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The Limits to Trusting the Robots

October 20, 2017 1 comment

After another day on Thursday of stocks starting to look mildly tired – but only mildly – only to rally back to a new closing high, it hardly seems unusual any more. I have to keep pinching myself, reminding myself that this is historically abnormal. Actually, very abnormal. If the S&P 500 Total Return Index ends this month with a gain, it will be the second time in history that has happened. The other time was in 1936, as stocks bounced back from a deep bear market (at the end of those 12 months, in March 1936, stocks were still 54% off the 1929 highs). A rally this month would also mean that stocks have gained for 19 out of the last 20 months, the longest streak with just one miss since…1936 again.

But we aren’t rebounding from ‘oversold.’ This seems to be a different situation.

What is going on is confounding the wise and the foolish alike. Every dip is bought; the measures of market constancy (noted above, for example) are at all-time highs and the measures of market volatility such as the VIX are at all-time lows. It is de rigeur at this point to sneer “what could go wrong?” and you may assume I have indeed so sneered. But I also am curious about whether there is some kind of feedback loop at work that could cause this to go on far longer than it “should.”

To be sure, it shouldn’t. By many measures, equities are at or near all time measures of richness. The ones that are not at all-time highs are still in the top decile. Buying equities (or for that matter, bonds) at these levels ought to be a recipe for a capitalistic disaster. And yet, value guys are getting carried out left and right.

Does the elimination (with extreme prejudice) of value traders have any implications?

There has been lots of research about market composition: models, for example, that examine how “noise” and “signal” traders come together to create markets that exhibit the sorts of characteristics that normal markets do. Studies of what proportion of “speculators” you need, compared to “hedgers,” to make markets efficient or to cause them to have bubbles form.

So my question is, what if the combination of “buy the dip” micro-time-frame value guys, combine with the “risk parity” guys, represents a stable system?

Suppose equity volatility starts to rise. Then the risk-parity guys will start to sell equities, which will push prices lower and tend to push volatility higher. But then the short-term value guys step in to ‘buy the dip.’ To be clear, these are not traditional value investors, but rather more like the “speculators” in the hedger/speculator formulation of the market. These are people who buy something that has gone down, because it has gone down and is therefore cheaper, as opposed to the people who sell something that has gone down, because the fact that it has gone down means that it is more likely to go down further. In options-land, the folks buying the dip are pursuing a short-volatility strategy while the folks selling are pursuing a long-volatility strategy.[1]

Once the market has been stabilized by the buy-the-dip folks, who might be for example hedging a long options position (say, volatility arbitrage guys who are long actual options and short the VIX), then volatility starts to decline again, bringing the risk-parity guys back into equities and, along with the indexed long-only money that is seeking beta regardless of price, pushing the market higher. Whereupon the buy-the-dip guys get out with their scalped profit but leaving prices higher, and volatility lower, than it started (this last condition is necessary because otherwise it ends up being a zero-sum game. If prices keep going higher and implied volatility lower, it need not be zero-sum, which means both sides are being rewarded, which means that we would see more and more risk-parity guys – which we do – and more and more delta-hedging-buy-the-dip guys – which we do).

Obviously this sort of thing happens. My question though is, what if these different activities tend to offset in a convergent rather than divergent way, so that the system is stable? If this is what is happening then traditional value has no meaning, and equities can ascend arbitrary heights of valuation and implied volatility can decline arbitrarily low.

Options traders see this sort of stability in micro all the time. If there is lots of open interest in options around, say, the 110 strike on the bond contract, and the Street (or, more generally, the sophisticated and leveraged delta-hedgers) is long those options, then what tends to happen is that if the bond contract happens to be near 110 when expiry nears it will often oscillate around that strike in ever-declining swings. If I am long 110 straddles and the market rallies to 110-04, suddenly because of my gamma position I find myself long the market since my calls are in the money and my puts are not. If I sell my delta at 110-04, then I have locked in a small profit that helps to offset the large time decay that is going to make my options lose all of their remaining time value in a short while.[2] So, if the active traders are all long options at this strike, what happens is that when the bond goes to 110-04, all of the active folks sell to try and scalp their time decay, pushing the bond back down. When it goes to 99-28, they all buy. Then, the next time up, the bond gets to 110-03 and the folks who missed delta-hedging the last time say “okay, this time I will get this hedge off” and sell, so the oscillation is smaller. Sometimes it gets really hard to have any chance of covering time decay at all because this process results in the market stabilizing right at 110-00 right up until expiration. And that stabilization happens because of the traders hedging long-volatility positions in a low-volatility environment.

