When I first came to the United States as a 17-year old college freshman, I was invited to the home of my Caltech biology professor for Thanksgiving, along with many other foreign students who had nowhere else to go. I immediately fell in love with this holiday. First, it comes on a Thursday leading into a long weekend. Second, you get to eat infinite amounts of food. Finally, after eating large quantities of food you get to lounge on the couch, unabashedly, with others, as you watch reruns of old Hollywood classics and football. My favorite was to binge on the Twilight Zone reruns, where strange things always seemed to happen under the veneer of normalcy. The weekend that followed was usually spent recovering from the food gluttony.
Sometime today, if it hasn’t already happened, a sort of grim Twilight Zone will also happen to many turkeys. This has been called the “turkey problem”, a parable that Nassim Taleb of “Black Swan” fame eloquently cited in his books. Here is that quote verbatim:
Consider a turkey that is fed every day, every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.
The turkeys extrapolate the most recent history of what has happened to forecast that things will be just as wonderful in the future. They are provided a lot of food to fatten them up, they roam freely, and every day become more confident that things will be just…great.
The problem is that Thanksgiving comes around every year, and a hundred million turkeys except maybe a couple pardoned by the President are slaughtered. This year “Peanut Butter” and “Jelly” will be pardoned and might live out their life in relative happiness. For all the other turkeys the “revision of belief” is quickly accompanied by a sudden death.
Investors in the bond markets have similarly become used to central banks providing a back-stop. Even as inflation rages wild and the “transitory” camp is now changing its tune, folks insist on buying government bonds. Both Jerome Powell and Janet Yellen are now talking about inflation perhaps being more persistent than they thought, but more important, now they are talking more about what they will do if they are wrong in this assessment. In other words, they are getting ready to give the markets a shock – or to use Taleb’s words, “a revision of belief” in easy monetary policy.
In 1994, another Fed Chair, now the fallen from grace “non-maestro” Alan Greenspan, shocked the bond markets by tightening policy suddenly on Feb. 4, 1994. Rates had been pinned low, stock markets had been on fire since the 1987 crash. A couple months later the Fed tightened again between meetings. Then in May of 1994 the Fed accelerated the pace of rate hikes by 0.50%! In order to play catch-up to the markets, the Fed hiked rates by 2.5% in 1994. Two year Treasuries went from 4% at the beginning of the year to over 7.5% at the end of the year (Source: Bloomberg). Amongst other levered investors who suffered, Orange County, CA, the county I call home now, went bankrupt. Turkeys.
I was then a young trader, and tried many times to catch the falling knife, literally. My education was swift and painful, and I, like the turkeys, felt how the markets can revise beliefs without much warning. I was that overstuffed turkey too.
Today, the Fed is in a similar situation, having fallen behind due to its own hubris and belief in its economic forecasts that have been plain wrong. Since government officials will never admit they are wrong, the markets will have to prepare to deal with the falling knife on their own. With real yields in deeply negative territory globally even as stock markets make records daily, bond markets are at the mercy of non-elected officials making ad hoc decisions. And when the revision of belief happens, there will be few places to hide in liquid asset markets.
Going back to my Caltech days there is one other thing I am not so proud of. Us undergraduates used to call the graduate students “grad turkeys”, presumably because surviving the math and physics courses designed for an undergrad at Caltech was considered too hard for graduate students who had gone to other schools as undergrads. With their ungainly figures, inability to fly, the “gobble-gobble” sounds, and most important the tryptophan overdose that puts you to sleep, turkeys have become a symbol of stupidity. Of course all of this bad press about turkeys is likely a myth. But we just can’t be sure.
True or false, turkey day reminds us of the fact that when you are in the markets, you don’t want to be the last turkey thinking everything will be ok forever. We are surely in the Twilight Zone of central bank-driven markets, and the hangover from the gluttony won’t be pretty for the bond markets.