era of dissonance

35
ERA OF DISSONANCE, 3 NOVEMBER 2011 1 MARKET INSIGHTS Era of Dissonance nsights Market Introduction Financial markets have entered an Era of Dissonance that will stand in sharp contrast to the relative harmony and economic expansion of the last half of the 20 th century. The Era of Dissonance will not easily resolve itself into a more comfortable and predictable environment and may last as long as a decade or more. During this transition period to a new world order there will be a continual conflict between perceptions of reality, widely variant possible outcomes, and confused future expectations. Financial markets will remain challenged, with bouts of uncertainty concerning strikingly different potential outcomes. The dissonance will profoundly disturb the dynamic evolution of market returns, volatilities, correlations, and risk-taking preferences. Our understanding of financial risk management is likely to undergo critical changes, because simplified approaches and traditional “rules of thumb” will not work during this period. Foreign exchange markets, as a natural focal point of economic imbalances among countries, will play a critical role in transferring sources of volatility into other asset classes, although not necessarily in a direct manner. The risk-on, risk-off nature of markets is not going away any time soon. One can no longer assume that over time market outcomes are drawn from distributions of possibilities with similar volatility and correlation structures. Correlation structures will not be stable and may even swing quite wildly. The ability to manage financial risks effectively over any time frame will be much more difficult. Market participants will need to re-assess many of the basic assumptions that guide their understanding of financial risks and form the basis for their decision making. Our hope and challenge in this report is to provide an intellectual framework for understanding how to construct an effective risk management strategy in this Era of Dissonance as well as to highlight some practical guidelines for navigating through these difficult times. Disclaimer. All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. This report and the information herein should not be considered investment advice or the results of actual market experience.

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Page 1: Era of Dissonance

Era of DissonancE, 3 novEmbEr 2011

1 markEt insights

Era of Dissonance

nsightsMarket

introduction

Financial markets have entered an Era of Dissonance that will stand in sharp contrast to the relative harmony and

economic expansion of the last half of the 20th century. The Era of Dissonance will not easily resolve itself into a

more comfortable and predictable environment and may last as long as a decade or more. During this transition

period to a new world order there will be a continual conflict between perceptions of reality, widely variant possible

outcomes, and confused future expectations. Financial markets will remain challenged, with bouts of uncertainty

concerning strikingly different potential outcomes. The dissonance will profoundly disturb the dynamic evolution

of market returns, volatilities, correlations, and risk-taking preferences. Our understanding of financial risk

management is likely to undergo critical changes, because simplified approaches and traditional “rules of thumb”

will not work during this period.

Foreign exchange markets, as a natural focal point of economic imbalances among countries, will play a critical

role in transferring sources of volatility into other asset classes, although not necessarily in a direct manner. The

risk-on, risk-off nature of markets is not going away any time soon. One can no longer assume that over time market

outcomes are drawn from distributions of possibilities with similar volatility and correlation structures. Correlation

structures will not be stable and may even swing quite wildly. The ability to manage financial risks effectively

over any time frame will be much more difficult. Market participants will need to re-assess many of the basic

assumptions that guide their understanding of financial risks and form the basis for their decision making.

Our hope and challenge in this report is to provide an intellectual framework for understanding how to construct an

effective risk management strategy in this Era of Dissonance as well as to highlight some practical guidelines for

navigating through these difficult times.

Disclaimer. All examples in this report are hypothetical interpretations of situations and are used

for explanation purposes only. This report and the information herein should not be considered

investment advice or the results of actual market experience.

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Our first step will be to identify the key sources of dissonance and gain an appreciation of their long-term economic

implications. We will examine the role of population dynamics, property rights, and policy constraints. For the most

part, these sources are well known, yet their impact on markets when taken together as a package is not necessarily

well-understood or fully-appreciated.

Population dynamics accentuate the economic growth divide between the slower-growing mature industrial

countries and faster-growing emerging market countries. Moreover, the faster-growing countries are less

efficient users of energy and commodities. As emerging market countries grow, they will add to global energy and

commodity demand at an even faster pace. And, as these countries build a larger middle class, their diets will

change and demand for agricultural products and clean water will soar.

Property rights represent a second critical source of dissonance. We define property rights broadly to represent

the legal, regulatory, and political environment that determines the context for consumer and business planning

for the future. This definition includes how businesses are regulated, what powers the state has to seize or limit the

use of private property, how people and companies are taxed, as well as the overall stability and predictability of the

political environment. What we see is the gradual erosion of property rights in the mature industrial countries adding

further friction to their economies and making unemployment reduction more difficult. The steady improvement of

contract law and political stability in the emerging markets is increasing their ability to attract global capital to their

countries, allowing stronger productivity growth that eventually encourages wage growth.

Policy constraints are our third source of dissonance. Constraints on the effectiveness of fiscal and monetary

policy in the mature countries will severely limit their ability to reduce the mountain of debt they have accumulated

over the years. The relative flexibility that emerging market countries have in both fiscal and monetary policy gives

them some tools to cushion, if only partly, the impact on their economies from the growth recession in the mature

industrial economies.

We might dub these dynamics – population, property rights, and policy – the Three P’s of Market Dissonance. And

while we start our analysis with these sources of dissonance, what is equally important is to gain an appreciation

that the long-term economic growth implications coming from the sources of dissonance naturally point to

conflicting expectations of how financial markets will resolve different perspectives. Moreover, the sources of

dissonance and their long-term economic implications dramatically increase the tensions within political systems.

This heightened tension is reflected in markets, making them much more sensitive to political agendas, not just

the economic trajectory. In short, the Era of Dissonance will be defined by a very large number of perceived

political and economic conflicts that will generate a seemingly never-ending series of widely divergent

expectations.

Our second step, then, is to work through a framework for analyzing how markets resolve dissonance. We will do this

by describing how markets deal with expectations of multiple scenarios of low probability but high impact events.

While the statistical and probability theories underlying our analysis are complex, the analytical intuition is

straightforward. Financial markets are designed to be forward-looking discounting mechanisms that resolve

differing perspectives on future scenarios. Markets do not function as smoothly when those competing future

scenarios become more distant from each other. The result is not only more volatility, but times in which volatility

and correlations may shift dramatically only to change again abruptly at some future time.

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The final step combines our analysis of the sources of dissonance with our appreciation of how markets resolve

dissonance to categorize in a practical manner the challenges all sectors face in managing financial risks in this

environment. We focus first on currency markets as a way to illustrate how shocks flow through the asset classes,

changing expected returns, volatilities, correlations, and the risk preferences of market participants in their wake.

We then examine the “risk-on, risk-off” nature of markets over the past several years. Finally, we draw some practical

conclusions for managing risk in the Era of Dissonance.

i. sources of Dissonance and Long-term Economic implications

The last half of the 20th century will go down in history as a very exceptional period of global economic expansion.

Following two horrendous World Wars with a Great Depression in between, the formerly protagonist industrial

countries shared common objectives of peaceful nation-building through economic growth and trade. Moreover,

despite large cultural differences, the various industrial nations had similar demographics with young and growing

populations needing to be put to work. A coordinated global monetary system, known as Bretton Woods, was

established to provide a framework for the maintenance of a stable, non-inflationary world financial system. The

industrial countries took broadly similar approaches to the use of fiscal policy to encourage economic growth and

cushion economic cycles, while accommodating well their different preferences for social programs.

Led by the G5 countries – US, UK, Germany, France, and Japan – economic growth among the industrial countries

of the world was impressive. Certainly, there were some big bumps along the way. The fixed exchange rate system

broke down in 1971. Energy prices surged in 1974-1975 and again in 1979. These economic challenges positioned

the decade of the inflationary 1970s as a potential turning point toward a world of policy conflict. Yet the industrial

nations came together again with the shared objective of taming inflation. They coordinated central bank policies,

created conditions for disinflation, and ushered in another two decades of solid economic growth and expansion of

world trade.

The first decade of the 21st century, however, served as a wake-up call. For those managing financial risks, it is

not news that we have already been sailing in uncharted waters for several years. From the time the US subprime

mortgage debacle burst into the public’s consciousness in 2007, to the Financial Panic of 2008, the European

Sovereign Debt Crisis of 2010-2011, and disarray in US budget policy in the summer of 2011, among other events,

financial market participants have been hammered with a sequence of exceptional challenges. Yet, in the first few

years after the Financial Panic of 2008, there was a general perception that somehow, sooner or later, markets

would settle down into a new order that would be relatively predictable and manageable, even if quite different from

the relative comfort of the latter half of the 20th century.

This resolution to a new order has not happened. Our first step in understanding why is to review the key sources

of dissonance that markets are facing. It matters not that these trends have been widely recognized for a long time.

What matters is that they are now on center stage, and they are working as a package, not independently.

First, population dynamics are splitting the world into younger and more mature countries. The younger

countries have brighter futures, higher expectations for future economic growth, more of a focus on job creation,

and more emphasis on the development of their economic infrastructure. By comparison, the more mature

countries are coming to grips with the reality of slower economic growth, a decaying infrastructure, massive over-

indebtedness, and huge challenges in the health care and social safety net arena due to an explosion in the number

of people of retirement age.

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Second, emerging countries are improving rapidly in terms of political stability, the enforcement of

contracts, and all the legal manifestations of the protection of property rights that enhance the ability of

consumers and corporations to plan effectively for future investment and growth. By contrast, mature countries are

seeing a steady erosion of the flexibility of their economic models due to tax and regulatory uncertainty, limitations

on property rights, and the increasing inability of the political system to reach a consensus and chart a steady

and reasonably predictable course, allowing for the kind of long-run planning by consumers and corporations that

measurably enhances economic growth.