But for the options trader, that process has an end – options expiration. In the market process I am describing where risk-parity flows are being offset by buy-the-dip traders…is there an end, or can that process continue ad infinitum or at least, “much longer than you think it can?”

Spoiler alert: it already has continued much longer than I thought it could.

There is, however, a limit. These oscillations have to reach some de minimus level or it isn’t worth it to the buy-the-dip guys to buy the dip, and it isn’t worth reallocation of risk-parity strategies. This level is much lower now than it has been in the past, thanks to the spread of automated trading systems (i.e., robots) that make the delta-hedging process (or its analog in this system) so efficient that it requires less actual volatility to be profitable. But there is a limit. And the limit is reach two ways, in fact, because the minimum oscillation needed is a function of the capital to be deployed in the hedging process. I can hedge a 1-lot with a 2 penny oscillation in a stock. But I can’t get in and out of a million shares that way. So, as the amount of capital deployed in these strategies goes up, it actually raises the potential floor for volatility, below which these strategies aren’t profitable (at least in the long run). However, there could still be an equilibrium in which the capital deployed in these strategies, the volatility, and the market drift are all balanced, and that equilibrium could well be at still-lower volatility and still-higher market prices and still-larger allocations to risk-parity etc.

It seems like a good question to ask, the day after the 30th anniversary of the first time that the robots went crazy, “how does this stable system break down?” And, as a related question, “is the system self-stabilizing when perturbed, or does it de-stabilize?”

Some systems are self-stabilizing with small perturbations and destabilizing with larger perturbations. Think of a marble rolling around in a bowl. A small push up the side of the bowl will result in the marble eventually returning to the bottom of the bowl; a large push will result in the marble leaving the bowl entirely. I think we are in that sort of system. We have seen mild events, such as the shock of Brexit or Trump’s electoral victory, result in mild volatility that eventually dampened and left stocks at a higher level. I wonder if, as more money is employed in risk parity, the same size perturbation might eventually be divergent – as volatility rises, risk parity sells, and if the amount of dip-buyers is too small relative to the risk parity sellers, then the dip-buyers don’t stabilize the rout and eventually become sellers themselves.

If that’s the secret…if it’s the ratio of risk-parity money to dip-buyer money that matters in order to keep this a stable, symbiotic relationship, then there are two ways that the system can lose stability.

The first is that risk parity strategies can attract too much money. Risk parity is a liquidity-consumer, as they tend to be sellers when volatility is rising and buyers when volatility is falling. Moreover, they tend to be sellers of all assets when correlations are rising, and buyers of all assets when correlations are falling. And while total risk-parity fund flows are hard to track, there is little doubt that money is flowing to these strategies. For example one such fund, the Columbia Adaptive Risk Allocation Fund (CRAZX), has seen fairly dramatic increases in total assets over the last year or so (see chart, source Bloomberg. Hat tip to Peter Tchir whose Forbes article in May suggested this metric).

The second way that ratio can lose stability is that the money allocated to buy-the-dip strategies declines. This is even harder to track, but I suspect it is related to two things: the frequency and size of reasonable dips to buy, and the value of buying the dip (if you buy the dip, and the market keeps going down, then you probably don’t think you did well). Here are two charts, with the data sourced from Bloomberg (Enduring Intellectual Properties calculations).

The former chart suggests that dip-buyers may be getting bored as there are fewer dips to buy (90% of the time over the last 180 days, the S&P 500 has been within 2% of its high). The latter chart suggests that the return to buying the dip has been low recently, but in general has been reasonably stable. This is essentially a measure of realized volatility. In principle, though, forward expectations about the range should be highly correlated to current implied volatility so the low level of the VIX implies that buying the dip shouldn’t give a large return to the upside. So in this last chart, I am trying to combine these two items into one index to give an overall view of the attractiveness of dip buying. This is the VIX, minus the 10th percentile of dips to buy.

I don’t know if this number by itself means a whole lot, but it does seem generally correct: the combination of fewer dips and lower volatility means dip-buying should become less popular.

