Nervous politicians complain about “wolf pack” and “bond vigilante” traders intruding into high politics. But many fund managers worry that markets are now being moved more by official decisions in Washington or Berlin than by traders in New York or London.
Ugly surprises move markets too, of course. As anti-Mubarak demonstrators surged through the tear gas into Cairo’s Tahrir Square last month, oil prices broke the $100-a-barrel mark. Many a carefully constructed emerging-markets trade was blown through its stops by this development, even as agricultural and energy plays got an unexpected boost.
I’ve spent some years of my life dealing with surprises, on Wall Street, in Silicon Valley and, most recently, at the Central Intelligence Agency’s National Intelligence Council. Before joining the CIA, I studied economics at Princeton University under then-professor Ben Bernanke, so in addition to my responsibilities as national intelligence officer for East Asia, the agency gave me an informal license to hunt for signs that markets were good at predicting political events.
From my experience, I was pretty sure we could learn something from money managers, particularly global macro traders, who obsessively monitor world events, place large directional and relative value bets on market movements and find out quickly if they are right or wrong. I agree with Harvard University professor Niall Ferguson’s observation in the foreword to Steven Drobny’s Inside the House of Money: “What impressed me about the global macro smart guys was the way they proceeded from theoretical insights derived from conventional economics, to empirical research, to the conception of a particular transaction, to the execution of the transaction — to the result itself.” Hedge fund traders can afford to build complex computer models, retain pricey consultants and sip white wine with policymakers at Jackson Hole, Davos and other high-altitude watering holes.
It quickly became clear to me that all sophisticated money managers, from Pacific Investment Management Co.’s bond traders to the private wealth managers at JPMorgan Chase & Co. to the prop desk at Deutsche Bank, place complex political bets as part of their investment strategies. Politicians move markets in ways that matter to these money managers, in several areas, which they watch very carefully.
Geopolitical events involving the fall of governments, the use of force or the sponsoring of terrorists move markets with shuddering intensity and usually little warning. The most-abrupt shocks come when countries go through major periods of political upheaval, regime change or even breakup: The September 11, 2001, terrorist attacks; Yugoslavia’s civil war; and Iraq come to mind. For example, Iraqi government debt obligations seesawed as its postwar constitution was being debated and there was a real possibility that the nation would be ripped apart. The country’s debt-to-resource ratio, a critical element in its credit rating, depended heavily on whether the oil-rich northern territories were considered to be part of Iraq or an independent Kurdistan.
War is fiendishly difficult to model, and because it is conducted under conditions of secrecy, it is usually an ugly surprise for financial market professionals. Revolutions and gunfire are bad, often very bad, for assets other than precious metals and short-dated U.S. Treasuries. It takes extraordinary contrarian fortitude to follow Lord Rothschild’s famous advice to “buy on the sound of the war cannons, and sell on the sound of the victory trumpets.”
From the trading desk, not only is such upheaval a surprise, but it is also nonlinear: It’s never clear how much violence and uncertainty it takes to move a market or how long the effects will last. For example, even though the salvo of missiles launched by Kim Jong Il in 2006 was a big deal for me as a Korea watcher at the CIA, South Korea’s equity index barely yawned at the unexpected Fourth of July fireworks. The North’s nuclear explosion a few months later didn’t move Seoul’s markets much either, resulting in a modest 2 percent downtick on the Korea composite stock price index.
By the same token, reactions to political chaos can be sharp, undiscriminating and transient. “The market response to many categories of event risk has degenerated into a binary decision tree — ‘risk on’ or ‘risk off,’ ” says Thomas McGlade, a portfolio manager at hedge fund firm Prologue Capital in Greenwich, Connecticut. “The Egyptian crisis sparked a knee-jerk ‘risk off’ trading response as it flared up, with stocks selling off, bonds rallying, the curve steepening, U.S. fixed income and the dollar outperforming on flight to quality, gold bouncing and CDS widening. However, the markets began over the weekend to recognize that the copycat contagion effect was not forthcoming. And so the trades were very quickly reversed.”