Third, monetary and fiscal policies are highly constrained tools of economic management in mature

industrial countries. In many cases, these policy tools have hit their limits of effectiveness in the mature countries,

yet some degree of flexibility remains in the policy arena for younger and faster growing countries.

a. Population Dynamics

There are strikingly different demographic patterns among the major countries of the world. What we have

observed is that while population trends are broadly recognized, the powerful political-economic implications of

demographic patterns are consistently under-estimated by financial market participants, possibly due to the slow-

moving nature of these trends. Our objective is to emphasize the long-term economic growth implications and the

political choices countries have to make that are heavily influenced by the context of their demographic situation.

1. Different aging Patterns

Here we want to take a brief look at the population pyramids of six major countries. In all of these charts, the

age cohorts represent five-year brackets, starting with the youth at the base of the pyramid, moving through the

working age population, and capping the chart with the elderly.1 When studying these charts, the issues we are

contemplating are the different political forces that are at work through the dynamics of the demographic patterns.

For example, is the political support for jobs versus health care programs, or for low inflation versus export growth,

the same across countries given the different demographic profiles shown below?

India and Brazil are striking examples of youthful nations.

1 All of the population pyramids were sourced directly from the website of the US Census Bureau, the International Data Base Section. Available online at www.census.gov/population/international/data/idb/informationGateway.php Populations are estimated for 2011, and all brackets are in millions of people with males on the left and females on the right side of the chart.

100+95 – 9990 – 9485 – 8980 – 8475 – 7970 – 7465 – 6960 – 6455 – 5950 – 5445 – 4940 – 4435 – 3930 – 3425 – 2920 – 2415 – 1910 – 145 – 90 – 4

Brazil - 2011

Population (In Millions)

Male

10 8 6 4 2 0

Female

0 2 4 6 8 10

100+95 – 9990 – 9485 – 8980 – 8475 – 7970 – 7465 – 6960 – 6455 – 5950 – 5445 – 4940 – 4435 – 3930 – 3425 – 2920 – 2415 – 1910 – 145 – 90 – 4

India - 2011

Population (In Millions)

Male

65 52 39 26 13 0

Female

0 13 26 39 52 65

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In stark contrast, Japan and Germany have the profile of much older populations.

And then, there are countries such as the United States and China which are aging rapidly, but are not yet facing

shrinking populations.

The mature industrial countries, represented by the US, Japan, the UK and Western Europe, are entering a period

when labor force growth is slowing or even shrinking. Their most challenging policy issues, such as health care,

surround the demographic cohort of the rapidly expanding retired population.

By contrast, emerging economies are challenged to put millions of young people to work or to find urban jobs for

workers migrating from rural areas. In some eerily similar ways, the emerging economies are entering a potentially

dynamic phase of economic growth much like the demographic context that helped propel the industrial countries

into a half century of growth starting back in 1950.

There are some anomalies. For example, China does not fit the pattern. While China has been one of the fastest

growing countries over the last 30 years, the country’s population dynamics are that of an older nation. What has

helped to sustain China’s rapid economic growth is a massive migration from rural areas to urban centers, which

100+95 – 9990 – 9485 – 8980 – 8475 – 7970 – 7465 – 6960 – 6455 – 5950 – 5445 – 4940 – 4435 – 3930 – 3425 – 2920 – 2415 – 1910 – 145 – 90 – 4

Japan - 2011

Population (In Millions)

6 4.8 3.6 2.4 1.2 0

FemaleMale

0 1.2 2.4 3.6 4.8 6

100+95 – 9990 – 9485 – 8980 – 8475 – 7970 – 7465 – 6960 – 6455 – 5950 – 5445 – 4940 – 4435 – 3930 – 3425 – 2920 – 2415 – 1910 – 145 – 90 – 4

Germany - 2011

Population (In Millions)

4 3.2 2.4 1.6 0.8 0

FemaleMale

0 0.8 1.6 2.4 3.2 4

p ( )

100+95 – 9990 – 9485 – 8980 – 8475 – 7970 – 7465 – 6960 – 6455 – 5950 – 5445 – 4940 – 4435 – 3930 – 3425 – 2920 – 2415 – 1910 – 145 – 90 – 4

United States - 2011

Population (In Millions)

15 12 9 6 3 0

FemaleMale

0 3 6 9 12 15

p ( )

100+95 – 9990 – 9485 – 8980 – 8475 – 7970 – 7465 – 6960 – 6455 – 5950 – 5445 – 4940 – 4435 – 3930 – 3425 – 2920 – 2415 – 1910 – 145 – 90 – 4

China - 2011

Population (In Millions)

70 56 42 28 14 0 0 14 28 42 56 70

FemaleMale

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has fed the growth of China’s industrial sector. This rural-to-urban migration was also a feature of Japan in the

1950s and 1960s when the nation regularly posted 10% increases in real GDP per year. The former Soviet Union also

effectively utilized the migration of workers from the farm to the city to power its industrial growth in the 1950s and

1960s, only to slow down dramatically when the supply of labor from the rural sector ran dry.

2. Long-run Economic growth Drivers

Demographic patterns are important economic drivers because they determine the growth of the industrial and

service sector labor force. When coupled with observations about the potential growth in the productivity of the

labor force, one has a framework for considering the impact on long-term growth prospects related to powerful

population dynamics.

The industrial and service sector labor force can grow for essentially three reasons. (a) There are more young

people entering the working age labor market than there are retirees leaving the market. (b) Working age people are

migrating from rural agricultural pursuits to urban industrial and service sector jobs. And, (c) working age people are

migrating from external locations into the domestic labor force.

Productivity growth also tends to come from three sources. (a) New capital investment can raise the productivity

of labor. (b) Urban industrial and service sector jobs tend to have much higher productivity than rural agricultural

employment in developing countries, so a switch from rural to urban employment can raise an emerging nation’s

labor productivity. And, (c) technological progress can raise labor productivity.

Most of these drivers are present in relatively young, emerging economies, while more mature countries are much

more dependent on technological progress to power economic growth, given the high quality of their existing capital

stock and their lack of labor force growth. Taken together, it is hard to expect annual real gDP growth in the

mature industrial countries to exceed more than 2.5% per year, and even that may be an over-estimate when

other factors are considered. by contrast, annual real gDP can reasonably average 5% or more per year in the

emerging countries.

Japan

Euro-Zone

UK

US

Brazil

India

China

0% 50% 100% 150% 200%

Cumulative Real GDP Growth from 2001 through 2010

Source: World Bank Annual GDP Data from Bloomberg Professional

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3. old versus Young Politics

Growth differentials have powerful implications for wage differentials. Labor productivity is very high in the

mature industrial countries, but now grows slowly only as technology progresses. In the emerging countries, labor

productivity is quite low and the potential for productivity growth is huge from investments in infrastructure and

new plant and capital equipment. The interesting challenge in the emerging countries is how the benefits from

rapidly growing labor productivity get divided between the wealthy class of owners and the middle class of workers.

Put another way, the middle class will certainly expand, but the income divide between the super rich and the poor

may also expand, leading to internal political tensions if wage growth falls too far behind productivity growth. This is

an important issue today, for example, in China, India, Brazil, and Russia, among other countries.

Energy demand will also be a focal point. The mature industrial countries are relatively efficient users of energy,

such that a 1% gain in real GDP results in something less than a 1% increase in energy demand. For emerging

market countries, it is a different story. They are not very efficient users of energy, and they are in the midst of

infrastructure building which can be energy intensive. For emerging market countries, energy demand is actually

an increasing function of economic growth. As emerging market countries establish a robust middle class, energy

consumption as a percent of real GDP rises.2 Consequently, if global growth is coming more from the emerging

countries, energy demand will rise considerably faster than otherwise.

Other indirect implications will affect both agriculture and water. Agriculture uses a lot of water, but so does

industry, not to mention the public’s consumption needs. Rapid growth in the emerging countries is going to

challenge simultaneously food production and clean water supplies around the world, creating political and market

tensions we can only imagine at this stage.

2 See “Fueling Growth: What Drives Energy Demand in Developing Countries?”, by Arthur van Benthem and Mattia Romani, The Energy Journal, published by the International Association for Energy Economics, Volume 30, 2009.

Oil Import Bills in Net Importing Less Developed Countries

Notes: 2011 estimated.

Source: ”Energy for All”, page 9, special early excerpt of the ”World Energy Outlook:

2011” published by the International Energy Agency, 2011.

Bill

ion

do

llars

(2

010

) 120

100

80

60

40

20

02000 2005 2010 2011

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The point here is that it is hard to underestimate the dissonance that will continually hammer markets from the ebb

and flow of these growth differentials as their direct and indirect implications work their way through the world’s

financial system. We can make, however, some broad generalizations about the political biases that population and

growth dynamics create.

a. Jobs. Youthful countries have a policy imperative to create jobs and to grow wages. With so many young

people entering the labor force, a country needs to creates jobs or political unrest is nearly a given. Consequently,

youthful countries have a clear bias to promote export-led job creation, and these countries fear any substantial rise

in the relative value of their currency that could hurt the job creation process necessary for political stability.

b. Wealth and health. By contrast, the political issue for an older country is wealth preservation (that

is, keep what you have earned), health care, pensions, and social safety nets. The bias toward wealth

preservation shows up as a preference for a stable to strong currency to maintain or increase the international

purchasing power of the wealth that has already been created. Creating new jobs is not as important over the long

haul, since the labor force has stopped growing, although putting people back to work after a recession will remain a

cyclical focus.

c. inflation tolerance. Similarly, the politics of aging changes the tolerance for inflation. A youthful country

is much more willing to tolerate some inflation as a small price to pay for job creation and the pressures that

accompany the establishment of a viable middle class. An older country does not need secular job creation and

wants no part of inflation, which depreciates the wealth already accumulated.

b. swinging Pendulum of Property rights and regulatory trends

Our inclusion of property rights as a source of dissonance is focused directly on the challenges consumers and

corporations face in planning for the future. As noted in the introduction our definition of property rights is broad,

intended to represent the ability of individuals and corporations to conduct their business on a level playing field

(i.e., laws, rules, regulations, taxes) with an expectation that the rules and goalposts will shift in an orderly manner

(i.e., political stability, consistency of court rulings and enforcement of contracts, etc.). That is, we are evaluating

the various elements that allow for effective planning, which we regard as an important determinant of long-term

economic growth.

