wknd notes: Goodhart's Law

“The United States does not recognize the unilateral referendum,” announced Secretary of State Tillerson. What does it take these days Rex? 93% of voters in the Kurdistan region voted to establish an autonomous state in northern Iraq. And the only surprising thing was that 7% voted against independence. In 1776 an estimated 15-20% of the population in our Thirteen Colonies were British Loyalists. But votes don’t win independence, bloodshed does. Or at least the prospect of it. And in 1776, not only were 80-85% of Americans willing to vote for independence, but a sufficient number were willing to fight for it. 241 years and one blood-drenched Civil War later, we Americans seem generally content to express our differences at the voting booth and peacefully accept the results. How else can you explain the fact that just 8% of Seattle voters pulled the lever for Trump; yet the remaining 92% have refrained from declaring an independent Republic of Amazonia? Or Starbuckistan? Hell, it would be richer than Lichtenstein. And it’s not just Seattle. When presented with the least-favorable candidate in the Democratic party’s history, just 10% of San Francisco voted Trump. 10% of Manhattan too. 22% of Queens voted for their hometown boy, about the same percentage as Los Angeles. Chicago was 21%, Denver 19%, Portland 17%. Dallas was 35% and even Houston failed to exceed 42%. America is more divided than it has been in our lifetimes. Urban centers - the source of our economic and technological might - have never been at greater odds with their rural neighbors. It seems we agree on almost nothing, we’re now fighting about kneeling. And as America’s prosperous urbanites consider their position, Spain’s wealthiest community heads to the polls, in defiance of their national government, to vote for an independent Catalonia. 

Week-in-Review (expressed in YoY terms): Mon: China implements steel production cuts early, Abe calls Oct 22nd snap election, North Korea accuses Trump of declaring war, NZ election fails to deliver clear winner, Merkel’s CDU/CSU wins 33% in election (previous 41.5%) and Far Right AfD wins seats for first time, Germany’s SPD rules out a coalition with Merkel, Greece no longer in breach of EU budget rules, Fed’s Dudley “weak inflation won’t last, further rate hike likely,” Trump adds eight nations to travel ban, VIX options trading hits new daily record (2.6mm contracts), S&P -0.2%; Tue: Japan PPI services +0.8%, Brent crude hits 2yr high (+30% since June), German import prices +0.2 to +2.1%, Case-Shiller home prices +5.9% (fastest pace in 3yrs and 5% above 2006 peak), Yellen speech titled ‘Prospects for growth: reassessing the fundamentals’ interpreted as hawkish (dollar jumps, bonds fall), Yellen “Fed should be wary of moving too gradually,” McMaster “US has 4-5 ways to resolve North Korea crisis,” S&P unch; Wed: Former BJP finance minister publishes scathing attack on Modi economic mismanagement, Saudi Arabia to issue $12bln in bonds, Schauble to leave finance ministry (post-election shuffle), Italian business confidence post-crisis highs, French consumer confidence falls 3rd month, Trump “US prepared to use devastating force against North Korea,” pending home sales -3.1% (limited supply and high prices), durable goods orders rebound sharply, 2yr yield 1.48% (9yr high), US wkly crude oil exports record 1.5mm barrels/day, weekly oil inventories decline, S&P +0.4%; Thur: Turkey economic confidence slips from 5yr high, EU economic confidence 10yr high, German CPI unch at +1.8%, Spain CPI -0.1 to +1.9%, Mexico rates unch at 7.0%, US 10yr treasury yield above 200-day avg, trade deficit narrows, Q2 GDP revised +0.1 to +3.1%, Trump urges bipartisan support for tax plan, S&P +0.1%; Fri: Japan core CPI +0.7% (fastest in 2017), South Korea bans ICOs, EU CPI unch at +1.5%, French CPI +1.0%, UK Q2 GDP revised down to +1.5%, Carney “UK close to rate hike,” London home prices fall 1st time since 2009, US consumer confidence eases, core PCE -0.1 to +1.3%, personal spending and income ease, Health Secretary Price resigns over private plane abuse, dollar index longest quarterly losing streak since 2008 (3 in a row), S&P +0.4% (record high, 8th quarterly gain); Sat/Sun: China announces targeted RRR cut, Catalans vote for independence, North Korea prepares missile launch, US/NK in direct talks.    

