a Reflexive Process in the Bond Market

earlier this morning we tweeted on the twitter an interesting post from FT’s Money Supply blog by Robin Harding (sub req) regarding some comments by the Bank of Japan’s Gov Shirakawa made over this weekend at a Fed conference on the financial crisis that focused on the Four Problems with Aggressive Monetary Policy.  Like Harding, we were especially interested in the 2nd comment whereby Shirakawa suggests low interest rates produce slowing growth by “making resource allocation inefficient”.

We have long posited that interest rates as they approach the zero bound (negative) are a function of Soros’ reflexivity, i.e. low interest rates begin to effect the slow growth they appear to be discounting.

What is reflexivity?

Per Wikipedia:  Reflexivity refers to circular relationships between cause and effect. A reflexive relationship is bidirectional with both the cause and the effect affecting one another in a situation that does not render both functions causes and effects…

In other words, reflexivity is similar to a feedback loop.

Feedback loops, speculative bubbles, convexity, death spirals and inefficient pricing are all reflexivity in action yet these observances are not unique to Soros.  What is unique, however, is that Soros recognized that a market reflexive relationship could begin to alter economic fundamentals in which they seek.  Perception becomes reality.

George Soros – The Alchemy of Finance

“A strong economy tends to enhance the asset values and income streams that serve to determine creditworthiness.  In the early stages of a reflexive process of credit expansion the amount of credit involved is relatively small so that its impact on collateral values is negligible.  That is why the expansionary phase is slow to start with and credit remains soundly based at first.  But as the amount of debt accumulates, total lending increases in importance and begins to have an appreciable effect on collateral values.  The process continues until a point is reached where total credit cannot increase fast enough to continue stimulating the economy.  By that time, collateral values have become greatly dependent on the stimulative effect of new lending and, as new lending fails to accelerate, collateral values begin to decline.  The erosion of collateral values has a depressing effect on economic activity, which in turn reinforces the erosion of collateral values.  Since the collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans, which in turn may make the decline more precipitous.  That is the anatomy of a typical boom and bust.”

Soros wrote that in 1987 but it sounds like he was explaining the root cause behind the 2008 Financial Crisis.  First it was internet stocks, then credit & real estate, now USTs?  Many think interest rates can stay low for a long time a la Japan but we believe there is a distinct difference because the Yen is not the World’s reserve currency.  Because the USD is the reserve currency the more dollars produced the more demand you create for UST coupons.  As you inflate your currency you are creating more demand for coupons as they become more negative or said another way, the demand increases as price gets more expensive.  That’s why its a bubble.  Has the supply of dollars peaked?

I don’t think its a stretch to think the bond market has been stuck in a reflexive process and when it ends there will be a lot of negative coupon long duration assets for sale.

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About exantefactor

capital market veteran of over 15 years covering multiple asset classes. Focused on analyzying markets ex ante (before the event).
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