Inside the Market’s Mind: Wetlands and Debtlands

Bonds, Liquidity and the Perfect Storm

“[A]t some point we get into territory where the consequences may be more bad than good” - Raghuram Rajan, Governor Reserve Bank of India, August 2015

“[We] can probably remove accommodation at a gradual pace” - Stanley Fisher, Vice-Chair Federal Reserve, August 2015

“How did you go bankrupt? Two ways. gradually, then suddenly” - Ernest Hemingway, The Sun Also Rises

“Après moi, le deluge” - Louis XV

Last month’s turmoil in markets was a bit of a breeze, forewarning that a perfect storm is brewing. For many years I have been highlighting that the global economy suffers from “Too Much (Off-Balance-Sheet) Debt, Serviced by Too Little (Real) Growth, Under Too Politicized Conditions”.ⁱ However the endgame of this theme is going to play out, it will obviously involve bonds. But there’s a lot of confusion, mainly due to the duality of the economic system. Specifically, we struggle to understand the interaction between the physical domain of the real economy and the mental domain of capital markets. So instead I will use metaphors and analogies to clarify the main issues, in particular liquidity. For inspiration, we’re going to look at nature. On that note, at Kames we recently participated in a number of presentations on climate change. Consequently, analogies with water and man-made impacts on the environment inform my story. In short, by comparing Mother Nature to human nature I will tell a tale about wetlands, debt-lands, and caterpillars.

From Wetlands to Debt-Lands

Normally, nature determines the boundaries between land and sea. Dunes, riverbeds, and cliffs are examples of natural boundaries. But we humans have not always been content with nature’s laws and decided to move the boundaries or create our own. Case in point: The Netherlands, where I was born, is a country of canals, rivers and wetlands. A significant part is below sea level, exemplified by polders. We reclaimed much of our land from the sea and then had to build protection by way of dikes and dams. Although they were aware of the risk, the Dutch intentionally moved to the polders and built their homes ‘under the water’. Specifically, they trusted the dikes, believed in their design, and had faith in the engineers who built and maintained them.

This episode has a rich history, made famous by the story of Hans Brinkers, the boy who plugs a hole in a dike with his finger while yelling for help.

Statue of Hans Brinkers in Harlingen, Netherlands¹

But why was he sounding the alarm? Well, once water starts to seep through a dike it eats away at the sand and stones that make up the dike. Moreover, one hole is a warning for the dreaded drip effect, i.e. that there are likely others in the making. Once they connect, the structure of the dike is compromised. This risks a devastating flood and Hans Brinkers was doing his version of ‘saving’.

Something similar is happening in the economic landscape. Normally, the real economy occupies the land with physical ‘stuff’. Capital, primarily in the form of money, streams in the rivers and seas, to evaporate and rain down again for growth on fertile lands. Savings and loans, credits and debits, all meet and flow together, like sweet and salt water. Importantly, like water, being liquid is one of capital’s prime properties.

However, a fast growing region in the global economy has become a cause of concern. These debt-lands are like polders where savers and spenders seemingly go about their lives and businesses. But theirs is not a natural “business as usual”. It has been artificially created, claimed and maintained. Whatever inhabitants of the debt-lands own (e.g. a home, a car, a degree, a pension, an oil-well), it is often structurally ‘under water’. It is safeguarded by monetary dikes and sustained by other ‘waterworks’ like monetary sluices and canals. These form the institutional rules and infrastructure that support the modern monetary system at the center of which is money creation via fractional reserve banking.² Today’s money is immaterial and involves fiat currencies. Consequently, monetary dikes are ultimately made up of non-physical ‘sand and stones’ which are designed and constructed by financial engineering. The latter is informed by mechanical equilibrium theories and delegated to (central) banks and government treasuries, the key central planners. Their designs and constructions ultimately depend on legitimacy, credibility, and trust. All in all, this makes the dikes more like ‘halls of mirrors’. Any cracks are warnings and any holes need plugging (e.g. by the savers.)