What is often underappreciated are the different directions in which the pendulum of property rights is

swinging for certain countries or groups of countries. This has powerful implications for relative political confidence

and risk among countries in the 21st century as compared to the last half of the 20th century. It is extremely

difficult, if not impossible, to measure quantitatively the comparative degree of property rights among countries,

or the degree to which regulations enhance or degrade economic activity, or even the relative political risks that

emanate from these sources. Our inability to measure something in a credible manner should not, however, become

an excuse to ignore the challenges to the global economy from divergent trends in property rights and economic

regulations, as well as their implications for market confidence in political governance systems.

In many of the emerging economies, political stability has been dramatically improved since the 1970s, 1980s, and

1990s. Contracts are more likely to be enforced. The regulatory structure, while sometimes complex and arcane, is

improving in its clarity and predictability. So, if we could measure it in a credible way, we would probably find that while

the absolute degree of property rights, regulations, and political stability may still favor the mature industrial countries,

the pendulum is swinging backward. Yet in the emerging economy world, the pendulum is swinging forward.

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Property rights trends are likely to lead to an environment in which regulatory competition among countries

becomes more the norm than international coordination. This represents an enormous challenge to multi-national

companies with global growth aspirations, and it also serves as a potentially huge source of market volatility.

Property rights and regulatory changes can come swiftly from both mature and emerging countries, and often the

changes come with very uncertain long-term implications.

For example, the Russian ban on wheat exports in the summer of 2010 was a trade regulation issue that impacted

global markets: first directly in terms of wheat prices, and then indirectly in terms of related commodities,

currencies of commodity producing countries, and even equities.

Wheat Prices Surge Due to Russian Wheat Export Ban

Russian ExportBan Commences

Sp

ot

Wh

eat

Pri

ces,

US

$ p

er b

arre

l,U

SD

A#

2 S

oft

Red

Win

ter

Wh

eat

@ C

hic

ago

Source: Spot Wheat Prices (WEATCHEL) provided by the Bloomberg Professional

Dec

-08

Feb

-08

Ap

r-0

9 –

Jun

-09

Au

g-0

9 –

Oct

-09

Dec

-09

Feb

-09

Ap

r-10

Jun

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Au

g-10

Oct

-10

Dec

-10

Feb

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Ap

r-11

Jun

-11

Au

g-11

9

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0

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The point can be further illustrated by comparing how the corporate planning process in the United States and

China is affected by government decision-making. China’s modern leaders have an obsession with five-year plans.

The country is currently in its 12th Five Year Plan. Plans change, and there are course alterations, but China wants

everyone to know the intended path. By contrast, the US Congress over the years has increased its use of stop-gap

legislation. Debt ceilings need to be raised every year or two. Tax legislation has expiration dates requiring new

legislation or a reversion to an old set of taxes. New regulations are enacted into law, but the agencies in charge are

under-manned and cannot meet mandated deadlines to interpret the new law, as with recent financial and health

care legislation. What is interesting is not that US corporations still have much more control over their own destinies

and freedom to conduct business than Chinese companies at an absolute level. What matters in economics is the

relative direction of trends, and the US system is becoming less friendly to long-run business planning, while the

Chinese system is becoming relatively friendlier.

To extend this illustration with a focus just on the US, observe the time it takes for labor markets to recover after

a recession. Over the last two decades there has been a steady increase in regulations and rules regarding the

relationship between corporations and their employees. The result of this regulation-creep has been a steady

increase in the explicit and hidden costs of labor. One of the manifestations of this shift in the relative cost of capital

and labor is that in a recession corporations have been quicker than ever to reduce costs through cutting back their

workforce. Then, during the recovery period, corporations have been much slower to rehire workers than they once

were given the increase in labor costs, especially related to health care and other benefits.

The current recovery period in the US is further challenged by the deleveraging that occurs after a recession caused

by a financial crisis, by the persistent problems in the housing market, and by the drag from fiscal policy. Even

taking these factors into account, though, the impressive recovery in corporate profits in 2010 and 2011 has not led

to much hiring by the private sector. The time it takes to regain the previous peak in employment is likely to set a

modern record, and by a very wide margin compared with the four years it took to recover from the 2000 recession,

and the two year recovery time averaged during the recessions occurring between 1948 and 1983.

Dec 2000

Mar 1990

Aug 1981

June 1974

Mar 1970

April 1960

April 1957

July 1953

Sept 1948

Pea

k of

Em

plo

ymen

t

US Employment Has Been Taking Longer to Recover after each Recession since 1990

Note: the mini-recession of March 1980 caused by the short-lived restrictions on credit cards is omitted due to its special circumstances. Source: Federal Reserve Bank of St. Louis ”FRED” Database

Number of Months from Peak to Recovery

0 10 20 30 40 50 60

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c. Policy context and relative constraints and/or flexibility

The constraints presented by the economic policy context in which countries find themselves are our third major

source of dissonance for markets. Economic policies can be broadly categorized as (1) fiscal policy, (2) monetary

policy, and (3) government asset/liability management. What is important to recognize is how much flexibility some

countries have in the policy area compared to how constrained others are. This relative matrix of constrained versus

flexible policy alternatives will be a large source of potential market dissonance between mature and emerging

market nations and also among the mature nations themselves as they go their own ways in this challenging

decade.

1. fiscal Policy

The expansion of government debt as a percentage of GDP in the mature industrial countries over the last two

decades and particularly over the last few years in response to the Financial Panic of 2008 has created a large class

of countries with little or no choice but to restrain fiscal policy and to focus on getting their debt under control.

To the extent that long-term growth rates of real GDP have decelerated for these over-indebted countries due to

population dynamics and property rights erosion, the problem is even worse.

What really matters is not just the size of the economy relative to the debt load, but the income growth available

to support the interest payments on the debt. Slower economic growth means less income to service a given size

debt load. By contrast, the emerging market world has much lower government debt to GDP ratios, as well as

much higher long-term potential GDP growth rates to service their smaller debt loads. Thus, fiscal policy is highly

constrained in the mature industrial world, while considerably more flexible in the emerging economy

world. Moreover, in the mature industrial countries fiscal restraint is likely to be a major drag on economic growth

for most of the decade to come.

2. monetary Policy

Following the policy efforts to recover from the Financial Panic of 2008, the central banks of many mature industrial

countries found themselves relatively ineffective. Immediately after the crisis, they had pushed short-term rates to

near zero and expanded their balance sheets aggressively. They had reached the limits of their abilities to influence

economic activity. By contrast, central banks of the emerging economies, with high interest rates and conservative

balance sheets, have some policy flexibility to deal with the challenges they face.

A comparison of the US and Brazil is a useful illustration. Over the past decade, the central bank of Brazil has consistently

maintained a steady premium between short-term market interest rates and year-over-year inflation – a classic central

bank approach to containing inflation pressures. As global economic growth slows and inflation pressures abate, there is

ample room to cut rates and provide some limited cushion for the economy from global impulses.

By contrast, the US Federal Reserve has not found it possible to operate in nearly as a consistent manner as the

central bank of Brazil (Banco Central do Brasil). As the growth recession in the mature industrial economies

continues, their central banks, such as the Federal Reserve, are effectively tapped-out in terms of providing

additional economic stimulus, since short-term rates are already at or near zero. This has led to experimentation

with balance sheet expansion, known as quantitative easing or “QE.”

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Comparison of Debt/GDP Ratios of Selected Mature Countries Compared to Emerging Market Countries

Slower Growers

FasterGrowers

0% 50% 100% 150% 200%

Outstanding Government Debt as Percentage of GDP – 2010

Japan

Greece

Italy

Germany

France

United Kingdom

United States

Brazil

India

Argentina

Mexico

China

Russia

Source: Based on US CIA’s World Fact Book and Eurostat Database.

The use of the central bank balance sheet in a fi nancial crisis to stabilize the banking system can prevent a recession

from turning into a depression. The evidence is still being collected, but it appears that QE programs have little to no

impact on providing economic stimulus. QE is effectively only a defensive tool to be used to prevent fi nancial market

disruption from contagion related to weak or insolvent banks.

In addition, when economies are in the midst of a deleveraging phase or when uncertainty about the future is at

highly elevated levels, neither consumers nor corporations are making their decisions based primarily, or even

secondarily, on interest rate considerations. In this environment, lower rates are not possible because they are

already at zero. And, the zero-rate policy has only limited effectiveness until the deleveraging ends or the cloud of

uncertainty is lifted. What is critical to watch is both consumer credit and bank lending to corporations. When these

indicators turn upwards and can extend that new trend for three to six months, this will be an indication that interest

rates have again become an important decision factor for consumers and businesses and the zero-rate policy may

start to have a stimulatory impact on the economy.

Page 13: Era of Dissonance

Era of DissonancE, 3 novEmbEr 2011

13 markEt insights

Brazil’s Central Bank Maintains Rates with a Steady Premiumover the Inflation Rate: Expectations of Declining Inflation Can Bring Lower Rates

Overnight Interest Rate

Inflation Rate

Source: Brazilian CPI and Rates Data from Bloomberg Professional

30%

25%

20%

15%

10%

5%

0%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Brazil’s Central Bank Maintains Rates with a Steady PremiumBrazil’s Central Bank Maintains Rates with a Steady Premiumover the Inflation Rate: Expectations of Declining Inflation over the Inflation Rate: Expectations of Declining Inflation Can Bring Lower RatesCan Bring Lower Rates

Overnight Interest RateOvernight Interest RateOvernight Interest Rate

30%

25%

3. asset/Liability management

Asset/liability management at the country level involves two very different tasks. On the liability side, the task is

debt management, which is most challenging for the over-indebted mature industrial countries. On the asset side,

the task is reserve management, which spans both the emerging countries and the mature countries, but does not

include the US. As the provider of the dominant reserve currency, the US dollar, the US has not had to worry about

asset management, but it may well have to cope with the repercussions of the portfolio decisions other nations

make regarding their international reserves.