But if dip-buying becomes less popular, and risk-parity implies more selling on dips…well, that is how you can get instability.

[1] This is not inconsistent with how risk parity is described in this excellent paper by Artemis Capital Management (h/t JN) – risk parity itself is a short volatility strategy; to hedge the delta of a risk parity strategy you sell when markets are going down and buy when markets are going up, replicating a synthetic long volatility position to offset.

[2] If this is making your eyes glaze over, skip ahead. It’s hard to explain this dynamic briefly unless I assume some level of options knowledge in the reader. But I know many of my readers don’t have that requisite knowledge. For those who do, I think this may resonate however so I’m plunging forward.

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Hard to Sugar-Coat Nonsense Like This

July 20, 2017 3 comments

Note: We are currently experimenting with offering daily, weekly, monthly, and quarterly analytical reports and chart packages. While we work though the kinks of mechanizing the generation and distribution of these reports, and begin to clean them up and improve their appearance, we are distributing them for free. You can sign up for a ‘free trial’ of sorts here.


One of the things that fascinates me about markets – and one of the reasons I think “Irrational Exuberance”, now in its third edition, is one of the best books on markets that there is – is how ‘storytelling’ takes the place of rational analysis so easily. Moreover, almost as fascinating is how easily those stories are received uncritically. Consider this blurb on Bloomberg from Wednesday (name of the consultant removed so as not to embarrass him):

Sugar: Talk in market is that climate change has pushed back arrival of winter in Brazil and extended the high-risk period for frost beyond July, [name removed], risk management consultant for [company name removed] in Miami, says by telephone.

Sugar futures have recently been bouncing after a long decline. From February through June, October Sugar dropped from 20.40 cents/lb to 12.74¢; since the end of June, that contract has rallied back to 14.50¢ (as of Wednesday), a 14% rally after a 38% decline. There are all sorts of reasons this is happening, or may be happening. So let’s think about ‘climate change’ as an explanation.

There are several layers here but it boils down to this: the consultant is saying (attributing it to “talk in the market,” but even relaying this gem seems like gross negligence) that the rally in the last few weeks is due to a change in the timing of the arrival of winter…a change which, even if you believe the craziest global warming scaremongers, could not possibly have been large enough over the last decade to be measurable against the backdrop of other natural oscillations. Put another way, in late June “the market” thought the price of sugar ought to be about 12.74¢/lb. Then, “the market” suddenly realized that global warming is increasing the risk to the sugar crop. Despite the fact that this change – if it is happening at all – is occurring over a time frame of decades and centuries, and isn’t exactly suffering from a lack of media coverage, the sugar traders just heard the news this month.

Obviously, that’s ridiculous. What is fascinating is that, as I said, in this story there are at least 4 credulous parties: the consultant, the author of the blurb, the editor of the story, and at least part of the readership. Surely, it is a sign of the absolute death of critical thinking that only habitual skeptics are likely to notice and object to such nonsense?

Behavioral economists attribute these stories to the need to make sense of seemingly-random occurrences in our universe. In ancient times, primitive peoples told stories about how one god stole the sun every night and hid it away until the morning, to explain what “night” is. Attributing the daily light/dark cycle to a deity doesn’t really help explain the phenomenon in any way that is likely to be useful, but it is comforting. Similarly, traders who are short sugar (as the chart below, source Floating Path, shows based on June 27th data) may be comforted to believe that it is global warming, and not unusually short positioning, that is causing the rally in sugar.

As all parents know, too much sugar (or at least, being short it) isn’t good for your sleep. But perhaps a nice story will help…

 

Inflation Trading is Not for the Weak

June 27, 2017 1 comment

I was prepared today to write a column about horse racing and value investing…that will have to wait until tomorrow…when this article was sent to me by about a dozen people:

Deutsche Bank Said to Face Possible $60 Million Derivative Loss

The article was sent my way because the loss was tied to a trade that used US dollar inflation derivatives, and since that’s a market I basically started back in 2003 folks figured I might want to know. And I do.

The inflation derivatives market is not huge. The chart below shows rolling 12-month inflation derivative volumes (source: BGC Partners) through last September, which was the last time I went looking for the data for a presentation. Total interbank volumes are around $10-15bln per month; customer volumes are not included here but are not insignificant (any more).