Crucially, sentiment affects the economic landscape similarly to how nature’s intangible forces move land and water.³ As a consequence, capital markets rise and fall, forming ripples, waves and tides. Specifically, sentiment accompanies booms and busts. Booms experience high tides that can eventually burst, flooding the landscape with deflation and default. In such instances they turn into busts which equate to low tides or even droughts. This is what monetary dikes are supposed to protect against, according to its engineers. However, whereas engineering Mother Nature is just as challenging, it is dangerous (and ultimately futile) in the case of human nature. The butterfly effect, which culminates in a hurricane, applies to sentiment in that it is sensitive to small initial disturbances that can turn it into an overwhelming force. In fact, modern finance’s dominant assumption and resulting treatment of ‘the market as a machine’ is the caterpillar for the butterfly in our story.

Artificially creating land is a fight against nature and its laws. Similarly, artificially creating wealth (e.g. the wealth effect) is a fight against economic laws. That fight may be politically correct, but it is not sustainable. It is more than ironic that this was acknowledged by Larry Summers, former US Treasury Secretary: “there are economic laws like there are physical laws and, as with physical laws, economic laws do not yield to political will.” Still, that hasn’t stopped politicians from trying. In Europe that means maintaining the union at any cost. In the US it means maintaining superpower status at any cost. And in China it means maintaining party rule at any cost. However, they all have something in common. Not only do they need to keep the debt-landers happy, including newly recruited inhabitants. They also need their support to help maintain the landscape, including plugging holes. They achieve this via ‘politically correct’ fiscal and monetary policies, for example aimed at channeling capital into centrally planned directions (e.g. mortgages) while offering insurance (e.g. Greenspan put) against damages.

Enter climate change. Climate change reflects unintended consequences of man-made policies.⁴ The main result is a general rise in sea levels, among others putting pressure on the dikes. In the debt-lands case, man-made policies⁵ vary from zero-interest rates (ZIRP) and quantitative easing (QE), to currency interventions and biased regulations. Unintended consequences include leveraged misallocation (e.g. debt-funded buy-backs), moral hazard (e.g. bail-outs), and uneven playing fields (e.g. high-frequency trading). The pressure is in the form of financial instability.

Under fiat conditions it is crucial that the financial engineers of the dikes are perceived to be in control. So, we need to look for holes in the dikes as warnings that this is an illusion and that we face the risk of a proper flood. Unfortunately, holes have appeared and we already need a growing number of fingers to plug them:

1. Losing control of currencies (e.g. the Swiss, Kazakh, and Vietnamese central banks).
2. Losing control of (dis)inflation (e.g. both the ECB and the Swedish Riksbank had to lower their interest rate below zero, the latter despite one of its earlier governors warning against it.)
3. Losing control of markets (e.g. China, OPEC).
4. Losing control of democracy (e.g. EU Troika ignoring Greece’s referendum.)⁶

There are other structural issues. One of the pillars of, what we may call, our Keynesian inspired variation of a “polder model” is the ‘creative accounting’ routine to turn liabilities into assets. The BOE has explained, for example, how this works in the case of quantitative easing, whereby a central bank expands its balance sheet by buying bonds as assets. In our analogy we could call them ‘under-water’ land claims. But not all structures are built equally in the debt-lands, with those at the periphery mostly at risk. The ECB is now considering buying riskier Asset-Backed-Securities, for example.⁷ Also, anecdotally we know that recently popular items are of questionable quality and won’t stand a chance against a flood. Examples include Pay-In-Kind (PIK) loans, subprime car loans and low-covenant loans.

Regular readers are familiar with my broader thesis of Mr. Market’s Mind in which I apply the mind sciences to the economy and capital markets. The mind sciences attempt to gain insights in the bridging between the body and the mind by identifying correlations between brain states and mental states.⁸ Similarly, but at a collective level, investors try to identify correlations between the physical fundamentals of the real economy and the psychological capital of markets. (August showed, once more, that the latter can indeed go ‘mental’). In this case we can look at (unusual) behavior of markets to get additional clues of a brewing storm. The first chart⁹ below shows the ‘volatility of volatility’, in this case the volatility of the fear-gauge VIX, an implied volatility index. It reached record highs. Next, the top panel of the second chart shows the spike in the VIX itself (1-month implied equity volatility), reaching highs not seen since 2008. I also plotted, in the lower panel, the ratio between the VIX and its 3-month cousin, confirming the extreme demand for short-term protection:

Chart 1. Volatility of implied volatility

Chart 2. Implied volatility (top), 1 month/3 month implied volatility (bottom)

The next chart shows various financial stress indicators, including one by Bloomberg (in red). Although they measure different variables and have not reached the 2008 systemic risk levels, they have now set a series of significant higher highs:

Chart 3. Financial stress indices

Finally, we calculated the cross-sectional sum of the absolute daily returns from a broad range of assets, each expressed in multiples of their standard deviations. If we plot the annual moving average of this it clearly shows markets have experienced a growing number of excessive price moves over the past year, not seen since the build-up to the Lehman collapse:

Chart 4. Average annual excessive price moves across assets

With these warnings how will a perfect storm look like?

Watersnoodramp: The Endgame

Although it had been subject to flooding before, in 1953 the Netherlands experienced its worst flood disaster. It became known as the Watersnoodramp. A perfect storm, where a high spring tide was accompanied by severe winds, broke the dikes.

Source: https://www.isgeschiedenis.nl/toen/watersnoodramp-van-1953/

It also affected other countries, including the UK. The US has had its own disasters and recently commemorated Hurricane Katrina which struck in August 2005.

The damage of a flood is not only caused by the initial bursting, but also by the aftermath. Normal life grinds to a halt. The land is left barren with crops flushed away. Goods, particularly clean water, are scarce. Prices rise, often to extreme levels.

The economic variation of this type of ‘liquidity event’ is a debt deflation followed by stagflation. The debt deflation starts once the debt-landers and the community at large realize that central planning is not only not helping but is actually damaging, with a ‘shocking’ final fix. How do we know central planning is causal in a negative way? Because it denies price discovery, the natural bridging between physical fundamentals and psychological capital. In terms of the market’s mind, it leads to a mental breakdown with physical consequences. As I wrote in an earlier article on inequality, this goes deep and far and markets will not remain ignorant, let alone immune, to these broader societal effects. There are two phases to this breakdown, the first showing the aforementioned cracks and holes. In situations where the ‘powers that be’ are starting to lose that power, they take desperate measures, the kind that ‘move the goal posts’ and jeopardize credibility and other foundations of their edifice. Earlier I mentioned the EU Troika which plugged a hole while blatantly ignoring a referendum. Another example is Japan where there “has been increasing talk of the introduction of a new CPI measure which would make it easier to achieve the target”¹⁰ of 2%. Holes start off as cracks. The cracks will probably get plastered over for a while, and the observed holes have not yet connected. Central planners will also make all attempts to keep the storm at bay. Their loss of control will be signaled by panic but we haven’t seen that yet. Still, due to their intrinsic nature, dikes are vulnerable and I suspect we will soon need more pairs of hands to do the plugging.

The trigger will occur when sentiment’s butterfly effect reaches its final state. It means, for example, that the savers (can) no longer plug the holes. This state also painfully exhibits the limitations of monetary policies. First, liquidity depends on money creation. The latter primarily occurs when the private sector takes out loans that get recycled as deposits, i.e. money. The relatively high uncertainty in a high debt, low growth, and politically driven economic environment means that demand for credit is muted. With relatively high levels of debt that require servicing, this is risky from a liquidity perspective. Second, and related to the first point, the pursued policies, particularly ZIRP, are causing a shift in sentiment towards money and debt. Specifically, although one can borrow cheaply, ZIRP means that depositing funds (even if temporarily) gets punished. So, when holders of cash and money-like debt no longer see them as fungible ‘assets’ and start to treat them differently, it causes shifts in capital flows to which currencies are particularly vulnerable. Third, open market operations have resulted in too unevenly distributed, i.e. concentrated, holdings of (public) liabilities, e.g. JGB holdings by the BOJ. As a result, the (patched-up) weaknesses in the coastal defenses become exposed. The holes will multiply and grow.