Tentative Signs that the US Consumer Has Stopped Deleveraging (US Consumer Credit Data)

Source: US Consumer Credit Data Provided Through Bloomberg Professional

US

Co

nsu

mer

Cre

dit

Ou

tsta

nd

ing

, Tr

illio

ns

of

Do

llars

3.0

2.5

2.0

1.5

1.0

0.5

0.0

Dec

-91

Jan-

93

Nov

-94

May

-95

Nov

-97

May

-99

Nov

-00

May

-02

Nov

-03

May

-05

Nov

-06

May

-08

Nov

-09

May

-11

Preliminary Indications that Corporations are Starting to Increase Borrowing From Banks Again

Source: US Bank Commercial & Industrial Loans and Leases Data Provided ThroughBloomberg Professional

US

BA

nk

Co

mm

erci

al &

Ind

ust

rial

Lo

ans

and

Lea

ses,

Tri

llio

ns

of

Do

llars

1.8

1.6

1.4

1.2

1.0

0.8

0.6

0.4

0.2

0.0

Dec

-91

Jan-

93

Nov

-94

May

-95

Nov

-97

May

-99

Nov

-00

May

-02

Nov

-03

May

-05

Nov

-06

May

-08

Nov

-09

May

-11

Page 14: Era of Dissonance

Era of DissonancE, 3 novEmbEr 2011

14 markEt insights

a. government Debt management. Within the mature industrial countries there are critical distinctions involving

the choices available for debt management. The determining criterion is the relationship between the currency

of denomination of the debt and whether the debtor country controls the central bank that issues the currency.

countries that issue debt in the currency which their central bank controls effectively do not have credit

risk – they have inflation risk. That is, at some point when the debt load is perceived as too crushing to manage

through fiscal policy, the central bank can issue liabilities (i.e., print money, depreciate the currency) and inflate the

value of the debt away. By contrast, when a country issues its debt in a currency it does not control, the inflation

alternative is not available, and the debt must be evaluated by world markets in terms of its credit risk.

In the 1960s and 1970s, it was typical of emerging market countries to issue debt in their own currency. But as

they over-extended themselves, they abused fiscal and then monetary policy, leading to currency depreciation and

inflation. One solution was to force debt issuance by certain emerging countries, particularly in Latin America, into

US dollars, a currency they did not control, making explicit the credit risk challenge. As emerging market countries

have been able to demonstrate policy credibility over time, they have been able to pay off their US dollar debts and

again issue debt in their own currencies.

The countries in the 21st century that find themselves in the credit risk market segment are the countries of the

Euro-Zone. While they may issue their debt in euros, the common currency of the region, no one country controls

the European Central Bank (ECB). As the sovereign debt crisis of Europe demonstrates, this is a crisis of credit risk,

which has evolved into a parallel crisis for the banks of Europe that took on excessive credit risk in the form of the

sovereign debt of weaker Euro-Zone countries.

What emerging market countries already knew from their own experience in previous decades, and what they are

learning again from watching the Euro-Zone struggle with its sovereign debt crisis is that they should avoid issuing

debt in another country’s currency, such as the US dollar, and issue their debt in their own currency. This has very

large implications for the currency management and currency convertibility policies of emerging countries that have

sought to restrict how their currency is used internationally. Currency restrictions and limited currency convertibility

are not compatible with a globally viable market in their currency’s debt.

We note that certain Western European countries chose not to join the Euro-Zone. For example, Sweden has had

a National Debt Office since the 1700s to manage the country’s liabilities, and for liability management and many

other reasons did not want to adopt the euro. The UK also places a high value on being able to manage its own

independent currency, which was among a variety of reasons this country also did not adopt the euro.

Page 15: Era of Dissonance

Era of DissonancE, 3 novEmbEr 2011

15 markEt insights

Country

US/UK/Japan

Euro-Zone Countries Before the Euro

Euro-Zone Countries After the Euro

Emerging Markets Then

Emerging Markets Then

Country IssuesDebt in its OwnCurrency With

Control of Central Bank

Country IssuesDebt in its

Own CurrencyWithout Controlof Central Bank

EUR

USD

YES

YES

NO

NO

YES

b. international reserve management. Between the years 1998 through 2011, countries of all stripes – from

emerging countries, such as Brazil, India, and China, to mature countries, such as Japan – accumulated

international reserves on the asset side of their central bank balance sheets and in the coffers of their sovereign

wealth funds. A majority of the international reserves are denominated in US dollars, which creates a potentially

large zone of tension specifically with the United States and a major source of policy dissonance for global markets.

Should the owners of these massive stockpiles of US dollar denominated assets choose a policy of currency

diversification, the implications for US interest rates and the US dollar will cause policy challenges not only for the

US, but for the whole world financial system.3

If, or perhaps we should say, when the owners of the US dollar denominated international reserves shift from

exchange rate stabilization policy goals to wealth preservation policy objectives, currency diversification will be an

obvious step to take. The catalyst for this asset allocation shift may come from the economics of the US, or it may

come from the global political arena. One of the political features of the Era of Dissonance is that it represents a

transition period from a world order dominated by one super power, the US, to a world order in which there are at

least two powerful countries at the world level – the US and China – and a number of important regional powers

with global ambitions – Brazil, India, and Russia. And, because of the disruptions of the sovereign debt crisis, it is

not at all clear where Europe fits into this power matrix.

3 The study of the role of economic growth, money supply, exchange rates, and the accumulation of international reserves has a long history, pioneered by Professor Harry Johnson, Nobel Prize winner Professor Robert Mundell, and the always-controversial Professor Arthur Laffer when they were together at the University of Chicago in the late 1960s and early 1970s. The author of this research report has also contributed to this scholarly literature, starting with “Money, Income, and Causality in the United States and the United Kingdom”, co-authored with Profes-sor D. Sykes Wilford and published in the American Economic Review, Volume 68, in 1978, and including more recently “Chinese Exchange Rates and Reserves from a Basic Monetary Approach Perspective”, co-authored with Professors Stephen Jay Silver and D. Sykes Wilford, published in the Journal of Financial Transformation, Volume 31, in 2011, as well as several books and other articles on the subject published over the years.

Page 16: Era of Dissonance

Era of DissonancE, 3 novEmbEr 2011

16 markEt insights

Brazil

Mill

ioin

s o

f U

S D

olla

rs o

f In

tern

atio

nal

R

eser

ves

No

t In

clu

din

g G

old

350,000

300,000

250,000

200,000

150,000

100,000

50,000

0

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2008

Source: IMF IFS Data Base from the Bloomberg Professional

What is clear, however, is that the role of the US dollar as the primary reserve currency for the world is a legacy from

the previous era and almost certainly will be challenged, if only by the requirements of portfolio diversifi cation. That

is, it is wrong to analyze the Us dollar’s reserve currency role starting from the assumption that the Us

dollar can only be replaced by a viable challenger, and seeing no viable challenger, jump to the conclusion

that the role of the Us dollar will continue more or less as it has been. There need be no viable challenger for

the US dollar’s role to erode as a reserve currency, just a strong desire by the nations of the world to manage their

reserves more like a diversifi ed portfolio.

There are several things to watch regarding the behavior of central banks and sovereign funds in terms of how they

manage the currency diversifi cation of their assets. First, central banks tend to focus on maintaining liquidity and

so they are the primary holders of US Treasury and Agency marketable securities. For the better part, they use the

Federal Reserve as their custodian, and the Federal Reserve issues a weekly report as to the quantity of marketable

securities it holds in custody for central banks and international agencies. If central banks are diversifying their

currency portfolios away from US dollars, this data series will fl at-line or turn downwards.

India

Source: IMF IFS Data Base from the Bloomberg Professional

Mill

ioin

s o

f U

S D

olla

rs o

f In

tern

atio

nal

R

eser

ves

No

t In

clu

din

g G

old

350,000

300,000

250,000

200,000

150,000

100,000

50,000

0

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2008

Japan

Source: IMF IFS Data Base from the Bloomberg Professional

Mill

ioin

s o

f U

S D

olla

rs o

f In

tern

atio

nal

R

eser

ves

No

t In

clu

din

g G

old

1.200,000

1,000,000

800,000

600,000

400,000

200,000

0

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

China

Source: IMF IFS Data Base from the Bloomberg Professional

Mill

ioin

s o

f U

S D

olla

rs o

f In

tern

atio

nal

R

eser

ves

No

t In

clu

din

g G

old

3,500,000

3,000,000

2,500,000

2,000,000

1,500,000

1,000,000

500,000

0

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

Page 17: Era of Dissonance

Era of DissonancE, 3 novEmbEr 2011

17 markEt insights

Data on US Treasury and Agency Marketable Securities Held in Custody by the Federal Reserve for Central Banks and International Agencies Can be Used to Monitor the Attractiveness of the US Dollar as a Reserve Currency

Source: US Federal Reserve H4.1 Report as provided by the Bloomberg Professional

Trill

ion

s o

f U

S D

olla

rs H

eld

by

Cen

tral

Ban

ks a

nd

Age

nci

es

4.0

3.5

2.5

2.0

1.5

1.0

0.5

0.0

Jan

-97

Nov

-97

Sep

-98

Jul-

99

May

-00

Mar

-01

Jan

-02

Nov

-02

Sep

-03

Jul-

04

May

-05

Mar

-06

Jan

-07

Nov

-07

Sep

-08

Jul-

09

May

-10

Mar

-11

Second, sovereign wealth funds are typically viewed as managers of less liquid investments, including equity,

joint ventures, private equity, real estate, etc. These funds are almost always well-diversified in terms of the

currency of denomination of their assets. To the extent that sovereign wealth funds are growing faster than central

bank international reserves, this is a sign of an increased preference for portfolio diversification. Indeed some

researchers put current sovereign wealth fund assets in the range of $2 trillion to $3 trillion or even higher. This

amount is projected to grow to as much as $13 trillion in the next ten years, an amount even larger than the current

stock of foreign reserves of about $7 trillion at year-end 2009.4

4 See the research paper, “Asset Class Diversification and Delegation of Responsibilities between Central Banks and Sovereign Wealth Funds”, by Joshua Aizenmann (University of California, Santa Cruz) and Reuven Glick (Federal Reserve Bank of San Francisco, published as Working Paper #2010-20 by the Federal Reserve Bank of San Francisco.