Most inflation books, especially these Volcker Rule days, are run pretty close to the vest. Most of these volumes will be set against customer flows, or against bond breakevens, or against other positions on the inflation curve. Net risk positions for any derivative book, especially these days, are pretty small…which is why Deutsche is investigating whether risk limits were breached in this case. In principle this should be easy to figure out, since DB and every other bank has risk control specialists whose job it is to monitor these risks.

But inflation risks are complex. Our firm breaks fixed-income risks down into six basis risks that add up to the net risk of a bond. For a TIPS bond, there is just one risk; for a corporate bond there will be six. Our risk schematic starts from real rate risks and builds up – unlike in most risk systems, which start with nominal risks and try to force real bonds to fit. Inflation-linked derivatives also have commodity deltas implied, since they are tied to headline inflation and headline inflation is tied largely to energy prices. Geez, I could write a book on this – it would be a combination of “Inflation Risks and Products[1] and, in this case, “Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports.”

Suffice it to say that even really sharp investors don’t always quite get it when it comes to inflation. In early 2014, a prestigious investment management firm took a multi-billion-dollar bath on a “risk-parity” product that hadn’t truly understood how to figure out the risks of TIPS. How much more difficult, then, is it for risk control officers, many of whom have shiny new Ph.D.s and very little direct market experience? A fast-talking trader who knows something about the product can, if he is unscrupulous, persuade risk control that he is not really taking risks that he knows, or ought to know, he is taking.

In short, I am sympathetic with the risk control guys in this case. They were probably outgunned by a slick operator pushing the limits of his limits. It’s almost assuredly the case: the market, as large as it is, is too small in the Volcker Rule era to allow the accumulation of a prudent position of large enough size to cause this sort of loss – especially in the recent period of exceptionally low market volatility.

This, then, is an object lesson: if you’re running inflation risk, and you think it’s pretty much like running nominal rate risk – you’re wrong, and you should get help before your firm’s name is the one in the Bloomberg article.[2]

Tomorrow, we can talk about horse racing.

[1] In which I co-wrote a chapter, on commodities actually, with Bob Greer.

[2] To be fair, in this case the problem was the combination of ignorance and what appears to be malfeasance. If you’re careful with your control structures and only hire high-quality people of sterling reputation, you shouldn’t have a problem with the second part of this formula.

Categories: Bond Market, TIPS, Trading

Who Keeps Selling These Free Options?

November 22, 2016 Leave a comment

It seems that recently I’ve developed a bit of a theme in pointing out situations where the market was pricing one particular outcome so completely that it paid to take the other side even if you didn’t think that was going to be the winning side. The three that spring to mind are: Brexit, Trump, and inflation breakevens.

Why do these opportunities exist? I think partly it is that investors like to be on the “winning side” more than they like ending up with more money than they started. I know that sounds crazy, but we observe it all the time: it is really hard (especially if you are a fund manager that gets paid quarterly) to take losses over and over and over, even if one win in ten tries is all you need to double your money. It’s the “wildcatter” mindset of drilling a bunch of dry holes but making it back on the gusher. It’s how venture capital works. There are all kinds of examples of this behavioral phenomenon. I am sure someone has done the experiment to prove that people prefer many small gains and one large loss to many small losses and one large gain. If they haven’t, they should.

I mention this because we have another one.

December Fed Funds futures settled today at 99.475. Now, Fed funds futures settle to the daily weighted average Fed funds effective for the month (specifically, they settle to 100 minus the average annualized rate). Let’s do the math. The Fed meeting is on December 14th. Let’s assume the Fed tightens from the current 0.25%-0.50% range to 0.50%-0.75%. The overnight Fed funds effective has been trading a teensy bit tight, at 0.41% this month, but otherwise has been pretty close to rock solid right in the middle except for each month-end (see chart, source Bloomberg) so let’s assume it trades in the middle of the 0.50%-0.75% range for the balance of the month, except for December 30th (Friday) and 31st (Saturday), where we expect the rate to slip about 16bps like it did in 2015.

fedl01

So here’s the math for fair value.