Which section is most vulnerable? Among the historically grown imbalances are the “outside money” bail-outs which were politically preferred to “inside money” defaults¹¹ and restructurings. The emerging economic conditions put pressure on cash flows and will ultimately lead to bankruptcies, particularly of ‘zombie’ debt-landers. That will increase the (credit) risk premia, even for those former ‘safe haven’ sovereign bonds. Combined with other, increasingly violent, capital flows, this will then instigate the panic mode. The panic will take hold once the dikes break which affect the inhabitants most closely located to or working on the waterworks (e.g. banks, insurers, real estate, and other leveraged debt-landers). Central planners will then resort to fiscal expansion with debt monetization, capital controls, transaction taxes, and further financial repression. They will reach the point that their implicit admission of guilt, i.e. “we have been part of the problem and we’re now resorting to the final fix”, can no longer be ignored. In short, central planners’ final fix will lead to a drought in private capital, increased risk premia, and currency crises, culminating in stagflation.

Painful Lessons

The reader will ask, quite rightly, what good came out of the Watersnoodramp? Well, better designed dikes, for one. But there were more intangible benefits as well, like the return of a healthy respect for the forces of nature.

In a similar vein, that is what the economic system requires. We need our version of King Canute to show the central planners that ultimately tides and waves cannot be controlled. Their overconfidence combined with a lack of respect for the delicate (and, yes, dangerous) market dynamics, is what jeopardizes our economic foundations. Talking about migration crises, certain regions in the economic landscape have become deserted, whereas others have become overcrowded. Waterways overflow, get drained or run dry. For example, first the central planners forced value investors out of bonds by lowering rates to the zero bound (and below). Next, they indicated that they will force momentum investors out of them by pushing inflation higher. Similar mass migrations were engineered in other asset classes. Finally, they regulated market makers away and allowed algorithms to take over. No wonder there is “no body” there. Financial engineering has weakened the market’s body and manipulation has confused its mind. To replace the market is part of their final fix in this engineering ‘feat’.

In its September issue, the journal Portfolio Institutional suggests that the recent volatility spikes “raise serious concerns about whether or not market participants really understand the liquidity environment we find ourselves in today.” To address this within our analogy setting, we first need to be clear about the role of beliefs, which are so-called intentional mental states, in rational behavior. We take our cue from a number of well-known philosophers.

Here is how it works: first you decide to treat the object whose behavior is to be predicted as a rational agent; then you figure out what beliefs that agent ought to have, given its place in the world and its purpose—and finally you predict that this rational agent will act to further its goals in the light of its beliefs. (Dennett, 1996, p. 17)

Our analogy focuses on the association between water and liquidity and how it extends to capital. There are multiple dimensions to understanding water. “Water = H2O” is an example of what philosophers call posteriori necessity, a physical fact. Physical facts inform our beliefs at the cognitive or psychological level. However, philosophy has also made strong arguments against identity physicalism, the view that every physical fact is fully identical to the associated mental fact. Specifically, the physical fact of water = H2O is not identical to the phenomenal fact that water feels wet (and then only in its liquid form). So the belief that water = H2O contains both a psychological and a phenomenal aspect. Some suggest that,

one may need to add a relational element, to account for the fact that certain beliefs may depend on the state of the environment as well as the internal state of the thinker. It has been argued, for example, that to believe that water is wet, a subject must be related in an appropriate way to water in the environment. This relation is usually taken to be a causal—where the causal roles stretch outside the head into the environment. (Chalmers, 1996, p. 21)

Within a broader belief system “appropriate” means consistent:

Beliefs support one another, and give each other content. Beliefs also have logical relations to one another. As a result, unless one’s beliefs are roughly consistent with each other, there is no identifying the contents of beliefs. A degree of rationality or consistency is therefore a condition for having beliefs—inconsistencies are perturbations of rationality, not mere absence of rationality. (Davidson, 2001, p.124-125)

Sentiment is infused with these mental aspects. It acts on capital like the elusive forces of nature that can move water or turn it from liquid to solid form. The consensus on market liquidity is that it is the condition where a real asset can be exchanged for capital, i.e. money. This physical fact, “real asset = capital”, does however not fully describe how market liquidity feels like. That experience is crucial to understand liquidity, just like you need to feel the water getting too hot or too cold to know that it’s time to get out. If we include the condition that market liquidity means that you can exchange your asset without affecting the price, then you need a sense of when the tide is coming in or is going out.