Disasters, natural or otherwise, present a similar dilemma for traders: They are high-impact, difficult-to-predict binary events, more in the category of “how to predict an earthquake” than “how to predict a currency revaluation.” As an uncomfortable example, the long-feared avian flu pandemic could break out any day now. Like war, this would be bad for every asset class other than gold and, perhaps, the equity of drugmaker Roche, the sole supplier of the Tamiflu antiviral.
Some money managers do trade disaster. When the World Health Organization, which works with Southeast Asian governments to analyze influenza biopsies, issued an otherwise humdrum press release that implied an apparent case of human-to-human transmission of H5N1 in Indonesia one afternoon in May 2006, the Standard & Poor’s 500 futures index took a shuddering dive of 25 points as a series of big short trades was triggered. I bet a lot of these conditional trades are still on the books.
Global macro traders scrutinize every Delphic pronouncement about monetary policy made by central bankers, parsing each sentence of each set of Federal Open Market Committee minutes, trying to decipher the interest rate tea leaves. They follow interest rate moves obsessively, as well as foreign exchange intervention, the assumption of private risk by public authorities (such as Fannie Mae), systemic risk, capital controls — now back in vogue in Brazil, South Korea and some corners of the International Monetary Fund — and direct interventions by governments in capital markets, such as the Troubled Asset Relief Program, the European Financial Stability Facility and, most recently, the Federal Reserve Board’s second round of quantitative easing.
Fiscal decisions are a key driver of real growth and sovereign debt. They can also produce some big surprises, including sovereign default. As one hedge fund strategist recently told me, “Unlike central bank policy, which is formulated and executed by a relatively rational and independent body, fiscal policy is the purview of elected politicians, with all of the attendant stupidities and inefficiencies, and so is less predictable.”
Monetary and fiscal policy together are the two big shaping events for most fund managers, with other government decisions operating largely in the background — at least, most of the time. Some traders carefully monitor high-profile regulatory decisions that can swing equity prices for large companies or even entire industries.
The downside of regulation from a fund manager’s perspective is the sheer uncertainty caused by a shifting rule book. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act took aim at a broad range of financial activities, from proprietary trading (the Volcker rule) to agency credit ratings; put some general principles in the statute; and then referred these to a host of diligent bureaucrats for detailed rule making. This process will create another year or two of uncertainty.
Tax rules shape trading strategies and profit-taking in profound ways. Congress and the British Parliament have been arguing about the proper treatment of taxes for private equity and hedge fund firms for three years. In the agonizing run-up to December 17, 2010, billions of dollars of capital gains hung fire while traders gazed incredulously at the Kabuki budget dance by U.S. President Barack Obama and the soon-to-be Republican Congress.
Back in the 1970s, when I was working at the State Department (for the late Richard Holbrooke) on multilateral tariff negotiations, government intervention in trade was a big deal. But this has ebbed as regimes such as the World Trade Organization constrain the capriciousness of state authorities in interfering with international flows, forcing them into “due processes” with deadlines, thus removing much of the surprise factor.
That said, government actions can ripple through commodity markets if the interference is drastic enough. Blunt instruments such as embargoes or price caps regularly clobber commodities like petroleum, wheat and rice. And officially directed purchasing decisions in large consuming countries such as China, which accounts for 40 percent of global demand for copper, can move commodity markets in big ways.
States have more latitude for sudden intervention in foreign direct investment decisions, as there are no treaties keeping them from blocking transactions on grounds of national or resource security. “The Committee on Foreign Investment in the U.S. [CFIUS] has blocked or imposed stringent conditions on several high-profile investments by foreign companies that raise national security concerns, to the surprise of the parties to the transaction. Other countries, including China and Germany, have recently established new rules to review foreign investments. These regulatory reviews can be opaque and unpredictable for investors,” says John Bellinger III, a former legal adviser for the State Department who is now a partner at Arnold & Porter in Washington. (Full disclosure: I regularly worked on CFIUS cases at the CIA.) Beijing routinely blocks foreign acquisitions of Chinese companies or imposes strict conditions on them, often to force technology transfers. Toronto recently scuttled BHP Billiton’s attempt to acquire PotashCorp under the authority of the Investment Canada Act, and the highest levels of the government in Paris were deeply involved in the 2010 recapitalization of Areva, France’s state-owned nuclear group.