14 days at 0.41%  (December 1st -14th)

15 days at 0.625% (December 15th-29th)

2 days at 0.465% (December 30th-31st)

This averages to 0.518%, which means the fair value of the contract if the Fed tightens is 99.482. If the Fed does not tighten, then the fair value is about 99.60. So if you buy the contract at 99.475, you’re risking…well, nothing, because you’d expect it to settle higher even if the Fed tightens. And your upside is 12.5bps. This is why Bloomberg says the market probability of a 25bp hike in rates is now 100% (see chart, source Bloomberg).

fedprob

There is in fact some risk, because theoretically the Fed could tighten 50bps or 100bps. Or 1000bps. Actually, those are all probably about equally likely. And it is possible the “turn” could trade tight, rather than loose. If the turn traded at 1%, the fair value if the Fed tightened would be 99.448. So it isn’t a riskless trade.

But we come back to the same story – it doesn’t matter if you think the Fed is almost certainly going to tighten on December 14th. Unless you think there’s a chance they go 50bps or that overnight funds start trading significantly higher before the meeting, you’re supposed to be long December Fed funds futures at 99.475.

The title of this post is a question, because remember – for everyone who is buying this option at zero (or negative) there’s someone selling it too. This isn’t happening on zero volume: 7207 contracts changed hands today. That seems weird to me, until I remember that it has been happening a lot lately. Someone is losing a lot of money. What is this, Brewster’s Millions?

*

An administrative announcement about upcoming (free!) webinars:

On consecutive Mondays spanning December 5, December 12, and December 19 at 11:00ET, I will be doing a series of one-hour educational seminars on inflation. The first is “How Inflation Works;” the second is “Inflation and Asset Classes;” and the third is “Inflation-aware Investing.” These webinars will also have live Q&A. After each session, a recording will be available on Investing.com.

Each of these webinars is financially sponsored by Enduring Investments.

Brexit and Trump and Free Options

November 9, 2016 1 comment

As the evening developed, and it began to dawn on Americans – and the world – that Donald Trump might actually win, markets plunged. The S&P was down 100 points before midnight; the dollar index was off 2%. Gold rose about $70; 10-year yields rose 15bps. Nothing about that was surprising. Lots of people predicted that if Trump somehow won, markets would gyrate and move in something close to this way. If Clinton won, the ‘status quo’ election would mean much calmer markets.

So, we got the upset. Despite the hyperbole, it was hardly a “stunning” upset.[1] Going into yesterday, the “No Toss Ups” maps had Trump down about 8 electoral votes. Polls in all of the “battleground” states were within 1-2 points, many with Trump in the lead. Yes, the “road to victory” was narrow, requiring Trump to win Florida, Ohio, North Carolina, and a few other hotly-contested battlegrounds, but no step along that road was a long shot (and it wasn’t like winning 6 coin flips, because these are correlated events). Trump’s victory odds were probably 20%-25% at worst: long odds, but not ridiculous odds. (And I believe the following wind to Trump from the timing of Obamacare letters was underappreciated; I wrote about this effect on October 27th).

And yet, stock markets in the two days prior to the election rose aggressively, pricing in a near-certainty of a Clinton victory. Again, recall that pundits thought that a Clinton victory would see little market reaction, but a violent reaction could obtain if Trump won. Markets, in other words, were offering tremendous odds on an event that was unlikely, but within the realm of possibility. The market was offering nearly-free options. The same thing happened with Brexit: although the vote was close to a coin-flip, the market was offering massive odds on the less-likely event. Here is an important point as well – in both cases, the error bars had to be much wider than normal, because there were dynamics that were not fully understood. Therefore, the “out of the money” outcome was not nearly as far out of the money as it seemed. And yet, the market paid you handsomely to be short markets (or less long) before the Brexit vote. The market paid you handsomely to be short markets (or less long) before yesterday’s election results were reported. And, patting myself on the back, I said so.

capture

This is not a political blog, but an investing blog. And my point here about investing is simple: any competent investor cannot afford to ignore free, or nearly-free, options. Whatever you thought the outcome of the Presidential election was likely to be, it was an investing imperative to lighten up longs (at least) going into the results. If the status-quo happened, you would not have lost much, but if the status quo was upset, you would have gained much. As I’ve been writing recently about inflation breakevens (which was also a hard-to-lose trade, though less dramatic), the tail risks were really underpriced. Investing, like poker, is not about winning every hand. It is about betting correctly when the hand is played.