Weekly Close: S&P 500 +0.7% and VIX -0.08 at +9.51. Nikkei +0.3%, Shanghai -0.1%, Euro Stoxx +1.3%, Bovespa -1.5%, MSCI World -0.1%, and MSCI Emerging -2.7%. USD rose +2.9% vs Mexico, +2.4% vs Chile, +1.9% vs Turkey, +1.6% vs Australia, +1.2% vs Indonesia, +1.2% vs Brazil, +1.2% vs Euro, +1.1% vs Canada, +1.0% vs China, +0.8% vs Sterling, +0.7% vs India, +0.5% vs Yen, and +0.1% vs Russia. Gold -1.4%, Silver -2.0%, Oil +1.9%, Copper -0.2%, Iron Ore -2.4%, Corn +0.8%. 5y5y inflation swaps (EU +1bp at 1.62%, US +1bps at 2.28%, JP flat at 0.37%, and UK flat at 3.40%). 2yr Notes +5bps at 1.49% and 10yr Notes +8bps at 2.33%.

Sept Mthly Close: S&P 500 +1.9% and VIX -1.08 at +9.51. Nikkei +3.6%, Shanghai -0.4%, Euro Stoxx +3.8%, Bovespa +4.9%, MSCI World +1.7%, and MSCI Emerging -1.4%. USD rose +3.2% vs Turkey, +2.3% vs Yen, +2.1% vs India, +2.1% vs Mexico, +1.9% vs Chile, +1.4% vs Australia, +1.0% vs Indonesia, +1.0% vs China, +0.8% vs Euro, and +0.4% vs Brazil. USD fell -3.5% vs Sterling, -0.8% vs Russia, and -0.1% vs Canada. Gold -3.3%, Silver -5.4%, Oil +7.9%, Copper -5.0%, Iron Ore -21.4%, Corn -0.3%. 5y5y inflation swaps (EU +1bp at 1.62%, US +5bps at 2.28%, JP +12bps at 0.37%, and UK +6bps at 3.40%). 2yr Notes +16bps at 1.49% and 10yr Notes +22bps at 2.33%.

Q3 Quarterly Close: S&P 500 +4.0% and VIX -1.67 at +9.51. Nikkei +1.6%, Shanghai +4.9%, Euro Stoxx +2.3%, Bovespa +18.1%, MSCI World +4.0%, and MSCI Emerging +6.1%. USD rose +1.2% vs Turkey, +1.1% vs India, +0.9% vs Indonesia, +0.7% vs Mexico, and +0.1% vs Yen. USD fell -4.4% vs Brazil, -3.8% vs Canada, -3.7% vs Chile, -3.3% vs Euro, -2.8% vs Sterling, -2.2% vs Russia, -1.9% vs China, and -1.9% vs Australia. Gold +2.7%, Silver -0.1%, Oil +9.8%, Copper +8.2%, Iron Ore -4.5%, Corn -8.8%. 5y5y inflation swaps (EU +4bps at 1.62%, US +2bps at 2.28%, JP +6bps at 0.37%, and UK -2bps at 3.40%). 2yr Notes +10bps at 1.49% and 10yr Notes +3bps at 2.33%.