Page 18: Era of Dissonance

Era of DissonancE, 3 novEmbEr 2011

18 markEt insights

Third, it is important to watch the demand for gold by central banks. Central banks and international agencies

spent the 1990s and into the 2000s largely as net sellers of gold. More recently, it appears this trend reversed. Gold

hoarding by central banks serves a clear purpose as an alternative to the US dollar as a reserve currency.

4. Politics matter more than Ever before

We started our analysis with the sources of dissonance and then gained an appreciation that the long-term

economic growth implications coming from the sources of dissonance naturally point to conflicting expectations

of how financial markets will resolve different perspectives. Moreover, the sources of dissonance and their long-

term economic implications dramatically increase the tensions within political systems. This heightened tension

is reflected in markets, making them much more sensitive to political agendas, not just the economic trajectory.

Politics will matter even more in the Era of Dissonance than in previous periods, as the interplay between economics

and politics leads to the potential for expectations of more divergent outcomes. As we observed in our introduction,

what will define the Era of Dissonance is that a very large number of perceived political and economic

conflicts will generate a seemingly never-ending series of widely divergent expectations. We now need to shift

gears and examine how dissonance gets resolved.

After the Panic of 2008, Central Banks Became Net Buyers of Gold

Source: International Monetary Fund Data provided through the Bloomberg Professional

Mill

ion

s o

f Fi

ne

Troy

Ou

nce

s o

f G

old

Hel

d

by

Cen

tral

Ban

ks A

rou

nd

th

e W

orl

d

1100

1080

1060

1040

1020

1000

980

940

920

900

Jan

-00

Au

g-0

0

Mar

-01

Oct

-01

May

-02

Dec

-02

Jul-

03

Feb

-04

Sep

-04

Ap

r-0

5

Nov

-05

Jun

-06

Jan

-07

Au

g-0

7

Mar

-08

Ocl

-09

May

-09

Dec

-09

Jul-1

0

Feb

-11

Page 19: Era of Dissonance

Era of DissonancE, 3 novEmbEr 2011

19 markEt insights

ii. market Dynamics and Ways Dissonance is resolved (or not)

Recognizing that the 21st century has a markedly different fundamental context – one governed by sources of

dissonance rather than the shared objectives and similar political and economic fundamentals of the latter half

of the 20th century – makes a powerful case that global financial markets are not going to settle back into older

patterns. Indeed, because the sources of dissonance are so powerful and so slow moving5, it is hard to avoid the

conclusion that financial risk management must be much more proactive and forward-looking to handle

effectively the challenges posed for world markets by the Era of Dissonance.

To get at the heart of understanding market dynamics that are governed by sources of dissonance rather than by

shared objectives and common fundamentals, we need to delve into the nature of financial market expectations.

Financial markets are designed to resolve conflicting expectations among market participants. This sounds basic.

Yet underlying this straightforward function of financial markets is a more complex process that is quite challenging

to analyze. We are expecting a long series of conflicts, with market participants holding widely varying expectations

of how the conflicts will be resolved. Contributing to the challenge is that many market participants will stubbornly

hold onto expectations based on past experience that now are highly unlikely in this new era. And, in many cases,

the political process will be deciding between widely divergent monetary and fiscal policy prescriptions.

To gain an intuitive understanding of the complexity of the expectations and market adjudication process, we will

start with the theory behind a relatively simple comparison of two different categorizations of market expectations,

namely expectations governed by shared fundamentals and expectations governed by sources of dissonance.

Please bear with us as we work through these theoretical cases. Our analytical framework will provide us with the

tools to cope with a series of market conflicts surrounding expectations in which multiple and potentially highly

divergent scenarios are possible. In studying how the sources of dissonance are likely to be resolved by markets, we

will first examine some basic theory, and then draw our practical conclusions.

a. Understanding two cases of Expectations, volatility, and correlations

We believe that there is a fundamental difference in the volatility and correlation behavior of markets depending

on (a) whether expectations are governed by shared fundamentals or (b) expectations are governed by sources

of dissonance. The shared fundamentals category generally produces a probability distribution of expectations

around a single most likely outcome (mode) and maintains a relatively consistent volatility (variance). By contrast,

expectations constructed in the sources of dissonance category are much more complex and may have more than

one quite different competing scenario. Even more disturbing for markets, estimated volatilities are not confined to

a reasonable range, but can shift, sometimes abruptly and dramatically. The practical implications for how market

conflicts are resolved relate in no small way on which categorization is in the ascendant.

5 One can think about the slow moving plate tectonics that eventually cause highly disruptive earthquakes. It is easy to forget about plate tec-tonics because it is such a slow moving natural phenomenon, but it is still not a good idea to build a big hydro-electric power dam or a nuclear power plant near a fault line, even an inactive one.

Page 20: Era of Dissonance

Era of DissonancE, 3 novEmbEr 2011

20 markEt insights

1. Expectations governed by shared fundamentals

The typical underlying assumption about the expectations of market returns is that they are centered around a

single mode and with defined variance (volatility). For most market models the assumption is even more specific –

expectations of returns are drawn from a normal distribution or can be described by a normal distribution without

doing damage to the basic conclusions, even if the distribution is non-normal. In our case, the normal distribution

assumption is not the important part. What is critical is that there is a single mode, even if the distribution has a

fat tail (skewness) or a tall or short central section (kurtosis). These types of distributions of expected returns are

relatively easy for markets to handle even though there are some difficult risk management challenges.

If market participants broadly share a similar vision of the fundamentals guiding economic behavior, then when

market participants receive new information, such as new economic data or a policy announcement, the expected

mean of future returns shifts, but the expected volatility remains more or less the same. Broadening the case into

a multi-exposure environment, market participants would also share a similar view of the correlation structure

of expected returns, which is assumed to remain stable even as market return expectations change with new

information.

Take for example what happens when new information comes to market participants, say in the form of the US

employment data that is released for the previous month on the first Friday of every month. When this data release

surprises the market in terms of the outcome being different than the consensus expectation, market participants

quickly revise their perspective on US Treasury yields, equities, and other securities. For example, a negative

surprise generally means lower US Treasury bond yields and lower stock prices, while a positive surprise is often

accompanied by higher US Treasury bond yields and higher stock prices. This means that the expected mean of the

probability distribution for both US Treasuries and stock prices has shifted. But the degree of confidence with which

market participants hold their newly-revised views does not change much – it stays in a reasonably well-defined

range, or confidence interval, for both bond yields and stock prices. That is, what we have is a new probability

distribution with a new mean but more or less the same variance (i.e., volatility or confidence).6

6 Financial practitioners refer to volatility, while academic economists will refer to the variance which is equal to the standard deviation squared. Confidence and volatility are tightly linked in terms of expected returns. One’s confidence in a forecast of expected returns is in-versely related to the expected volatility (variance) of those returns. That is, high volatility is associated with low confidence in a given forecast.

Page 21: Era of Dissonance

Era of DissonancE, 3 novEmbEr 2011

21 markEt insights

New Information Causes the Expected Mean to Shift,But the Standard Deviation and Probability Curve

Shapes are not Changed

US 10-Year Treasury Yield. Source: Calculation by CME Economics Research

Pro

bab

ility

Dis

trib

uti

on

Scenario A(sluggish growth):10-Year Treasury=2% Yield expectation

Scenario B (new payroll data suggests possibility of stronger growth):10-Year Treasury Yield=2.5% Yield

25%

20%

15%

10%

5%

0%

0 1 2 3 4 5

2. Expectations governed by sources of Dissonance

The distribution of expectations of future market returns can take on a very different shape when there are two

potential outcomes that are very far apart from each other. The challenge is that the market is trying to combine

expectations of market participants that cannot be reasonably described by a distribution with a single mode.

Let’s take an example from the world of mergers and acquisitions. Suppose company A has made a bid for

company B at a price of $120 representing a 20% premium over the previous market price of $100 – that is, the

bid represents a substantial premium to gain full control of the target company. Now, suppose that the regulatory

authorities decide to review the potential merger and that there is a reasonable probability that the merger

might be rejected. Let’s say that after the merger is announced but before the regulatory authorities make their

decision, there is a 50/50 probability of approval or the merger. How does the market resolve these conflicting

expectations?

Effectively, there is a one set of expectations for the stock price of company B if the merger is approved and that is

$120, with a very small variance, since an adjustment to the bid in this case is not assumed to be very likely. And if

the merger is rejected by the authorities, then the stock price of company B would likely fall back to its pre-merger

announcement price of $100, give or take, and there would be considerable uncertainty as to the future of company

B (high variance) since a new suitor might appear or the company might be perceived as damaged goods and the

stock price spiral downward.