At this hour, stock markets are bouncing and bond markets are selling off. These next moves are the difficult ones, of course, because now we all have the same information. I suspect stocks will recover some, at least temporarily, because investors will price a Federal Reserve that is less likely to tighten and the knee-jerk response is to buy stocks in that circumstance. But it is interesting that at the moment, while stocks remain lower the bond market gains have completely reversed and are turning into a rout. 10-year inflation breakevens are wider by about 9-10bps, which is a huge move. But there will be lots of gyrations from here. The easy trade was the first one.

[1] And certainly not “the greatest upset in American political history.” Dewey Defeats Truman, anyone?

August: More Esther, Less Mester

The last two weeks of July felt a lot like August typically does. Thin, lethargic trading; somewhat gappy but directionless. Ten-year Treasury note futures held a 1-point range except for a few minutes last Thursday. The S&P oscillated (and it really looks like a simple oscillation) between 2160 and 2175 for the most part (chart source Bloomberg):

dull

In thinking about what August holds, I’ll say this. What the stock market (and bond market) has had going for it is momentum. What these markets have had going against them is value. When value and momentum meet, the result is indeterminate. It often depends on whether carry is penalizing the longs, or penalizing the shorts. For the last few years, with very low financing rates across a wide variety of assets, carry has fairly favored the longs. In 2016, that advantage is lessening as short rates come up and long rates have declined. The chart below shows the spread between 10-year Treasury rates and 3-month LIBOR (a reasonable proxy for short-term funding rates) which gives you some idea of how the carry accruing to a financed long position has deteriorated.

carry

So now, dwelling on the last few weeks’ directionless trading, I think it’s fair to say that the markets’ value conditions haven’t much changed, but momentum generally has surely ebbed. In a situation where carry covers fewer trading sins, the markets surely are on more tenuous ground now than they have been for a bit. This doesn’t mean that we will see the bottom fall out in August, of course.

But add this to the consideration: markets completely ignored the Fed announcement yesterday, despite the fact that most observers thought the inserted language that “near-term risks to the economic outlook have diminished” made this a surprisingly hawkish statement. (For what it’s worth, I can’t imagine that any reasonable assessment of the change in risks from before the Brexit vote to after the Brexit vote could conclude anything else). Now, I certainly don’t think that this Fed, with its very dovish leadership, is going to tighten imminently even though prices and wages (see chart below of the Atlanta Fed Wage Tracker and the Cleveland Fed’s Median CPI, source Bloomberg) are so obviously trending higher that even the forecasting-impaired Federal Reserve can surely see it. But that’s not the point. The point is that the Fed cannot afford to be ignored.

wagesandprices

Accordingly, something else that I expect to see in August is more-hawkish Fed speakers. Kansas City Fed President Esther George dissented in favor of a rate hike at this meeting. So in August, I think we will hear more Esther and less Mester (Cleveland Fed President Loretta Mester famously mused about helicopter money a couple of weeks ago). The FOMC doesn’t want to crash the stock and bond markets. But it wants to be noticed.

The problem is that in thin August markets – there’s no escaping that, I am afraid – it might not take much, with ebbing momentum in these markets, to cause some decent retracements.

Categories: Federal Reserve, Trading, Wages

Britain Survived the Blitz and Will Survive Brexit

June 24, 2016 6 comments

So I see today that former Fed Chairman Alan Greenspan says this is the worst crisis he has seen. Bigger than the 1987 Crash? Bigger than Long Term Capital? Bigger than the internet bubble collapse? Bigger than the Lehman (et. al.) collapse? Really?

As humans, we tend to have short memories and (ridiculously) short planning horizons. Greenspan, especially in his apparent dotage, has a shorter memory even than he had previously – maybe this is convenient given his record. I don’t want to comment on his planning horizon as that would seem uncharitable.

Why is Brexit bad? The trade arrangements and treaties do not suddenly become invalid simply because the UK has voted to throw off the shackles of her overlords and return to being governed by the same rules they’ve been governed by basically since the Magna Carta. But Jim Bianco crystallized the issue for me this week. He pointed out that while Brussels could let this be a mostly painless transition, it has every incentive to make it as painful as possible. In Jim’s words, “if it isn’t painful then hands shoot up all over Europe to be the next to leave.” That’s an astute political observation, and I think he’s right. The EU will work hard to punish Britain for having the temerity to demand sovereignty.

But Britain survived the Blitz; they will survive Brexit.