YTD Close: S&P 500 +12.5% and VIX -4.53 at +9.51. Nikkei +6.5%, Shanghai +7.9%, Euro Stoxx +7.4%, Bovespa +23.4%, MSCI World +13.8%, and MSCI Emerging +24.4%. USD rose +1.1% vs Turkey. USD fell -11.9% vs Mexico, -11.0% vs Euro, -8.0% vs Australia, -7.9% vs Sterling, -7.2% vs Canada, -6.5% vs Russia, -4.7% vs Chile, -4.2% vs China, -3.9% vs India, -3.8% vs Yen, -2.8% vs Brazil, and flat vs Indonesia. Gold +10.0%, Silver +3.0%, Oil -9.6%, Copper +16.3%, Iron Ore -21.3%, Corn -6.1%. 5y5y inflation swaps (EU -13bps at 1.62%, US -14bps at 2.28%, JP -11bps at 0.37%, and UK -12bps at 3.40%). 2yr Notes +30bps at 1.49% and 10yr Notes -11bps at 2.33%.

YTD Equity Indexes: Poland +42.0% priced in US dollars (+24.2% in zloty), Argentina +41.8% in dollars (+54.1% in pesos), Austria +41.7% (+26.6%), Chile +35.0% (+28.7%), Portugal +33% (+18.9%), Italy +32.0% (+18.0%), Czech Republic +32.0% (+13.4%), Greece +31.4% (+17.4%), Turkey +30.3% (+31.7%), Denmark +29.5% (+15.9%), Hungary +29.5% (+16.5%), Brazil +26.7% (+23.4%), Mexico +25.5% (+10.3%), Germany +25.0% (+11.7%), Norway +25.0% (+15.5%), Belgium +24.7% (+11.4%), Korea +24.6% (+18.2%), Netherlands +24.4% (+11.2%), India +24.4% (+19.6%), HK +24.3% (+25.2%), Spain +24.2% (+11.0%), France +22.7% (+9.6%), Euro Stoxx 50 +22.3% (+9.2%), Finland +21.3% (+8.4%), NASDAQ +20.7% (+20.7%), Sweden +20.1% (+8.0%), New Zealand +19.9% (+15.2%), Singapore +19.2% (+11.8%), Taiwan +19.1% (+11.6%), Ireland +18.2% (+5.6%), Switzerland +16.9% (+11.4%), Thailand +16.7% (+8.4%), Philippines +16.3% (+19.5%), South Africa +14.1% (+12.5%), Malaysia +13.6% (+6.9%), China +12.9% (+7.9%), S&P 500 +12.5% (+12.5%), Colombia +12.2% (+9.8%), Indonesia +12.0% (+11.4%), UK +12.0% (+3.2%), Japan +10.3% (+6.5%), Canada +10.2% (+2.3%), Russell +9.9% (+9.9%), Israel +9.7% (+0.8%), Australia +8.9% (+0.3%), Saudi Arabia +1.1% (+1.0%), Russia -1.1% (-7.0%), and UAE -3.3% (-3.3%).

Heisenberg Principle: “My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation,” admitted our Fed Chairwoman. “Our understanding of the forces driving inflation is imperfect, and we recognize that something more persistent may be responsible for the current undershooting of our longer-run objective,” she said, blinking, blinded by flashing photographers. “The influence of labor utilization on inflation has become quite modest over the past 20 years, implying that the inflationary consequences of misjudging the sustainable rate of unemployment are low. But we cannot be sure that this modest sensitivity will persist in the face of strong labor market conditions, given that we do not fully understand how it came to be so modest in the first place,” whispered Yellen, unsure of anything, eyeing the exit.

Arbitrageurs: Oxpecker stood atop Rhino. Feeding freely on the ticks and larvae that infected the fearsome beast’s many open sores. Yet Oxpecker had a taste for the largest parasites, leaving smaller ones to aggravate Rhino. And the little bird craved Rhino’s blood, drawing its share day by day, sip at a time. At the first sign of danger, nervous Oxpecker flapped it wings just so. And Rhino, terribly shortsighted, understood the signal, steeled itself for attack, saving them both. It could have gone on forever, but one day, Oxpecker grew to be the size of Rhino.   