Page 22: Era of Dissonance

Era of DissonancE, 3 novEmbEr 2011

22 markEt insights

Scenario A: Merger Approved (Mean = 120, STD=2)

Source: Calculation by CME Economics

25%

20%

15%

10%

5%

0%

70 80 90 100 110 120 130 140

Pro

bab

ility

Dis

trib

uti

on

Scenario B: Merger Approved (Mean = 100, STD=6)

Source: Calculation by CME Economics

25%

20%

15%

10%

5%

0%

70 80 90 100 110 120 130 140

Pro

bab

ility

Dis

trib

uti

on

Combination of Scenarios A & B at 50% Each (Mean=110, STD=4)

Source: Calculation by CME Economics

25%

20%

15%

10%

5%

0%

70 80 90 100 110 120 130 140

Pro

bab

ility

Dis

trib

uti

on

Normal Distribution (Mean=110, Standard Deviation=4)

Stock Price Source: Calculation by CME Economics

25%

20%

15%

10%

5%

0%

70 80 90 100 110 120 130 140

Pro

bab

ility

Dis

trib

uti

on

The expected value (mean) of the combined distributions depends on the probability of scenario A (merger

approved) or scenario B (merger rejected). At 50/50 probabilities, the expected mean for the combined probability

distribution is $110 and the standard deviation is 4.

In the fi gure shown on the left above, the probability distribution on the left combines a 50% chance of Scenario A

with a 50% chance of Scenario B to produce a distribution that is clearly not a bell-shaped curve and also has two

modes. The fi gure on the right has the same mean ($110) and the same standard deviation (4), and is the familiar

bell-shaped curve or normal distribution.7 A very high percentage of quantitative models assume that the fi gure on

the right (single-mode, bell-shaped curve) represents reality, and in most fi nancial environments over the last half of

the previous century this was not a bad assumption to make. if the reality is more like the bi-modal distribution

on the left, then just knowing the mean (expected return) and the standard deviation (estimated future

volatility) is not remotely enough to manage one’s risk properly.

7 Note, a bi-modal distribution would have two humps like a Bactrian camel from Mongolia. In fact, one will not see a bimodal shape when com-bining two normal (bell-shaped) distributions unless the difference between the two means is quite large. This is just another way of saying that unless the two scenarios are far apart one will not get the kind of probability distribution that will cause markets lots of problems.

Page 23: Era of Dissonance

Era of DissonancE, 3 novEmbEr 2011

23 markEt insights

ProbabilityScenario A:

MergerApproved

Mean ofCombined

Distribution

StandardDevaition of

CombinedDistribution

100

102

104

106

108

110

112

114

116

118

120

6.0

5.6

5.2

4.8

4.4

4.0

3.6

3.2

2.8

2.4

2.0

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Indeed, the likely market volatility actually depends importantly on the probability of Scenario A (merger approved)

versus Scenario B (merger rejected), assuming each scenario remains unchanged. That is, the expected volatility

the market is pricing (e.g., in options for example) moves with the perceived likelihood of each scenario, rather than

the scenarios changing. As the likelihood of Scenario A (merger approved) gains favor, the mean (stock price) rises

toward the acquisition bid price, and the estimated volatility declines. Thus in our example, the expected volatility

goes from 6.0 to 2.0 as the probability of the merger being approved (Scenario A) goes from 0% to 100%.

Let’s explore this more. Now, some new information arrives. Maybe it is a rumor that the regulatory authorities are

leaning against merger approval. If the odds against merger approval go down, the expected mean of the combined

probability distribution declines and the estimated standard deviation (volatility) rises.

Another form of new information would be the possibility of a white knight with a higher bid. A new suitor entering

the fray would shift the expected mean higher and might decrease the standard deviation.

Note that both the expected mean and the estimated standard deviation (volatility) shift in these cases where a bi-

modal distribution of two far apart scenarios with different probabilities govern the combined distribution that sets

market prices. Put another way, what is nearly certain is that the market price will not stay where it is once

the regulatory authorities make their decision. the status quo is decidedly unstable.

b. Practical implications for market volatility and correlations

Sources of dissonance that create these kind of bi-polar outcomes tend to focus considerable attention on revising

estimates of volatility, not just expected outcomes. In turn, this makes risk management practitioners much more

focused on options8, which price volatility, in addition to futures and physical securities which price direction.

Moreover, historical measures of volatility are of little to no use at all in these bi-polar cases, especially

as the two potential scenarios get farther and farther apart. That is, the implied volatility embedded in an

option price on company B’s stock will depend on the probabilities associated with regulatory decisions and not the

previous history of the stock price’s volatility.

8 The simplest option pricing models, such as the famous Black-Sholes model, require five inputs into the valuation formula, of which four are known and one has to be estimated. The strike price, current price of the underlying security, market borrowing rate, and the time to option expiration are all known inputs. The unknown input is the estimated volatility of the expected returns of the underlying security.

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Our merger example was constructed to focus on why expected volatility shifts around as a function of the

probabilities changing for the two potential scenarios. If we move more into the real world, the actual case studies

take us quickly into cross asset class situations, and we see that not only are volatilities not stable, but correlations

will move abruptly, too, as probabilities about far apart scenarios change.

As shown in the chart above, the annualized volatility of the S&P 500 Index looks much less stable when viewed

through the lens of only 60 business days of historical data compared to 260 business days (one year). Moreover,

one can easily see, and as the financial regulators always insist that asset managers tell their clients, “the past is not

necessarily indicative of future performance”, which clearly applies to volatility analysis. Or put another way, in the

Era of Dissonance one should not drive a car looking only through the rear view mirror – be aware there are

going to be some hairpin turns up ahead that you will not want to miss.

Historical Volatility Looks Very Different Depending on Your Time Perspective

Source: Volatility Calculations by CME Research based on S&P 500 Index (SPX) data provided through Bloomberg Professional.

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11An

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Correlations shift in powerful ways, as well, especially in flight-to-quality liquidity events as shown in the chart above.

The chart above illustrates the correlation between US Treasury 10-Year Note price percent changes and S&P 500

Index daily percent changes. The correlations goes strongly into negative territory (inverse relationship) when

markets shift from greed into fear.

Take the sovereign debt crisis in Europe that started in 2009 and 2010 and then in the summer of 2011 spread from

Greece to worries about Italian bonds, to a downgrading of the euro against the Swiss franc, to concerns about

the capital adequacy of French and other European banks, to a correction in global equity markets. As market

participants questioned the capital adequacy of certain European banks, this led to fears that the global payments

system would breakdown. Thus, the focus shifted simultaneously (a) to the European Central Bank (ECB) to see

whether it would or would not serve as lender of last resort and provide essentially unlimited overnight funding (as

long as necessary) to prevent a disruption of the banking system and (b) to the stronger European governments

to see if they could craft a meaningful bail-out plan. Differing views by market participants as to the potential

actions by the ECB and European governments meant there was a low probability expectation that a Lehman-style

banking system failure was possible set against a more typical suite of expectations about how the situation could

be resolved less disruptively. The least likely scenario in this bi-modal distribution was the then-current set of

market prices, because the dissonance would be resolved either by a dramatic breakdown or by some form of policy

compromise to muddle through the crisis, but the status quo was clearly not sustainable.

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Average Daily Trading Volume (in contracts) in CME Nearby EUR/$ Futures Contract over Previous 60 Days

The European sovereign debt and banking capital adequacy crisis also has interesting implications for relative

counterparty risk. Take the FX market. Participants can acquire currency exposures through exchange-traded

futures contracts or through bank-sponsored forward contracts. While there are a number of possible differences in

these methods of implementing currency exposures, one of the more subtle differences is the relative counterparty

risk being taken on by the ultimate investor. After the financial panic of 2008 and as the European sovereign debt

crisis morphed into concerns about European banks, and while other factors were also at work, FX futures, with their

risk associated with a central counterparty clearing house (CCP), saw an increase in trading volume.

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Another example makes the same point. In July and August of 2011, the US hit its legislated debt ceiling, and

without an Act of Congress to raise the debt ceiling, the government would have defaulted on its outstanding debt.

The low probability expectation of a Congressional deadlock leading to even a temporary suspension of interest

payments on US Treasury securities was accompanied by predictions of rather dire consequences for the US and

global economy. Another set of expectations ruled out the default scenario and was centered on expectations of a

compromise for future fiscal policy. What was clear was that the status quo could not be maintained and that there

were two possible resolutions to the conflict with outcomes that would be strikingly different and each scenario

came with its own inherent volatility and correlation structure.

But it is not just about the US and Europe. China is continually evaluating its renminbi (RMB) policy. In 2005, it

started to allow incremental appreciation of its currency. Then, in response to the Financial Crisis of 2008, the

appreciation policy was abruptly halted, only to resume again a few years later. When China is fixing the value of

the RMB, there is essentially no volatility – until the government decides not to fix the currency to the US dollar and

then a degree of volatility re-enters the market. As China approaches the time in which it will want to normalize its

currency in terms of its role in world financial markets, volatility will increase, and the lack of historical volatility will

have little or nothing to say about future volatility of the RMB. Yet again, risk managers must be forward-looking.

In the Era of Dissonance, what we are likely to see are a lot more examples of conflicts leading to two, or even more,

distinctly different and widely divergent potential scenarios. We will still have plenty of cases of expectations

shifting modestly around reasonably consistent confidence or volatility estimates, as in the case of shared

fundamentals, but the number of dissonant scenario cases is likely to be much, much higher than in the half century

that just ended.

1. volatility and correlations as moving targets

When there are multiple, very powerful sources of dissonance, the financial environment is highly conducive to

market participants holding the view that the status quo is not sustainable. The perspective of a status quo that is

not sustainable is often associated with alternative scenarios differing quite widely; that is, a low probability disaster

scenario couched against a more likely alternative. Unfortunately, markets do not cope well with bi-modal or multi-

modal expectation distributions. Both modes effectively represent very different new environments with different

implied volatility and correlation structures.