Indeed, Britain will survive longer than the Euro. The sun is beginning to set on that experiment. The first cracks happened a few years ago with Greece, but the implausibility of a union of political and economic interests when the national interests diverge was a problem from the first Maastricht vote. Who is next? Will it be Greece, Spain, Italy, or maybe France where the anti-EU sentiment is higher even than it is in the UK? The only questions now are the timing of the exits (is it months, or years?) and the order of the exits.

As I said, as humans we not only have short memories but short planning horizons. From a horizon of 5 or 10 years, is it going to turn out that Brexit was a total disaster, leading to a drastically different standard of living in the UK? I can’t imagine that is the case – the 2008 crisis has had an effect on lifestyles, but only because of the scale and scope of central bank policy errors. In Iceland, which addressed the imbalances head-on, life recovered surprisingly quickly.

These are all political questions. The financial questions are in some sense more fascinating, and moreover feed our tendency to focus on the short term.

A lot of money was wagered over the last few weeks on what was a 52-48 proposition the whole way. The betting markets were skewed because of assumptions about how undecideds would break, but it was never far from a tossup in actual polling (and now perhaps we will return to taking polling with the grain of salt it is usually served with). Markets are reacting modestly violently today – at this writing, the US stock market is only -2.5% or so, which is hardly a calamity, but bourses in Europe are in considerably worse shape of course – and this should maybe be surprising with a 52-48 outcome. I like to use the Kelly Criterion framework as a useful way to think about how much to tilt investments given a particular set of circumstances.

Kelly says that your bet size should depend on your edge (the chance of winning) and your odds (the payoff, given success or failure). Going into this vote, betting on Remain had a narrow edge (52-48) and awful odds (if Remain won, the payoff was pretty small since it was mostly priced in). Kelly would say this means you should have a very small bet on, if you want to bet that outcome. If you want to bet the Leave outcome, your edge was negative but your odds were much better, so perhaps somewhat larger of a bet on Brexit than on Bremain was warranted. But that’s not the way the money flowed, evidently.

Not to worry: this morning Janet Yellen said (with the market down 2.5%) that the Fed stood ready to add liquidity if needed. After 2.5%? In 1995 she would have had to come out and say that every week or two. A 2.5% decline takes us back to last week’s lows. Oh, the humanity!

Just stop. The purpose of markets is to move risk from people who have it to people who want it. If, all of a sudden, lots of people seem to have too much risk and to want less, then perhaps it is because they were encouraged into taking too much risk, or encouraged to think of the risk as being less than it was. I wonder how that happened? Oh, right: that’s what the Fed called the “portfolio balance channel” – by removing less-risky assets, they forced investors to hold more-risky assets since those assets now constitute a larger portion of the float. In my opinion (and this will not happen soon), central banks might consider letting markets allocate risk between the people who want it and the people who don’t want it, at fair prices. Just a suggestion.

One final point to be made today. I have seen people draw comparisons between this episode and other historical episodes. This is refreshing, since it reflects at least some thoughtful attempt to remember history. Not all of these are apt or useful comparisons; I saw one that this is the “Archduke Ferdinand” moment of this generation and that’s just nuts. Europe is not a military powderkeg at the moment and war in Europe is not about to begin. But, to the extent that trade barriers begin to rise again, the idea that this may be a “Smoot-Hawley” moment is worth consideration. The Smoot-Hawley tariff is generally thought to have added the “Great” to the phrase “Great Depression.” I think that’s probably overstating the importance of this event – especially if everybody decides to respect Britons’ decision and try to continue trade as usual – but it’s the right idea. What I want to point out is that while rising tariffs tend to produce lower growth and lower potential growth, they also tend to produce higher inflation. The fall of the Berlin Wall and the opening of Eastern Europe is one big reason that inflation outcomes over the last few decades have been lower than we would have expected for the amount of money growth we have had. The US has gone from producing all of its own apparel to producing almost none, for example, and this is a disinflationary influence. What would happen to apparel prices if the US changed its mind and started producing it all domestically again? Give that some thought, and realize that’s the protectionist part of the Brexit argument.

We can cheer for a victory for independence and freedom, while continuing to fight against any tendency towards economic isolationism. But I worry about the latter. It will mean higher inflation going forward, even if the doomsayers are right and we also get lower growth from Brexit and the knock-on effects of Brexit.

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