Wednesday 13 May 2015

The Bund and the Paradox of Tranquility

A joy of reading about Post Keynesian Economics is that the whole basis of the subject is that economics a) must make sense for the whole system rather than for individual rational agents and b) must be empirically observable.

It is so refreshingly correct - obvious in fact. And yet Post-Keynesian economics has been relegated to an economic backwater whilst neo-classical economics, with mathematical precision, makes a mathematically precise complete hash of understanding the bigger picture.

One of the miserable things about reading about Post Keynesian economics is that they have been broadly right for 30-40 years and yet are still generally ignored.

One idea, simple but beautiful, is summed up by Marc Lavoie's term, coined in 1986 and based on Hyman Minsky's ideas, the 'Paradox of Tranquility'. To quote Lavoie in his book 'Post Keynesian Economics' (italics are mine):
According to Minsky, a stable growing economy is a contradiction in terms. A fast-growing free-market economy will necessarily transform itself into a speculative booming economy. In a world of uncertainty, without full information about the fundamentals, a string of successful years diminishes perceived risk and uncertainty. People tend to forget the difficulties encountered in the past... As time goes on memories fade and economic agents dare to take higher levels of risk. Or else, as time goes on, the risk levels as computed by engineering models of finance, such as the very popular value at risk model, appears to get smaller because the last recession is just one remote observation among a series of more recent successful years. The longer the economy is in a tranquil state of growth, the less likely it is to remain in such a state.
This was intended as a description of the equity market, but it could recently be also applied to the government bond market. 

What this paradox states is that a long period of growth with low volatility will, by its very nature, eventually lead to a crash. That the low volatility, rather than a signal of low risk, is a signal of overconfidence and thus is a signal of high risk when the confidence suddenly disappears.

I was reminded recently looking at the German government bond (Bund), which was for a long time seen as a one way bet. This is the Bund performance until April this year:

Up 19% , with 14.5% annualised returns on a 3.7% annualised volatility. The steadiness of this rise is exceptional.

Meanwhile, this was happening to the one year realised volatility since 2012:

At this point, FT Alphaville, who considered this a bubble, were running a competition to guess the date that Bunds would reach negative yields (for the record they reached about 0.06% positive yield). 

The assumption that the ECB would buy back the Bunds from you whatever the price (up to a negative 20bps yield) led to overconfidence. Narratives of pension funds forced to buy this debt even at negative yields made this a greater fool theory play (although unusually the greater fool was largely a Central Bank here).

Of course, as Lavoie states above, the longer the market appears to be calm the less likely it is to remain that way. As was found soon after:

The nature of the unceremonious crash of the Bund was not a surprise to anyone who regularly observes the behaviour of markets. All of the hedge funds that had amassed large positions now had to get out of their positions at the same time. Consensus was slow to build up but quick to reverse.

What is in store for the Bunds in future? I don't know. I don't believe that the economic growth that we will see in Europe will facilitate large rises in yields (falls in price) for a while. I may be wrong - I am not an expert here.

To me this was just an interesting example of how Post Keynesian economics has got it right and Neo-Classical economics, based as it is on efficient markets, can not explain the real world in anywhere near as realistic a manner.

1 comment:

Sorry, I have had to moderate comments because of an annoying pest spammer who keeps posting American football matches links.