SOME TRENDS ARE STRENGTHENING THE HANDS of traders in divining the course of policy events, but equally powerful trends are pushing things in the other direction. We are in a cross sea of ignorance and uncertainty.
Traders are ignorant if they are unaware of the full set of possible actions and outcomes in the case they are considering, let alone their likelihoods. For example, traders may be in a situation of ignorance with regard to a future regulatory ruling if they are unaware of all the powers that the regulatory agency possesses.
In the extreme, a trader in a state of ignorance may not even be aware that an action will be taken. Ignorance corresponds to what American military strategists call “unknown unknowns,” a term popularized by former Defense secretary Donald Rumsfeld. I used to brief him on national intelligence estimates, of which he was a thoughtful and critical consumer. Most senior politicians are lawyers by training, and they instinctively look at new information as a way to buttress their case. In contrast, Rumsfeld often looked for evidence in my brief that would contradict his views; I thought this was pretty remarkable, and much more in line with how successful macro traders think.
Traders are in what might be called nonquantifiable uncertainty if they know the full range of actions and outcomes in a particular case and have some notion of conditional gains and losses, but cannot assign a probability measure to those actions and outcomes — at least, not to enough of them. Traders are in the comfortable and potentially more profitable environment of quantifiable uncertainty if they know the range of outcomes and actions, can assign a probability measure to these outcomes and can estimate their gains or losses associated with these outcomes.
On balance, the expected profits of trading on the actions of nations varies in proportion to the trader’s state of uncertainty; the closer to ignorance traders are, the less able they will be to make a profit from designing and executing a rational trade. So by reducing their degree of uncertainty — by acquiring new information or conducting further analysis — traders can improve the expected profitability of political-event trading and thus become more willing to make these bets.
The closer to ignorance traders are, the more likely they are to limit the downside of their trades by inserting stops, trigger points that will close out the position if the asset values in question exceed a particular level. Stops have a cost — there is usually a counterparty to the stop trade who will extract a contingency fee for the traders’ “out” from their position. There is also the risk that stops will be automatically triggered by transient events tangential to the underlying bet.
As I discovered during my search for open source intelligence, four trends are pushing political decisions down the gradient from ignorance toward quantifiable uncertainty, thereby making state actions more profitably tradable, at least to fund managers with clear eyes and exceptionally strong nerves.
• Money to burn to make money. With the typical 2 percent management fee and 20 percent performance fee structure, hedge fund managers have remarkable amounts of money at their disposal to research, simulate and game the outcomes of state actions. The deepening of derivatives and swaps markets, combined with the availability of unprecedented amounts of reasonably reliable information on otherwise arcane price data series, allows traders to implement large multistage trades conditioned on actions by states, across a range of assets in a mix of currencies and maturities, that used to be impossible or uneconomic. Traders can then build sophisticated monitoring systems that scan web sites, blogs and other media for early warning signs of political events. These monitoring systems range from straightforward web crawlers and filters to elaborate, customized private intelligence networks.
• Front-running the politburo. China is a striking example of elite diffusion, giving investors indirect access to decision making behind the high vermilion walls of the Zhongnanhai compound in Beijing. China’s leaders guard decision making with reflexive secrecy. Yet now these debates leak in ways unthinkable in the 1970s and ’80s.
The wires in Beijing, Shanghai and Hong Kong buzz with information about economic decisions made by the Politburo Standing Committee (and subcommittees) within hours or minutes after they have been committed to paper by the ever-efficient Central Party scribes. As the economic management problems for China become more complex, including the sheer logistical overhead required for the People’s Bank of China to keep sterilizing foreign exchange inflows, the circle of people “in the know” inevitably widens and there are more opportunities for traders to front-run the decisions.
By the same token, as China is now a major player as a consumer in many markets, early indications of decisions by state-affiliated companies to buy or sell are worth a great deal to traders. It is even harder to keep these decisions hush-hush within Zhongnanhai; some provincial and even municipal state-owned enterprises (SOEs) can move these markets in meaningful ways.
There is a cottage industry of suppliers of political intelligence clustered around monetary and fiscal policymakers in Beijing, Washington and Brussels — often former officials, party cadres or parliamentarians who repackage information for their financial sector clients through a daily brief, periodic reports or on a bespoke basis.
