The savings imbalance story is hard for policymakers to understand. Setting up tariffs and trade constraints is not going to solve the problem. Micro solutions to macro problems are providing the wrong first aid for chronic problems. This applies to both the US and China. China needs to reduce savings and become more consumer focused. The US needs to increase savings and investment. 

The US has a false narrative about China motivations and actions which are often economically rational, and the China has false narratives that are generated to maintain the current power structure within China. The extension of current narratives lead to conflict as each party responds to real and perceived falsehoods. Standing down through cooperation is an optimal solution yet is not the solution that most will choose. Game theory, while not explicitly discussed, provides us with a framework of how solutions can be found, yet the obvious solution is not always the first choice when politics are driven by rhetoric targeted to the average citizen of each country. 

Roach provides detailed information on China and US relations and each reaction over the last few decades, but the overall story could have been condensed into a tighter presentation. I agree with his false narrative presentation, but I am afraid that this framework is simplistic and does not address the complexities of the competitive conflict that has arisen over the last two decades. We have expected that by having China enter the WTO, it would be ripe for change into a more democratic/ capitalist country. This was a false premise that is the crux of the current problem. 

Can both countries move beyond the false narratives described by Roach? I am not optimistic. False narratives are hard to reverse because the falsehoods are often wrapped in some basic truths. China and the US are competitors, yet for the good of the world this competition must be tempered though finding a common ground of trust. 

The Why Axis - It is all about finding the right incentives

 

Economics is often the study of incentives. People act based on the incentives faced. These actions can be often quantified in simple basic economic classes through a discussion of price demand, yet prices may not be the sole motivation. Human behavior is more complex, and economist have now determined that extracting the correct incentives and motivations is much harder than often thought. The book The Why Axis: Hidden Motives and the Undiscovered Economics of Everyday Life by Uri Gneezy and John List provides a very readable introduction to the current trends in microeconomics which focus on field work to measure incentives for behavior in regular behavior. The authors talk about their long-term research agenda to tease out incentives for practical problems that have important applications.

What has been a significant trend over the last two decades is a pivot to field work that sets up controlled experiments on what incents behavior, or what can be used to motivate behavior. How do we get donors to increase giving? How do we get students to learn? How do price products to increase sales? Gneezy and List find that what may seem like to obvious answer is not often correct. Motivations and incentives are complex and often need to be measured through careful experimentation between a test group and a control group.

This work becomes very interesting when tied to finance. What causes investors to buy and sell stocks? The simple answer is to make a return on investment, but what information or packaging of information works to cause investors to engage and act. I don't think we often know the answer. We see herding behavior. There are behavioral biases. Some news cause reactions while other news which may seem important later are greeted with a yawn. The motives of investors are still a mystery and require further deep study. The incentives for financial decisions is more than just saying that investors want to make money.

Spearman versus Pearson correlation which is better?

The classic correlation is the Pearson formulation which is a measure of linear correlation between two variables, the ratio of the covariance to the product of their standard deviations cov(X, Y)/[stdev(X)*stdev(Y)]. The nice property of this correlation is that it is insensitive to linear transformation of location and scale. If X becomes a+bX and Y becomes c+dY, and b and d are >0, the correlation will be the same. If you want to give this measure different interpretations, try the nice paper “Thirteen Ways to Look at the Correlation Coefficient”. It is a true workhorse for any investment analysis. So why mess with perfection with something that is easy to calculate and everyone uses?

The answer is in the definition. It is a linear measure. If there is non-linearity between X and Y, you will either not capture it or you will get a false interpretation. Hence, there is a reason to look at the Spearman rho correlation. Spearman measures the rank correlation which a nonparametric measure between ranks.  It is looking for a monotone relationship. The Spearman and Pearson correlation using ranks will be the same.  If one of the variables is ordinal, then use Spearman.  If the distribution is non -normal and or has some extreme values, then use Spearman. If the Spearman correlation > Pearson correlation, then the relationship is monotonic but not linear. To make a variable linear may require a transformation.  

A good practice is to use both especially if one or both variables have outliers that make for non-linear relationships.

Decision Analysis to Solve Uncertainty Through Action Planning

 

Uncertainty can be described as the limited knowledge about future, past, and current events. Uncertainty is the gap between available knowledge and the knowledge decision-makers need to make their best choice. Uncertainty involves subjectivity which distinguishes it from risk which is measurable. 

There has been a large amount of research on decision-making with high uncertainty, yet little of this work has trickled down to finance even though predictions about asset returns is highly uncertain. Much of this uncertainty work focuses on long-term projects or high uncertainty modeling like climate change. In finance, predictions must also be made about the environment for which the decider has little control. For example, thinking about longer-term growth also means thinking about the political environment that will exist over a forecast. Risk as something that is measurable is a subset of uncertainty. 