In this type of financial environment, market participants are nearly certain that the present price structure will not

last, even if they cannot agree on the eventual outcome. One or the other scenario (or more) will take control of both

reality and expectations. Until that happens, however, markets are prone to large price swings, and because the new

information tilts expectations toward one or the other scenario (mode), there is a big swing in expected volatility

and expected correlations as well. That is, in widely divergent expectation cases, the market has to combine not

only expectations of future returns, but the options market must also put a price on the different scenarios involving

widely different expected volatilities and correlations. This creates and sustains what has become known as the

risk-on, risk off environment, when the market swings wildly from risk-seeking to risk-aversion, as the probabilities

of different scenarios shift with new information.

2. Looking to the future: Policy confusion or coordination?

In practice, the dynamic evaluation of the potential outcomes is critical. one outcome is for the sources of

dissonance to push countries apart, lead to competitive devaluations of currencies, trade restrictions, and

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a general unwillingness to seek shared solutions to global problems that cross national boundaries, such as

water rights among many other challenges. This “every man for himself” scenario is a prescription for sluggish

global growth with significant volatility and possibly a global recession. a second outcome could involve a more

cooperative world in which several global or regional powers, from china, to brazil, to india, to russia

compete aggressively yet with clear objectives to further trade among themselves and with the mature

industrial countries. In this scenario, the slower growing industrial countries recognize their limits and also avoid

protectionist tendencies. This scenario could lead to strong world economic growth, as multi-national corporations

in the mature countries maximize the benefits from the robust growth of the emerging market countries, and

interestingly, even with higher economic growth, financial market volatility might be reduced.

Assigning probabilities to these two very different scenarios for the coming decade is not easy. Countries have

many incentives to work together. Yet, there are multiple political hurdles at the domestic level that push countries

away from cooperative efforts. As new information comes into the market about economic trends and political

opinions, whatever our initial probabilities were between the two scenarios, they will be adjusted, dynamically, to the

new information. As one scenario becomes more likely than the other, the expected mean and expected variance of

the combined distribution can change quickly and quite dramatically.9

If we expand this perspective to a variety of financial exposures, we can also appreciate that the correlation

structure that might be stable within each scenario could be quite different between the two scenarios. And, as

the probabilities shift between the two scenarios, the correlation structure from the combined distribution would

appear as unstable. In short, until one or the other scenario becomes the consensus view, financial markets are

very likely to encounter periods in which new information triggers rapid shifts in expectations of outcomes, volatility,

and correlation structures, not to mention risk-taking preferences.

We entered this environment in 2008 with the financial panic. And, instead of seeing a resolution into a consensus

scenario, market participants have been hit by a series of events that involved choices among scenarios that were

strikingly different. There was the Russian ban on exporting wheat in the summer of 2010. There is the stop/start

incremental appreciation policy of the RMB managed by China. The US debt ceiling debacle in the summer of 2011

was a choice between a low probability of default and a high probability of compromise. The European sovereign

debt crisis has swayed between a “muddle-through” scenario and a break-up of the euro and break-down of the

European banking system. The future of the US dollar depends very much on whether central banks and sovereign

wealth funds move aggressively to diversify their portfolios or whether they are content to maintain a majority of

their assets denominated in US dollars. recognizing that the sources of dissonance, taken as a package, are

creating a storm of divergent choices for market participants is a major step toward an appreciation of the

difficulties we face in managing financial exposures in the Era of Dissonance.

9 The alert reader will perceive that the market expectations process espoused by the author is following the rules of Bayesian inference. Bayesian methods that adapt to new information are likely to be among those approaches that work better in the Era of Dissonance than more traditional “frequentist” statistical approaches, because they learn from their mistakes and can also accept expert information, so are less dependent on historical data. See “New Bayesian Statistical Approaches to Estimating and Evaluating Models of Exchange Rates Determina-tion,” by Bluford H. Putnam and Jose M. Quintana, American Statistical Association, 1994 Proceedings of the Section on Bayesian Statistical Science, and “Multivariate Dynamic Models for Financial Time Series: Is the Whole Greater than the Sum of the Parts,” by Jose M. Quintana, Eric Norland, Bluford H. Putnam, and Janine Shagoury, American Statistical Association, 1997 Proceedings of the Section on Bayesian Statisti-cal Science, among other articles that illustrate the use of Bayesian learning methods in financial management.

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iii. risk management challenges

The market implications and risk management challenges from the Era of Dissonance are enormous. Policies are

inherently in conflict as opposed to being drawn into coordination as they were in the latter half of the 20th century.

The interaction of financial exposures within asset classes will be influenced simultaneously with the different

impacts regarding how asset classes interact among themselves. To gain an understanding of the risk management

challenges we look to foreign exchange markets as the pivot point for how the different sources of dissonance are

simultaneously reflected in a variety of asset classes. We will then focus on the risk-on, risk-off phenomenon, which

is a direct reflection of the market’s difficulties in adjudicating bi-modal distributions of expectations. Finally, we

want to draw some general conclusions concerning the implications for practical risk management in the Era of

Dissonance.

a. fX markets as the fulcrum

The interplay of economic and policy dissonance places currency markets in the forefront as arbiters of market

consequences regarding the different directions in which countries are headed. While the process is simultaneous,

and one could choose any starting point, the analysis of currency markets shows how the effects of economic

and policy dissonance spread outward into other asset classes, from rates, to equities, to energy, metals, and

agriculture.

While other things are never equal, it is useful to run down a selection of how certain economic factors typically

impact currency markets. Then, we can introduce some caveats to show how quickly the analysis becomes

complex.

1. Economic growth and currency markets

Let’s take long-run growth differentials as an example. Countries with more robust long-run economic growth

potential, ceteris paribus (i.e., everything else being equal), would be expected to be relatively powerful attractors

of capital, to have relatively strong equity markets, and to see their currencies appreciate relative to slower growing

countries. In the cases where the country is dependent on export growth, however, an appreciating currency might

not be considered a positive development by domestic policy makers. They might worry about the rising relative

value of their currency increasing their export prices and slowing down their engine of growth. Countries facing

this quandary might choose to have their central bank intervene in the currency markets to keep the exchange rate

stable. The currency intervention means buying the reserve currency, namely US dollars, and potentially acquiring

a large pile of US dollar assets, usually held in the form of US Treasury bills, notes, and bonds. To quite different

degrees, both China and Brazil have taken this course of action.

China has had faster economic growth than Brazil over the last decade, but has resisted the implied pressure on

its exchange rate, keeping it fixed for a long period before allowing small incremental steps in the appreciation

process.10 The result has been that China has accumulated an enormous quantity of international reserves, about

$3 trillion by IMF estimates.11

10 While the pace of RMB appreciation over the last few years has frustrated US policy makers, the cumulative appreciation of the RMB is now about 30%, which is a decidedly non-trivial adjustment. 11 In their IFS Data Base, the International Monetary Fund tracks country’s international reserves less gold, measured in US dollars. All interna-tional reserve data cited in this report was obtained from this source.

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Brazil has used a mixed policy approach over the last decade. There has been no attempt to fix the value of the

Brazilian real to the US dollar, but the central bank has undertaken considerable intervention and accumulated

$300 billion of international reserves (not including gold). Brazil has also introduced rules and regulations

effectively to tax certain types of currency transactions in an effort to contain the appreciation of the Brazilian

real. The use of exchange rate taxes and controls should be considered a step backwards in terms of planning and

property rights.

The accumulation of large hoards of international reserves comes with its own policy quandaries. As the wealth

stored in the international reserves gets larger and larger, there is greater political pressure to manage that wealth

to an investment performance benchmark which typically means diversifying its assets and currency exposures.

This is problematic, however, in that the policy objective of exchange rate stabilization (or leaning against the wind

of currency appreciation) is what results in the accumulation of international reserves, and a policy of diversifying

the currency exposures will undo the currency stabilization efforts. The point at which currency stabilization

policies may become less attractive depends in part on (a) the growth of domestic demand making export growth

less important to the economy and (b) the relative value of the international reserves to the size of the country. For

example, Singapore, a small country with a large accumulation of international reserves, long ago opted for more

currency diversification and chose to manage its currency relative to a basket instead of just the US dollar. China

remains more focused on exports, currently maintaining currency stability against the US dollar, and with a target

currency basket a possible next policy move. Brazil is highly sensitive to the fact that China has surpassed the US

as its largest trading partner, and China links the RMB to the US dollar, doubling down Brazil’s exposure to the US

dollar.

2. interest rates and currency markets

Let’s take another example, relating exchange rates to interest rates. Exchange rate markets often appear to have

a love/hate relationship with interest rates. In expansionary economic times, market participants are drawn to

owning (being long) the higher interest rate currencies and borrowing (being short) the low interest rate currencies.

At various times in the past decade this showed up as long Australian dollar, short Japanese yen, or long Brazilian

real, short US dollars, and the like. The profitability of this “carry trade” making enough to justify its inherent risks

depends on the assumption that the high interest rate currency will not depreciate against the low interest rate

currency. The viability and robustness of this assumption hinges on many things, not the least the economic growth

prospects of the high rate country. If the high rate country is also a commodity producer, benefiting from strong

global economic growth, then evaluating the robustness of the assumption takes on yet another dimension. What

seems clear is that emerging markets, with their strong long-term growth potential and the inflationary pressures

that naturally accompany an economy that is building infrastructure and growing its middle class, are going to have

the high interest rates that can gain the favor of currency markets.

Typically, the carry trade can make money seemingly in a dependable fashion for many months (or years) in a row,

but when it crashes it usually has a rather dramatic end. Events that call into question a global economic expansion

undercut the assumption that the high rate currencies will not depreciate against the low rate currencies. Once this

assumption is threatened by a new event or new market information, the rush to the exit from the carry trade is not

always pretty and is often associated with what is called a “flight-to-quality”. Flight-to-quality turns interest rate and

exchange rate relationships on their head.