Summer 2007: The statistical arbitrage models had made such strong returns. But as money flowed in, their Sharpe ratios declined from exceptional to great. Then great to good. So on, so forth. But by doubling leverage the Sharpe ratios could be magically restored to their former glory. Doubling leverage required doubling positions, which in turn supported prices, and this lowered volatility - producing strong profits without an appearance of an increase in risk. And that all worked incredibly well, as of course it should, until it blew up. 

Coiling: The British Raj grew concerned by the abundance of venomous cobras in Delhi. A reward was offered for every dead snake. And in they slithered. One by one at first. Then in baskets, barrels. “Our strategy has proved a great success,” announced the Raj, yet still the number of captured cobras swelled. You see, the breeders had entered the business. When Raj learned of this betrayal, the law was abruptly abandoned. And the captive snakes, as worthless as they were abundant on a scale never before seen, were set free. Coiled throughout Delhi. 

Fair Enough: Merrill produced a measure called “Percent Cheap.” It allowed you to monitor where convertible bonds traded in relation to fair value. The measure explained the profitability of convertible arbitrage strategies throughout the cycle. The strategy was profitable, consistent. As money flowed in, the funds swelled, until the assets of all convertible arbitrage funds multiplied by their leverage equaled more than the sum of all global convertible bonds. Returns naturally declined to zero. Turned negative. Sparking small redemptions. Then it all imploded.  

Setting Targets: King Leopold set rubber gum quotas. Failure to meet them was punishable by death. Congo soldiers were ordered to provide a severed hand to the Belgium post commander to prove each execution. Soon, rubber quotas were being paid in part or whole using severed hands. When quotas were too high to fill, villages raided one another to sever their neighbor’s hands - which became a currency, an end in itself. Soldiers were rewarded for outsized hand collections. And in time, baskets of hands laid before Belgium post commanders became a symbol of Congo. 

Onehanded Applause: “The objective of monetary policy is to maintain price stability,” declared the Sveriges Riksbank Act. Stability is defined as 2% inflation, itself an oxymoron. “Sustainable growth and high employment are to be supported,” says the Act, though they’re of secondary importance. Inflation is now at the 2% target, a consequence of overnight interest rates at -0.50% and central bank bond buying, which weakened the krona, sparked +5.3% IP growth, +4.1% services output, unprecedented real estate speculation, and surging consumer debt.

Anecdote: “When a measure becomes a target, it ceases to be a good measure,” said the Englishman, stepping outside of himself. “That’s Goodhart’s Law.” Charles Goodhart observed that central banks measured money supply, and found certain M1 growth rates to be optimal. But once they targeted that optimal range, M1 lost its value as a measure. Market and economic actors adjusted their behavior to game the M1 system. So central bankers shifted to M2, then M3, and M4. “Investing is obviously not a science, but if it were, we would say that you can’t act on something and observe it at the same time.” French colonialists discovered this in rat infested Hanoi, when they offered a bounty for killing rodents. To receive the reward, the Vietnamese were required to produce severed tails. Soon thereafter, tail-less rats scurried throughout the city. The bounty hunters removed their tails and released them to the filthy sewers to breed. Boosting their bounty. “Investors discover pricing anomalies from the past. And they pile into them, ensuring that for a time they persist.” They mistake the distortions of their wall of money for the wisdom of their observations. They interact with the market as if they’re exogenous, when, in fact, they’ve become endogenous. “Today’s greatest example of Goodhart’s Law in action can be found in volatility markets.” The VIX index measures the expected volatility of the S&P 500, and is calculated by multiplying expected 30-day variance by 100. As a measure of market fear, it was quite useful, until it became something that could be traded. “The sheer size of outstanding positions in VIX futures, VIX options, ETFs, ETNs and bank volatility selling programs is such that those trading these markets can no longer separate the true measure of volatility from their own actions.” 

Good luck out there,

Eric Peters