DPAM Blog

STATE OF AFFAIRS

• • Today we discuss the Nash Equilibrium and apply the concept to central bank strategies. The Nash equilibrium exists in the realm of game theory.

• • Game theory sits at the core of financial market functioning and applies seamlessly to investment management. Over long horizons speculative investment management resembles a zero-sum game. Proper investment management can be considered a positively skewed game in which investment managers vie for an increase in wallet share by convincing institutional and retail investors that a consistent investment process edge leads to above average results. After costs. The Nash equilibrium, named after the mathematician John Nash Jr., defines the solution of a non-cooperative game involving two or more players. In a Nash equilibrium, each player is supposed to know the equilibrium strategies of the other players and no player has anything to gain by changing only their own strategy. Effectively most developed market (DM) central banks have chosen and communicated at length on their strategies. The common trait of these strategies builds on enforced forward guidance in policy rate setting next to sustained asset purchase programs that absorb duration, contain rate volatility and keep funding level for governments at bay. Over the past weeks, a lot of ink has flown on potential lift-off moments for policy rates next to assessments on the impact of asset purchase tapering. I would use the word tinkering instead of tapering. The previous episode, 2015- 2018, has shown that aggressive tapering by the FED quickly delivered unintended consequences. Unintended consequences known under the label of tightening of financial conditions. Tightening of financial conditions leads to market instability. With higher levels of leverage and margin debt currently visible in the financial system, the point of instability might come even faster today than was the case over H2 2018. Back then, the rules of the Nash equilibrium were trespassed giving rise to negative externalities. Fact is that financial market instability quickly spills over into negative real economic impact. Negative main street impact that requires central bank intervention or another round of fiscal support. And the whole cycle can start once more, leading to ever more central bank control on the price (read rates) formation mechanics across markets. We will make a quick tour that unveils the presence of Nash equilibrium awareness across central bankers. It’s a fragile equilibrium but one that maintains cost of funding for indebted DM governments well below levels that would ensue in a world without QE and enforced forward guidance.

• • On April 21, the Bank of Canada (BoC) announced that it would trim its asset purchase program to CAD 3 billion a week from CAD 4 billion and advance the timing for a possible interest rate hike – from 0.25% – to 2022 from 2023. Tapering is tinkering. Moving the lift-off marker is playing games with markets in a way to assess its vulnerability. The Canadian rates market did not really budge, the yield curve embraces the status quo. Thumbs up for the BoC. On March 19, the Bank of Japan (BoJ) decided to maintain its QQE (qualitative and quantitative easing) framework with yield curve control, but to enlarge the band to 25bp from 20bp around the 0.00% target level for the 10-year JGB rate. They also tinkered regarding ETF purchases, moving from Nikkei trackers towards TOPIX ETF’s. The TOPIX index has the largest number of component stocks and would better contain the shareholding ratio of the BoJ. Over the past week, the Bank of England has informed the public that they will tinker QE towards GBP 3.5 billion a week from GBP 4.5 billion. Martin Kazaks, the Bank of Latvia governor and ECB council member, was eager to announce this week that the ECB would review asset purchases in June. He added as well that winding down PEPP (that will be fully depleted and run till March 2022) might make room to increase the old APP program. We can expect that, within the FED, such announcements might be scheduled during the end of August Jackson Hole central bank ‘Hohe Messe’. Throughout all the noise delivered by the central bank community, we observe a well-orchestrated, officially non-cooperative, solution/outcome that pleases all central banks: We observe orderly moves across government bond markets. The timing for lift-off stretches from Q4 2022 to Q1 2023 for early flyers like the BoC, Reserve Bank of Australia or New Zealand Central Bank. Traditionally, these central banks test the waters. The FED might come into action over H2 2023. At best, we expect the ECB to start tinkering with policy rates by Q4 2024. Whether the Bank of Japan might lift policy rates ever again remains a key question that deserves an answer. The Bank of Japan has experimented the most with the use of unconventional instruments. As such it will take a lot of time to reverse course, leading to a rise in policy rates which have sat at -0.10% since 2016, before a long stint at +0.10% between end of 2008 till end of 2015. At best, expect a move towards +0.10% between 2025 and 2030. Before the pandemic, during an episode of accelerating globalisation between 2001 up to 2018, a Nash equilibrium state among central banks was less evident. The ECB policy rate mistakes of 2008 and 2011 come to mind. The FED mid-cycle hiking cycle between end of 2015 till end of 2018 has probably been a bit of an aberration. The prevailing tendency over the next decade might become a more orchestrated withdrawal of accommodative policy across central banks. By now, the players in the game have reached a higher level of understanding. So instead of focusing on the question of what is the terminal rate for the FED, we should answer the question what is the optimal terminal rate for the FED in this game? An optimal rate that will not disturb the Nash equilibrium allowing for steady, redistributive and climate oriented fiscal policy to unfold across DM, and by extension Emerging Market (EM) economies. The market has a terminal rate FED policy rate priced at 2.25%-2.50% today. However, that would read as a repeat of the ‘2015-2018’ mistake. Maybe, the moment the hot US economy debate loses some steam, the market might shift towards a lower end state for FED policy rates….1.50% anyone? This scenario would have a highly consolidating effect on current US long rates.

• • If a Nash equilibrium is in place and we account for the interconnectedness of international fixed income flows, I become more convinced that long term rates among OECD countries have entered an era of convergence. Surplus regions like the EU and Japan will perpetuate a solid interest towards US bond products. A positive windfall might also befall some EM economies as they get pulled into the gravity field of DM long rates and profit from lower funding levels. Countries like Romania, Czech Republic, Serbia across Eastern Europe or Mexico as main contender in Latam spring to mind. Central banks that apply Nash equilibrium principles in the conduct of their strategy might also have a compressing impact on term premium that market participants levy on various point of respective yield curves.