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Flight-to-quality market conditions are always associated with deleveraging or with market participants becoming

more risk averse. The actions required to deleverage or to reduce risks basically involve shrinking exposures. This

means that borrowers of the low rate currency need to buy that currency to pay back their lenders (or to cover their

short positions). This sends the low interest rate currencies soaring, and to no small extent explains the above

average performance of the Japanese yen, Swiss franc, and US dollar during periods of financial distress in the world

economy. Simultaneously, the flight-to-quality environment leads to lower equity prices and higher bond prices in

government bond markets.

3. nation-building, currencies, commodities, and Equities

The economic growth prospects of emerging market countries present another interesting example of the tight

linkages among asset classes. Emerging market countries are big investors in infrastructure as they grow their

countries and build a thriving middle class. During periods of robust growth the central bank will typically lean

against the wind of currency appreciation. In the case of China, the currency policy appears extreme, as only a

very incremental, step-by-step appreciation of the RMB has been allowed. Yet, the slow pace tends to mask the

fact that over the 2005-2011 period the cumulative appreciation of the RMB against the US dollar has added up to

an impressive 30%. In the case of Brazil, there is some intervention to accumulate international reserves, but the

currency is clearly allowed to float despite taxes and rules to increase trading costs. In both cases, though, currency

strength or accumulation of international reserves is a reflection of the strong economic growth. The strong growth

drives global commodity prices and equity prices higher. Any interruption in the growth pattern, such as a growth

recession in the mature industrial world leading to slower exports from the emerging market countries, can lead

to an abrupt drop in the currencies of the emerging market countries, simultaneously accompanied by a drop in

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emerging market equity indices and global commodity prices. It is a tightly linked world across asset classes.

A corollary concept is that disruptions in energy or commodity markets can spread through other asset classes

quickly. It matters, however, whether the price disruption in, say, energy, is a supply shock or a demand shock.

A supply shock can raise energy prices, even as it lowers stock prices and the currencies of emerging market

countries. On the other hand, a demand shock – increased probability of greater global growth – raises energy

prices, even as it supports equity prices and the currencies of emerging market countries, the source of the

demand shock.12 What matters for risk analysis is that we must understand the source of dissonance (i.e.,

in this case, supply shock or demand shock) to understand how correlations among asset classes may be

impacted.

b. risk on/risk off

The flight-to-quality discussion in the preceding section leads us to a more in-depth examination of the “risk-on,

risk-off” phenomenon that has occurred frequently since the financial panic of 2008. Essentially, “risk-on” means

that the greed-fear pendulum is swinging toward greed and “risk-off” means that fear is in the ascendant. If market

participants are making their decisions based in part on the relative trade-off between return expectations and

risk assessment, any event that simultaneously raises risk assessments while lowering return expectations is an

effective double-whammy on markets.

As policy choices involve possible outcomes that are far apart, risk becomes harder to assess and increases as

well. Since possible outcomes are widely divergent from each other, any policy change or event or new information

that raises the probability of the very bad outcome simultaneously lowers returns expectations and raises the risk

assessment. Our sources of dissonance, taken as a package, are presenting market participants with a series of

these divergent choices and creating an environment in which “risk-on, risk-off” is a more frequent description of

markets.

What is very interesting to study in the “risk-on, risk-off” environment is the behavior of correlations. Correlations

are deeply connected to causality, which is not easy to assess statistically, but intuitively one can understand why

shifts are likely when there are two or more forces acting on an exposure. For example, stock prices are heavily

influenced by market sentiment and the mood of the market may shift from greed to fear and back. Then, it should

not be surprising that there is one correlation structure for market dominated by fear and another for markets

dominated by greed.

Within the asset class being downgraded – for example, say equities when fears of a recession emerge – the

correlations between expected returns for pairs of stocks rise together. That is, individual stocks (or sectors)

fall together, in part because the effort to discern which stocks (or sectors) might fall less than others is

overwhelmed by a desire to reduce exposures to equities in general. This happens in commodities, as well.

When the “risk-off” signal is heard, correlations among commodities rise as they all move down in price together.

12 The distinction between supply shocks and oil shocks and how this results in difference correlations between the oil price and equities, as well as other asset classes is the subject of current research by Avihai Rapaport, “Supply and Demand Shocks in the Oil Market,” Chicago Booth Working Paper 2011..

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And, not surprisingly, less liquid securities and credit-challenged securities see the same pattern.

Correlations across asset classes are not so clear. Risky asset classes remain correlated, but low risk assets, the

destination of flight-to-quality money rise in price. That is, government bond prices rise (yields fall) as equity indices

are declining. And with currencies, the winners are the low rate “funding” currencies that now must be paid back,

and depreciating currencies are the former high flyers.

In fear-dominated markets, the potential for major policy shifts increases. A large portion of market participants

expect that the governments and/or central banks should be doing something to calm market fears. In some cases,

these expectations may not be realistic, but the pressure on policy makers and central banks is no less real. This

creates a market situation where two types of forecasting errors can occur. Market participants can expect a given

policy change and not get one. Or, market participants can expect no policy action and get one. Both types of errors

can disturb markets and trigger a move toward “risk-off” or “risk-on” depending on the nature of the forecasting

mistake and the policy that was enacted.13

The bottom line for “risk-on, risk-off” environments is that we need to keep two sets of correlation structures at the

ready. if we develop our exposure management strategy in a “risk-on” environment, then we need to stress

test possible outcomes if the world shifts to a “risk-off” environment in a sudden manner. Since correlations

among exposures within an asset class are inherently higher in the “risk-off” world than in the “risk-on” world, using

a correlation structure from a history dominated by “risk-on” will underestimate risks and by no small amount.

By a similar token and not at all as well appreciated, after a crisis, historical correlation calculations may cause

future risks to be over-estimated and profit opportunities foregone. What is required is a forward-looking

analysis on the potential for “risk-on” versus “risk-off” and setting one’s risk preferences with an eye toward

understanding the worst cases.

c. the need to construct an informed forward-Looking global assessment

The combined nature of (a) policy events feeding rapidly through the asset classes, from currencies, to rates,

to equities, to energy, metals and agricultural commodities, and (b) the stresses of uncertain and confusing

policy decisions leading to a persistent “risk-on, risk-off” market environment challenges some key assumptions

embedded in many risk models and risk management approaches; namely, the assumptions that volatilities remain

in a relatively accepted range14 for each type of exposure and that the correlation matrix that represents how the

movements of different exposures work together is stable. in the Era of Dissonance assuming a stable regime

for volatilities and correlations may turn out to be extremely dangerous to one’s financial health. In options-

speak, the Era of Dissonance is all about “vega” risk, the Greek letter that represents the risk of shifting volatilities in

options trading. Practically speaking, asset classes now are considerably less independent of each other than in the

previous half century.

13 “Credit Risk Dynamics in Response to Federal Funds Target Rate Changes”, by Professors Kwami Dunbar and Abu S. Amin, working paper, 2011, John Welsh School of Business, Sacred Heart University, Fairfield, CT.14 That is, the assumption of volatility homoscedasticity (stable volatility) is no longer useful, as we are in a world of heteroscedasticity, or ever-changing levels of volatility. Homoscedasticity is a fundamental assumption on which some basic statistical techniques such as ordinary linear least squares regressions, are based. In short, some very typical and standard research techniques should be used only with extreme caution or modified to be more dynamic and to accommodate changing volatility environments.

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1. static asset allocation based on asset class categories may not work nearly so well in this period as in

the past. The old long-term rule of thumb of 55% equities, 35% fixed income, 10% cash allocation needs to be

carefully and critically re-evaluated and possibly relegated to the dust bin in favor of more flexible and dynamic

asset allocation methodologies.

2. Dependable diversification can be especially hard to achieve when correlations can switch directions.

This argues for a much more forward-looking approach to risk management.

3. The clear and present danger from these powerful sources of dissonance is that risk assessment and risk

management are both more important than ever and also more complex. What is required is a forward-looking

view of risk and a much more dynamic analytical process for risk assessment and management. The search by

some for the “Holy Grail” of risk measurement, namely one number that provides a measure of risk for a complex

organization or portfolio, needs to be abandoned completely. Risk management is part art as well as science.

Moreover, risk management involves forecasting and cannot be solely dependent on data calculations made

from historical time series.

4. Adding to the challenge, policy decisions can be made suddenly and often have many hidden, indirect, and

unintended consequences. In an era of potentially abrupt policy shifts and confusion in market expectations,

markets may tend to remain in a “risk-on, risk-off” mode for long periods of time. That is, instead of focusing more

on relative value within an asset class, market participants are forced into a situation in which their biggest

decision is not where to position their risk, but how much risk to take. And unlike the past half century, the

risk level decision must be managed continuously rather than made once and put into action for an extended period

of time.

Source: S&P 500 Index Value (SPX) provided through the Bloomberg Professional, Calculations by CME Research

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The toolkit one requires to navigate these challenging times is a broad one. From the bottom up perspective, those

at the front lines of executing trades and implementing market positions or hedging exposures need to have more

effective methodologies to assess market depth, liquidity, and trading costs. At the bigger picture level, market

analysis that frames issues in a consistent manner and focuses on the interaction of economics and politics will be

critical. A corollary point is that quantitative tools for analysis must be dynamic and embed “learning” capabilities,

such as Bayesian systems or other next-step-ahead modeling approaches. Finally, the importance of indirect effects

and interactions across asset classes and markets requires a portfolio perspective rather than a single market

perspective. The Era of Dissonance is going to be an interesting decade – or longer.

blu Putnam

Chief Economist, CME Group

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The information within this brochure has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Although every attempt has been made to ensure the accuracy of the information within this brochure. Additionally, all examples in this brochure are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience.

Citation: Please reference as “Era of Dissonance” Bluford H. Putnam, CME Group Market Insights Series, November 2011, www.cmegroup.com/marketinsights

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