“Fourty four years after the end of the Bretton Woods System global central banks have manipulated the cost of risk in a competition of devaluation leading to a dangerous build up in debt and leverage, lower risk premiums, income disparity, and greater probability of tail events” says Chris Cole of Artemis Capital in his recent paper titled Volatility and the Allegory of the Prisoner’s Dilemma: False Peace, Moral Hazard, and Shadow Convexity.
Izabella Kaminska at FT Alphaville, praised it as “rare glimpse into his imaginarium” but I wonder if this was also a way to downplay its talk about tail event risks which are “equated with a loss of faith in the entire dollar system”. Precious metal investors will consider it far from imaginary and find much to agree with, such as:
“We are nearing the end of a thirty year ‘monetary super-cycle’ that created a ‘debt super-cycle’, a giant tower of babel in the capitalist system. As markets now fully price the expectation of central bank control” it is not possible for those central banks to “remove extraordinary monetary accommodation with risking a complete collapse of the system”.
Chris makes a number of complex points in an entertaining way but ultimately I see the piece as a case against complacency. One point that caught my eye and which I think goes a long way to explaining gold’s bear market is his identification of a shift from the central bank put, “policy action employed in response to, but not prior to, the onset of a crisis”, to pre-emptive central banking, which is “monetary action in anticipation of future financial stress to avert a market crash before it starts”.
Chris says that this “shift toward pre-emptive central banking occurred in the summer 2012: first with Mario Draghi’s pledge to do ‘whatever it takes’ to save the Euro on July 26th; and followed thereafter by Bernanke’s QE3 speech at Jackson Hole on August 30th.” He demonstrates this shift on a chart of the VIX and financial stress indexes. I have reproduced this chart, with the gold price overlayed, below.
Note that the period between Draghi’s ‘whatever it takes’ and Bernanke’s QE3 was gold’s last hurrah before its relentless downward trend. Once the markets realised that central bankers would intervene to prevent excessive losses, gold lost favour and we entered the weird world where “bad news is good news [but bad for gold] and vice versa because the intervention is more important than fundamentals”.
However, Chris argues that by artificially suppressing volatility all central banks have done is encourage “rampant moral hazard” and merely “taken tail risk from the present and shifted it into the future … the risk is not gone”. His solution is to “to own volatility on both the right and left tail of the return distribution … when markets are euphoric buy optionality to protect against deflation” in asset prices.
Izabella notes that such insurance is “expensive. For a reason. There’s a cost to maintaining resilient independent defences that depend on no-one.” I think it is obvious to this audience what that insurance might be, but Izabella notes a possible solution to this era of “central bank arms race of devaluation” as being “a united central bank equilibrium where all currencies became tied to one central global bank”.
Izabella summarises Chris’ comments about Mad Max 2 as “the ultimate long convexity film, because only someone with nothing to lose (no skin in the game) can really defend those who do”. Many have argued that gold sits outside of the financial system – being no one’s debt/obligation – making this “no skin in the game” asset capable of defending the rest of one’s investments from central bank hubris. Might it also make it an independent reference point to which currencies could be tied?
Frank Holmes of US Global Investors is known for talking about gold’s Love Trade and Fear Trade. Buried in Chris’ 50 page piece is a line which I think could be appropriated as the ultimate gold sales letter call to action:
“Buy the fear and you will be protected from the horror.”