So the belief that capital is liquid, e.g. that it is ‘freely floating’, involves sensations. This phenomenal dimension is essential in price discovery. Sensations complete the market mind’s holism, the interdependence of the various aspects of its mentality. Unfortunately, abusing capital markets for political purposes and turning them into mechanical automatons has repressed the natural sensations of freely floating capital. For example, the associated natural fear that too much of it can make you drown. Others, like the pains from creative destruction, have been medicated away. More broadly, we lost the sense of what it means to be in markets because they lost their purpose. Consequently, we, who make up the market’s mind, are as confused as the little fish in the story by David Foster Wallace. Its message is that we should keep reminding ourselves over and over “This is water, this is water” because if we don’t we “will be totally hosed.” It means that instead of engineering, central planners should concentrate on safe-guarding price transparency and price discovery in order to keep capital clean and liquid.

The perfect storm and the subsequent “deluge” are thus not triggered by some physical economic event, not even multiple ones. They are triggered by the mental breakdown, the sudden realization of the inconsistencies in the current belief system that designed the waterworks. It is captured in the age-old saying that you cannot have your cake and eat it too. It is also the culmination of our butterfly effect.

Conclusion

Our caterpillar turned into a Death’s-head butterfly.

It flapped its wings a long time ago. The resulting perfect storm is brewing but it’s currently offshore. Still, water has started to seep through the dikes and Hans Brinkers has been yelling for a while now. Who’s listening?

Like nature’s laws, economic laws will eventually prevail. Water will find its own way and the debt-lands will see their inevitable cleansing. Sometimes floods are the only (hard) way to learn and all we can do is manage the consequences.¹² On that note, water can also be a creative force of destruction which will enable us to rebuild and improve the economic landscape. Perhaps we should then start with a mind-body perspective of the economy and markets, and treat them in organic rather than mechanical terms? Now that is a different caterpillar all together.

References:

ⁱ Aka “TMD, TLG, TPC”. Recently a number of reports (BIS, McKinsey) updated the status of global debts around the world. The general conclusion is that debts continue to grow, both in absolute and relative terms. Specifically, Eurostat, the statistical agency of the EU, reported that government debt in the euro area rose by 1% to 92.9% of GDP. In the US, the debt to GDP ratio has crossed the 100% mark and is expected to grow to 106% by 2019. The IMF expects the debt/GDP ratio for China to grow to 250% if no reforms take place. The Bank of Canada compiled a database on sovereign arrears, defaults, and restructurings. It paints a bleak picture on sovereign solvency. Finally, according to the World Bank in the five years following the peak of the credit crisis in 2009 corporations and governments in emerging markets collectively issued $ 1.5 trillion in bonds. This is triple the amount over the period 2002-2007.

¹ Source: https://www.politiebond.nl/informatie-zoeken/npb-waarschuwing-ovw-niet-langer-van-kracht

² Among the technical elements of our modern monetary waterworks are concepts like loan creation, the real bills doctrine, inside and outside money, and repo and securities lending.

³ Sentiment covers mood and other collective mental forces. I will not discuss these here. Nature’s forces include, for example, the weather (e.g. wind, temperature) but also gravity.

⁴ This is the scientific consensus.

⁵ They can also include other policies that have an economic impact, like immigration controls or one-birth policies.

⁶ Let’s ignore other events that signal potential loss of control, like some initial defaults in the US (Detroit, Puerto Rico, and students) and the EU immigrant crisis.

⁷ As usual, the BOJ has moved even further up the risk scale and holds equity ETFs, for example.

⁸ This, as well as any causality, forms part of the famous “mind-body problem”.

⁹ Source all charts: Bloomberg.

¹⁰ Source: Morgan Stanley

¹¹ Although painful, there remain misplaced fears for such an outcome. In an updated 2014 paper, Reinhart and Trebesch analysed the impact of debt relief achieved through default and restructuring. They concluded “The economic landscape after a final debt reduction is characterized by higher income levels and growth, lower debt servicing burdens and lower government debt. Also ratings recover markedly, albeit only in the modern period.”

¹² Of course, it could turn out to be a wintery storm with record low temperatures that will freeze up the sea, rivers and canals. Even then, it will pressure and likely break the faulty designed waterworks.