Some operate as so-called reverse lobbyists. Rather than use their contacts to persuade bureaucrats or legislators to take specific actions, they aim to get a sense of the timing and magnitude of state actions already in the works. Others emulate private intelligence operations. The venerable Oxford Analytica issues a daily report for its customers explicitly modeled on the president’s daily brief, which my CIA colleagues and I used to write for the White House every morning.
“Events in Tunisia, Egypt and beyond demonstrated that macro political diligence is as important as financial or legal diligence for investors,” says Nader Mousavizadeh, Oxford Analytica’s CEO. David Gordon, my former CIA colleague and now director of research at the Eurasia Group, agrees. “Political risk is back,” he says. “It’s back big-time.”
• The flash news cycle. The constellation of state events that move markets is now tracked with an intensity and speed of diffusion that continue to accelerate. I don’t know any macro traders who read newspapers or watch television for more than idle amusement. For them, most useful information comes flashing across a proprietary screen or is found on the web. They scan, among other sources, the two dozen or so semitechnical macro trading weblogs that wax and wane in popularity based on their authors’ insights, writing skills and senses of humor. Some blogs are uproarious, some are analytically astute, and yet others are freighted with deliberate disinformation.
True or not, these ideas quickly move from the blogs into the mainstream. Economist Nouriel Roubini first propagated his views on his New York University faculty home page; now he charges for access. MIT Sloan School of Management professor Simon Johnson started out as a blogger before his ideas on bank concentration and “too big to fail” became commonly accepted.
It is striking to me how the sources of information blur into one another, thoroughly confusing traders and officials alike. For example, a blogger with a reasonable following on the web might receive a tip from a colleague about a central bank action and repackage it in a blog post with just enough detail to make it plausible. Within minutes two or three instant news channels pick up this post and pass it on, with a cascade of repeats occurring via Really Simple Syndication feeds, spreading virally across the Internet. Four or five daily commercial news sources might repeat the item from the RSS feeds, but now thinly edited, perhaps with a phone call to official spokespeople to confirm or deny the rumor and an on-the-record quote from a think tank pundit or reverse lobbyist.
In the last act of this high-stakes compressed drama, the BlackBerry of the hapless official spokesman of the central bank “in play” buzzes a hole in his pocket until a decision is forced and the government issues guidance or an official statement, confirming or denying the rumor but almost never ignoring it, thus bringing to a conclusion one of the biggest uncertainties in any government bureaucracy — namely, when the need for an important decision will finally come to the usually distracted attention of the leaders. A fusillade of queries from reporters poised to file stories or go on the air repeating the initial rumor will usually do the trick.
The pressure to feed the beast and stay ahead of the television coverage of the rapidly unfolding story in Egypt forced President Obama to talk about his heart-to-heart discussion with Hosni Mubarak within minutes of hanging up the Situation Room phone. In the meantime, asset markets were moving up, down and sideways as probabilities of the Egyptian spillover effects on the region and the Gulf’s oil supply lines were continually reassessed by traders and their semiautomated trading models, with billions of dollars at risk.
For a trader or investment strategist struggling to sift the information kernels from the background chaff, as the stakes of the political event went up, the signal-to-noise ratio of the news reporting went down. In this way, both traders and policymakers often find themselves in the same boat on a very confusing cross sea.
Politicians are not above manipulating the flash news cycle themselves, using leaks or fast-out-of-the-blocks press releases to set in motion a wave of speculation and commentary to corner another official or even an entire government. For example, the European Commission used adroit leaks and op-ed pieces to force the German government into supporting the European Financial Stability Forum at several points during the Greek euro zone negotiations.
• Multilateral rules. The binding terms of groups such as the WTO and the Bank for International Settlements reduce the range of actions that states can take. These terms frequently force these authorities to tip their hands in regard to both the process of decision making and the timing of a policy choice’s release to the public. Traders who are smart and diligent enough to crack the minutiae of these codes can gauge the range with a fair amount of accuracy.