Focus on scenarios or alternative views of the world as opposed to a single approach. There is a multiplicity of plausible futures, and it is important to think about these choices before there is a probability assessment. The normal view of "predict-then-act" should be augmented with "monitor and adapt" thinking. When faced with deep uncertainty, action should be delayed but adaption should be constant. 

Problems and questioned should be framed, then futures should be explored, and only then choices should be structured for future action. This can be done through either looking forward or forming a future and then working backwards on how to get there. In a high uncertain world, there needs to be greater focus on contingencies and not just forming a single path of action. 

The path for action must create exit ramps or contingent action given that the world may change quickly. This process has been called formally robust decision making that includes assumption-based planning, scenarios, exploratory modeling, and contingency formations. It has also been called dynamic adaptive planning. These approaches can be formally modeled but always contain the idea of forming several alternative view as opposed to a single narrative. 

Dealing with uncertainty through anticipatory action requires thinking through several types of action: mitigating action which reduces certain vulnerabilities, hedging action which reduces uncertain vulnerabilities, seizing action which takes advantage of opportunities, exploiting action which prepares to take advantage of uncertain developments, and shaping action which prepares to reduce points of failure.  

Dealing with uncertainty needs to look beyond just dreaming of "what-if" scenarios. It requires thinking through a complete action plan. 

Fed liquidity breaks the link between financial assets and economic risk

What is the Fed trying to do with providing liquidity to financial markets during a crisis? Think of the fed actions as an attempt to break the link between financial assets and economic risks. Smooth the returns of financial assets through reducing downside and there will be less economic risk for the real economy. The Greenspan and Bernanke put were attempts to delink financial assets and economic activity. The response to the pandemic was an attempt to break the link between financial assets and the real economy. Don't let assets fall and there will be no spillover to the real economy. 

Of course, in the process of keeping financial assets high, inflation of financial assets, there has been an increase in real assets, traditional inflation. Now, any attempt to stop real inflation will carry-over to financial assets. Both will go down when rates are increasing. The link between financial assets and economic risks is again tied together. A fall in inflation will also lead to a fall in financial assets and there will be a real effect on economic growth.  The link cannot be escaped.

The liquidity to the banking system, albeit expected to be temporary, is again an attempt to slow any sell-off of assets to reduce real economic risk. However, the financial disintermediation that will continue from higher rates cannot be stopped.

Risk Premia and Skew - Know your skew and embrace skew

Are you paid for skew or is skew the result of crowded high returns to risk? This is an interesting question for strategy selection and important for the risk premium narrative, yet it may be difficult to unpack. 

If a risk premium or strategy has negative skew, there is the belief that investors should be paid for taking this extra risk. Conversely, there may be strategies that generate higher return to risk that then get crowded and lead to negative skew events or crashes. Crashes create negative skew. In either case, strategies or risk factors that have more negative skew will require a larger risk premium. 

The idea of a momentum crash would be an example of negative skew generated from herd behavior. Too much capital in one direction may lead to sharp reversals especially for shorts when there is a market rally shock. The negative skew in currency carry is another example of a crash risk albeit not from crowding. Money is made on a regular basis until there is a disruptive event which causes a pricing change that exceeds the carry returns. Carry investors will receive extra return to offset the chance of this disruptive negative skew. 

It may be hard to distinguish between these two alternatives, but it is worth a discussion on causality and drivers for return. The impact of skew on return is a deeper story than the simplistic premium received for higher risk with a strategy narrative. There is also a unique skew premium that seems to be independent of classic risk factors like carry, value, and momentum that is closely tied to volatility shocks. Buying high negative skew and selling strong positive skew is independent of other risk factors. 

Knowing asset, strategy and risk premium skew and embracing these skews is important for adding return and is not hard to incorporate into a portfolio. 

The c factor and group effectiveness

Group dynamic can have significant value through the wisdom of crowds. A diverse group should reach better decisions and make better forecasts; however, it is also well-known that group dynamics can lead to herding and disfunction. Just because you place smart people in the same room does not mean that they are going to get better results. The interaction between groups members matters. There is name for this, the c factor, the collective intelligence of a group which is not the same as the individual intelligence of a group member. 

Thinking about the c factor is a form of positive psychology that focuses on how groups can function efficiently instead of focusing on the level of disfunction. Similar to intelligence, the c factor is the ability of a group to perform a wide variety of tasks. Group skill is more relevant to group success than the average or maximum individual intelligence. There is such a thing as group intelligence which is not just a combination of individual skills. The group skill is tied to experiential knowledge. For example, has the group worked on similar problems or have familiarity with the problems? 

