When I first arrived in the United States at the age of 17, I was invited to my Caltech biology teacher’s home for Thanksgiving, along with many other international students who had nowhere to go. I immediately fell in love with this vacation. First, it happens on a Thursday leading up to a long weekend. Second, you can eat endless amounts of food. Finally, after eating copious amounts of food, you can shamelessly relax on the couch with the others, while watching reruns of old Hollywood and football classics. My favorite was gorging myself on Twilight Zone reruns, where weird things always seemed to happen beneath the veneer of normalcy. The weekend that followed was generally devoted to recovering from gluttony.
Today, if that hasn’t happened already, a sort of dark Twilight Zone will happen to many turkeys as well. This has been called the “turkey problem,” a parable that Nassim Taleb of “Black Swan” fame has cited eloquently in his books. Here is that quote verbatim:
Consider a turkey that is fed daily, each feed will strengthen the bird’s belief that it is the general rule of life to be fed daily by friendly members of the human race “looking out for its best interests. “, as a politician would say. On the Wednesday afternoon before Thanksgiving, something unexpected is going to happen to the turkey. This will lead to a review of beliefs.
Turkeys extrapolate the most recent history of what happened to predict that things will be just as wonderful in the future. They are given a lot of food to fatten them up, they roam free and become more confident every day that things will be just… great.
The problem is, Thanksgiving comes back every year, and a hundred million turkeys except maybe a couple pardoned by the president are slaughtered. This year, “Peanut Butter” and “Jelly” will be pardoned and could live their lives in relative happiness. For all other turkeys the “belief review” quickly leads to sudden death.
Investors in bond markets have also become accustomed to central banks providing a safety net. Even as inflation rages and the “transitional” camp now changes its tone, people insist on buying government bonds. Jerome Powell and Janet Yellen are now talking about inflation that may be more persistent than they thought, but more importantly now they are talking more about what they will do if they are wrong with that assessment. In other words, they are about to shock the markets – or to use Taleb’s words, “a belief review” in accommodative monetary policy.
In 1994, another Fed chairman, now ousted “non-maestro” Alan Greenspan, shocked bond markets by suddenly tightening policy on February 4, 1994. Rates had remained low, stock markets had been on fire since 1987 . crash. A few months later, the Fed tightened again between meetings. Then, in May 1994, the Fed stepped up the pace of rate hikes by 0.50%! In order to catch up with the markets, the Fed raised its rates by 2.5% in 1994. Two-year Treasuries rose from 4% at the start of the year to over 7.5% at the end of the year (Source: Bloomberg). Of the other leverage investors who suffered, Orange County, Calif., The county I call home now, went bankrupt. Turkeys.
I was a young trader then and tried several times to catch the falling knife, literally. My upbringing was swift and painful, and I, like turkeys, felt how markets can revise beliefs without much warning. I was also that over-stuffed turkey.
Today, the Fed finds itself in a similar situation, having fallen behind due to its own pride and belief in its economic forecasts which are dead wrong. Since government officials will never admit they are wrong, markets will have to prepare to face the fall of the knife on their own. With real returns in deeply negative territory globally, even as stock markets set daily record highs, bond markets are at the mercy of unelected officials making ad hoc decisions. And when the belief review does occur, there will be few places to hide in the liquid asset markets.
Going back to my Caltech days, there’s one more thing I’m not so proud of. We undergraduates called graduate students “graduate turkeys,” presumably because surviving the math and physics courses designed for an undergraduate at Caltech was considered too difficult for the graduate students who had gone to college. ‘other schools as undergraduates. With their unsightly silhouettes, their inability to fly, the “gobble-gobble” sounds, and especially the tryptophan overdose that puts you to sleep, turkeys have become a symbol of stupidity. Of course, all this bad press about turkeys is probably a myth. But we cannot be sure.
True or False, Turkey Day is a reminder that when you’re in the markets, you don’t want to be the last turkey thinking you’ll be okay forever. We are surely in the twilight zone of central bank run markets, and the gluttony hangover will not be pleasant for the bond markets.