This involves lawyerly, journeymanlike analysis and a lot of drudgery, and requires a good deal of patience as well as political common sense. Traders can derive a good sense of the timing of the release of decisions by monitoring and then tapping the circle of experts who follow such things — a bit of overlap with front-running the politburo, although in these cases it’s front-running a WTO tribunal or a BIS expert committee.
It’s fairly clear that the first trend — the modeling riches available to financial traders — makes state actions and their likelihoods more predictable. The second and third trends, elite diffusion and the flash news cycle, provide traders with more-accurate estimates of the probabilities of state actions with known effects. The last three trends narrow the range and timing of state policy actions and increase the transparency of official decisions.
These four trends make the world of political bets appear a bit less murky. But they may lead unwary traders into a conceptual mousetrap by reinforcing their assumption that politicians are both rational and coherent. Many traders reason thus: “If I just know the underlying strategy of the government and can monitor what it does closely enough, I can anticipate what it will do in the future.”
Monolithic decision making by rational actors is a brave assumption. From my experience, many policy choices are driven as much by bureaucratic infighting as by rational strategy, confirming the wisdom of the Washington adage that “where you stand depends upon where you sit.” Even the most rational decision makers are often led astray by the errors of mirror-imaging and other biases of ascription. They’ll think, for example, that another country behaves the same way we do or that it is doing something to hurt us rather than to achieve some other goal.
Despite its media reputation as a “crazy state,” North Korea is the exception to the turbid reality of confused and often irrational state actors. From years of close observation, I am convinced that Kim Jong Il is entirely rational and that Pyongyang basically is a monolithic state. Kim Jong Il makes all the big calls himself, and he does so on the basis of a pretty cool calculation of his objectives. On the other hand, he does view the outside world through a twisted, lost-in-the-funhouse lens, which makes predicting Korean Peninsula outcomes a challenge for intelligence officers and emerging-markets debt traders alike.
GOING FORWARD, IT IS LIKELY that the painful adjustments required by fiscal consolidation will result in an even more rapidly revolving door between political players and financial market traders, a constant reshuffling of elites in European capitals and even more customers for the New York–Washington shuttles. Expanded communication between these elites on both sides of the Atlantic may reduce some of the risk inherent in political bets. However, and most inconveniently, several powerful trends are pushing political bets in the diametrically opposite direction, from quantifiably uncertain to nonquantifiably uncertain and even all the way into Rumsfeld’s unknown unknowns. They include:
• Creeping central bank politicization. Over the past decade several institutional transformations have made market-focused decisions more overtly political, particularly the much-lamented decline of central bank independence. Monetary authorities from the Fed to the European Central Bank to the People’s Bank of China are increasingly subordinate to their political masters and thus more inclined to promote political goals such as growth and employment over price stability.
As politicians come to see their options for managing growth by fiscal expenditure reduced, they are more inclined to lean on central bankers to pump up the economy with monetary policy tools and inflate their way out of the debt burden. In the process, the definition of a monetary policy tool has become increasingly elastic, blurring the borderline between monetary and fiscal policy.
Skeptical traders see political calculations intruding into technical decisions such as the rules for short-selling or derivatives trading — even into the basics of financial accounting. There are striking examples of this last transformation on both sides of the Atlantic, with the European Commission having intimidated the formulators of international accounting standards and the U.S. Congress having browbeaten the proposers of generally accepted accounting principles when mark-to-market accounting presented inconvenient truths to regulators.
There is another wrinkle in the trend toward central bank sensitivity to political objectives that makes the range of outcomes both murkier and harder to assign probability to: The central bankers themselves may be increasingly at sea — an underlying source of ignorance that greater transparency can do nothing to dispel.
As Peter Katzenstein and Stephen Nelson observe in a scholarly dissection of Federal Reserve deliberations, the summary of risk and projections that is appended at irregular intervals to the minutes of the FOMC contains a section on “uncertainty and risk” that has appeared 12 times between 2008 and 2010, in contrast to only once between 2005 and 2007. The general tenor of the reports indicates that in recent years nearly all participants shared in the judgment that their projections of future economic activity were subject to greater-than-average uncertainty.