Additionally, it has been found that three factors help with a high c factor, social sensitivity, gender composition, and equitable turn-taking. The social sensitivity can come in a few forms, but a good word may be empathy or a sense of understanding another person's point of view. Since social sensitivity is hard to measure, it has been found that a higher degree of gender differences will lead to more social sensitivity. The third factor is ensuring that there is not dominance by just a few members. The group benefits collapse when there is less cross communication or the allowance for everyone to speak and be heard. 

An investment committee can work more effectively if there is more open communication, increased willingness to listen to other opinions, and bringing in more diversity. Yes, this may sound obvious, yet it is often hard in practice. Regardless of the investment firm, there will always be group dynamics even if it is in the form of research meetings; consequently, every firm should work on improving group dynamics and intelligence.

Science is now less disruptive

 

Economic growth is closely tied to productivity and productivity is linked to innovations in science. The link between scientific discovery and business innovation can take time and increases in productivity can be delayed for decades from the initial breakthrough, but discovery in science is necessary for this process of economic technological change to work. No new discoveries and there will be limited technological change. No new technology and productivity will not improve, and real incomes will not increase. 

Recent work suggests that science is becoming less disruption. Now, this is not easy to measure, but some have taken on the task and finds that papers and patents are up but cutting edge discoveries are down on a relative basis. See "Papers and patents are becoming less disruptive over time" in Nature. There are fewer breakthrough discoveries and more of the research work is mopping up what has already been discovered or just improving ideas on the margin. Of course, these improvements are important, but big technological change is not driven by marginal science. There is more research being done, more papers being published, more patents being granted but the level of disruption is falling. 

The authors form a CD index that looks at the consolidation and disruption of research through looking at a papers and patents to measure how often subsequent work will reference prior work to the innovation. A disruptive work will see future research refer less to work before the innovation. A true breakthrough will choke off the use of prior research. This is an innovative way of thinking about disruption, but it gives a measure for discussion. 

We are will not feel the effect of this slowdown immediately, but the cumulative effect of less disruptive research will start to weigh on productivity. The link may be weak, but the ramifications of less new science will impact all economies.

Manage coskewness and improve momentum trading

I am biased toward momentum trading whether cross-sectionally or as a time series. It is simple to implement and has been a consistent risk factor across long periods of time. Of course, it may fall out of favor over short periods, but it has generally produced strong returns over the long run. Unfortunately, a problem exists. 

Momentum is subject to crashes and shows negative skew.  Past returns winners show negative skew while past losers show less skew. The net result is that a winners minus losers portfolio will have negative skew. The gains from momentum are balanced against the pain from these periodic crashes. If only the negative skew problem could be solved, momentum would be an even better core strategy. 

What must be managed is the coskew, the covariance between asset returns and squared market returns. Coskew is higher with stocks that have extremes. If the coskew is negative, returns will fall when market volatility increases. Some will even argue that the excess returns of a momentum portfolio are compensation for the risk of holding a coskewed basket. 

Crashes are more likely when volatility is high. Hence, if momentum portfolios are conditioned on volatility or more importantly coskew, there is the potential for improvement versus a momentum portfolio that is not adjusted for this factor. This issue is addressed in the paper, "Coskewness and Reversal of Momentum Returns: The US and International Evidence". 

The authors find that coskew for stocks is important especially during less volatile periods. Momentum returns reverse during high volatility periods but not from coskew. Overall, if coskew rises (falls) above (below) a certain level, it makes sense to cut (increase) momentum exposure. This simple rule will reduce the change of a momentum crash and improve the overall return from holding winners minus loser momentum portfolios.

H.4.1 data - Fed balance sheet and QT reversal

 

Looking at the data and you would conclude that we are having a major financial crisis, yet bank stocks have stabilized as measured by well known indices. The total assets of the Fed through several asset and lending programs have increased by close to $400 billion. This offsets almost 5 months of QT in less than a month.  

There has not been a deep policy discussion although the bank crisis has been front and center in the news. The balance sheet increase may have topped out, but it far from clear that the crisis is over. The liquidity has done much to avert and pain in the stock market. For example, the SPY and QQQ are both higher for the month based better liquidity and only a 25 bps increase from the FOMC.  

When will this liquidity be offset or will the Fed balance sheet just move from Treasuries to other assets from bank lending program.  The price of credit is rising but the balance sheet is growing does this make sense? It may of there is a liquidity crisis, yet are we having a liquidity crisis or is this just the process associated with the Great Bond Repricing? 

The global economy and China - A two-pronged issue - geopolitics and economics

Investment and economic views concerning China are key to global market success in 2023 especially since there is the view that the US will likely be in a recession starting in the second half of the year. 

There is a clear geopolitical risk based on the tensions with the US surrounding trade and Taiwan. This uncertainty slows long-term investment. Who will invest in fixed plant and equipment when the 5 to 10 year horizon is cloudy? This uncertainty only increases based on the unclear market and regulatory environment inside China. 