• Fiscal game of chicken. The unsustainable sovereign debt load is certainly not a new phenomenon, but what is striking is the ragged but relentless march of so many states right up to the edge of insolvency, with — at least in the euro zone — interlinked financial systems that could drag them all over the brink together. Budget politics of this magnitude resembles a serial game of chicken; nobody blinks until the situation looks truly awful. Politicians around the world are being forced to raise taxes and cut benefits — deeply. This will require crisis after crisis, awkward tangos into the default danger zone and extremely delicate coalitional bargaining to edge back out. This dance is conducted under the harsh lights of the media, including the implacable flash news cycle of the blogosphere.
From the sidelines, traders need to simultaneously estimate the outcome of events in peripheral euro zone states (Greece, Ireland, Portugal), the actions of the Germans and French with regard to the European Union, the byzantine maneuvers of the European Commission and the equally mysterious actions of the ECB. The IMF gets a role in this play too, as its conditions are embedded in the intra-EU memorandums of understanding regarding fiscal consolidation. There are enough variables and moving parts that these trades are increasingly close to the territory of nonquantifiable uncertainty.
As the levels of official coordination required to pull off, say, the Irish bailout increase, so do the risks of any single actor pulling down the show in the European game of chicken. Officials also have their eyes on the traders, trying to guesstimate what level of commitment is sufficient to reassure the dealers in sovereign debt markets. This lends an element of reflexivity to the causal chain of assumption and inference, pushing the traders further back toward ignorance.
• Revival of state capitalism. Even as many developed states in Europe continue to divest and semiprivatize SOEs in utilities and transportation, many emerging-markets states are expanding their ownership and control of companies in the mining, agricultural, petroleum and natural-gas markets.
Dubbed “the revival of state capitalism” by pundits, state-owned companies now control an estimated 88 percent of the world’s proven oil reserves, are integrated downstream and increasingly bid among themselves for new exploration properties. This government push into natural resources has more than offset the wave of privatizations of SOEs in Europe, principally in telecommunications and transportation, that took place in the 1980s and ’90s. Ironically, one of the primary drivers of that privatization wave was the need to raise cash and reduce state debt to meet the convergence criteria of the 1992 Maastricht agreement, which established limits of 60 percent on the ratio of debt to GDP and 3 percent on the ratio of ordinary deficits to GDP.
Many of the governments relying on natural-resource largesse are in emerging markets in which state activity has been erratic, opaque or merely corrupt, thereby further skewing the odds for traders. Examples of newly rich resource regimes that must be carefully observed and whose actions must be predicted — many bearing more than a passing resemblance to traditional rentier states — include Iran, Kazakhstan, Sudan, Venezuela and, of course, Russia.
• Stubborn regime flaws. As noted earlier, even though multilateral regimes such as the WTO limit the range of state actions and thus reduce uncertainty, some glaring structural flaws in these agreements have pushed things further in the direction of uncertainty. And these flaws aren’t going away any time soon.
In the set of international financial regimes, the most glaring weakness is the lack of a mechanism within the international settlements system to force adjustment on permanent surplus countries such as China. The flip side is the lack of a mechanism to smoothly adjust the permanent deficit of the U.S.
Though many states pursued export-led growth in the 1970s and ’80s, few central banks succeeded in achieving monetary sterilization on the scale that the People’s Bank of China has managed to accomplish for more than a decade. The PBOC purchases about $2 billion of foreign exchange on each trading day and promptly neutralizes the effect of these purchases on the domestic money supply through a combination of issuing “sterilization bills” (which the state-controlled banks are obliged to buy) and, now and then, increasing required reserve levels. This could go on for a very long time.
Another example, the most glaring flaw in the nuclear nonproliferation regime, is the absence of any mechanism to prevent would-be acquirers of nuclear weapons from assembling delivery systems while methodically enriching nuclear fuel, an act that can be carried out while remaining compliant with the letter, if not the spirit, of the Nuclear Non-Proliferation Treaty.
Some fund managers have invested in early warning systems keyed to signals of an Iranian nuclear breakout as well as a Western preventative strike. An air strike, possibly by Israel, is likely to precede an Iranian nuclear breakout, with probability and timing unclear. According to one line of analysis, such an attack is feasible under current conditions, but not if the Iranian air defense system is significantly upgraded. The Russians have been dangling a potential sale of their powerful S-300 surface-to-air missiles to Iran for years; the shipment of these missiles to Iran would virtually force Israel to strike. It is a hard bet whether turmoil in Egypt and Jordan, combined with a new Hezbollah government in Lebanon, will increase or decrease the odds, and influence the timing, of an Israeli strike.
THE OBVIOUS PRESCRIPTION for traders is to take advantage of those trends that are reducing uncertainty and hedge those trends moving in the other direction. This requires factoring the political world into a set of operational decisions, including traded asset classes, risk management, information systems design and even the recruiting and training of traders.
The first, and most obvious, challenge is to clarify exactly what political assumptions are embedded in a trading or portfolio strategy — a step that smart global macro traders take instinctively. Some find it useful to make these assumptions explicit and write them down by category, in effect filling out a matrix of geopolitical, monetary, fiscal, regulatory, and trade and investment events. These are the strategy’s white-swan assumptions, to use Nassim Nicholas Taleb’s famous Fooled by Randomness formulation. Then they go down the list and flip these assumptions one by one, going from white to black, testing for which state events (alone or in combination) blow the stops or, quite possibly, their entire trade.
This is obviously easier to do for a macro trading strategy in which a price is assumed to go from x to y within z variance (with stops at the top and bottom of z) than it is for a total portfolio strategy, but the same logic underlies both kinds of bets.
For a complex portfolio rather than a single trade, this suggests systematically scrubbing all of the elements of the portfolio (equity, commodity, fixed income and so forth) for their political assumptions — implicit and explicit — and then aggregating these positions to get a sense of the total terrain of the fund’s political bets. Some of these embedded political bets may cancel each other out, while others complement or compound the stakes riding on a white-swan outcome; they may have symmetrical or different levels of stops and similar or different trigger events. In any case, it may be more profitable to rebalance these political bets on an overlay basis for the total fund portfolio — a sort of “political hedge book” — rather than readjust the individual trades and component funds.
For the really big political bets, especially the events moving closer to ignorance than quantifiable uncertainty that were noted above, fund strategists should also have a clear picture of how much perturbation risk from black-swan events they are willing to accept. They should also think carefully about whether these events induce changes in the correlations between asset markets as well as changes in the volatility in those markets.
The alarming confluence of central bank politicization and fiscal chicken is moving the two single-biggest bets made by funds into the realm of greater uncertainty. If the Fed’s rule book is increasingly obscure, and if the decision makers themselves acknowledge that they are making it up as they go along, as the FOMC narrative suggests, then a thoughtful trader would seek to employ front-running the politburo and the flash news cycle as much as possible to help offset these two trends.
This recommends to fund managers a renewed attention to monitoring their trade strategies, and the importance of putting in place a formal or informal mechanism to provide an early warning if the key assumptions about political events are reversed, from white to black swans. A warning system can range from a carefully cultivated Rolodex of trusted experts and former policymakers to an automated web crawler scanning the relevant blogs and RSS networks.
As for the stubborn regime flaws, the inconvenient lacunae in the multilateral rule books aren’t likely to be closed any time soon. Far-sighted traders would resign themselves to the fact that discontinuous currency realignments by surplus countries — possibly big ones, certainly involving the renminbi — are going to be with us for a while. Beijing’s currency revaluation is a solid one-way bet, and the proliferation of nuclear weapons is (unhappily) about as close to a one-way bet as you can make in geopolitics. Political instability and nuclear weapons are an unnerving pair of black-swan events flapping together out of the Middle East.
At the end of the day, it may be that black swans move markets more than politicians and traders combined. When former prime minister Harold Macmillan, who presided over Britain’s loss of empire in the Middle East, was asked what worried him the most as a statesman, he languidly but accurately replied: “Events, my dear boy. Events.”
James Shinn (jshinn@princeton.edu) is a lecturer at Princeton University’s School of Engineering and Applied Science. After careers on Wall Street and in Silicon Valley, he served as the national intelligence officer for East Asia at the Central Intelligence Agency and then as assistant secretary of Defense for Asia at the Pentagon. Shinn, who has an MBA from Harvard Business School and a Ph.D. in public policy from Princeton, also serves on the advisory forum of London-based hedge fund firm CQS.