The cloudiness is embedded in stock prices, yet there is a more positive investment message for the short-term. One, COVID restrictions have been lifted. The November rally is clear. Two, there has been an increase in credit available for investment through looser monetary policy. The PBOC is not following the western approach of monetary tightening. Three, the economic data are stronger as presented by the recent PMI especially for non-manufacturing spending. An increase in Chinese consumer spending can be a strong factor for global growth if there is an increase in imports. 

The monetary policies of yesterday create the market structure failure of today

We will tolerate moral hazard, bailouts, lax supervision, and zombie firms to not address the bubble in financial assets. We don't want to pay the price for financial policy sins and allow for an economic morality play.  To lay blame requires self-analysis and requires admitting to mistakes. 

The more recent problem started with the mistake of economic shutdowns from COVID that were relieved through excessive monetary policy. Of course, we are not focusing on the large problems arising from excessive policy post the GFC. The public would not tolerate shutdown if they were not paid to accept these policy choices. The true problem arose when an immediate solution became a normal policy action which led to monetary excess. Now the Fed is trying to reverse the excesses. The Fed put that worked in a low inflation environment has now become a Fed focused on a market structure that does not allow failure.

The Fed valued labor over inflation to the point that it now needs to raise rates and reverse the excess. The result is no Fed put for financial markets, but a selective support of institutions based on politics and sentiment. In the case of SVB, the bailout was not for any banking institution but for the politically powerful venture industry. The Fed and government are using selective support to stop the natural result from the reversal of the monetary and fiscal policy bubble. 

The current policies create a large transfer from bond holders to creditors through a combination of stronger growth, higher inflation, and the repricing of bond risk. US marketable debt to GDP has fallen from highs. We are living through a new period of financial repression where inflation exceeds the interest rates and wealth is taken from savers and lenders and given to spenders and borrowers. Because the Fed is slow to respond to their bubble there is a large wealth transfer that will disrupt current market institutions.

Can you put a price on everything?

 

Michael Sandel, a Harvard economist, writes a breezy book What Money Can't Buy: The Moral Limits of Markets, which discusses the important question of the pricing of everything. Should your body parts be for sale? Are ticket scalpers providing a good service? Should we pay students to read books? Is it immoral to buy and sell death contracts? Is there something wrong with naming rights? 

An economist can say there is a price for everything, but does that mean we should make all activity transactional? Are there moral limits on what we can put a price on? What are the limits to a pricing scheme?

There are a lot of questions that are addressed in this book which makes it thought provoking for a wide audience. One the one hand, there is efficiency with pricing all activities. If I want to see a concert, I should be able to pay a premium for someone to stand in line for me. A sports owner should be able to sell naming rights to their stadium.  However, should I allow people to sell one of their kidneys? We have both volunteer and paid blood donors. 

Sandel presents interesting cases where placing a price on a good changes the demand for it. Similarly, he also presents cases where people do not respond to economic and price incentives. Consumers do not respect as expected to higher or lower prices. We also do not get the result that we want from changing incentives. Our behavior is often adjusted by the process of pricing.  The title discusses moral limits but there are cultural limits to how we look at the price of goods and service. Nevertheless, there is something very primal and efficient on trying to price everything.

The Fed Strategy - raise rates, follow QT, and don't blow-up the financial system

Current Fed policy is combination of three strategies: one, raise interest rates to choke inflation; two, continue to cut the Fed's balance sheet through QT to return to normal; and three, don't blow-up the financial system in the process of following one and two. We now know that it is not easy to meet all three goals. 

Raising interest rates from the zero bound will have ramification greater than just slowing economic growth. Financial markets have been addicted to low rates and the transition is more difficult than expected. These are the not so hidden risks of repricing assets. Even with book value accounting, the losses may be delayed but will not be hidden. 

QT is a long-term goal, yet we now see that if there is a financial crisis, the Fed balance sheet can balloon quickly and reverse months of QT sales. We are also aware of the impact of QT on bank reserves and overall market stability. The recent bank funding can be considered similar to the BOE gilt purchases last fall It will be hard to lower the balance sheet if there are continual crises from raising rates. 

Financial stability is paramount in attempting to minimize the chance of pushing the economy into a recession, yet raising interest rates increases financial instability. Stability is based on asset prices not falling. Full stop, asset values are being repriced and there will be losers.  The trade-off is becoming clear, control inflation and increase financial instability or lower rates to support the banking system but allow for more inflation. 

The bond market may not be right, but it is pricing in lower rates as a central bank attempt to minimize the risk for a financial meltdown. The Fed has erred in the past toward adding liquidity to solve a stability crisis. It is expected that this will happen again.