There is a massive move underway in markets, GMO’s resident contrarian James Montier noted in a white paper titled “Six Impossible Things Before Breakfast.” Like an Alice in Wonderland journey, James Montiergoes down rabbit holes of ” financial repression ” of free market thought as he attempts a rare feat in the history of algorithmic analysis: Modeling an assumed free market to its correlation impact on a centrally-influenced market featuring negative interest rates. Modeling the point at which a “repressed” market impacts a free market is a feat rarely accomplished in public with a high degree of difficulty. The author’s resultant “two key assumptions, neither of which (he finds) very palatable,” question the linkage between interest rates and stocks as an investment priced based on assumed risk.

Financial Repression The “Perfect foresight” graph. How perfect.

James Montier On Financial Repression – The correlation linkage between bonds and stocks explained with drug lingo

“If bond markets are smoking weed, then the stock market appears to be hooked on crack,” Montier says with an apparent smirk as he considers “financial repression.” It is unclear if he uses false drug equivalency as the two distinct drug types, particularly the addictive crack, is increasingly spoken in the same paragraph with financial repression. This is often true for those dependent on interest income, such as pension funds. Montier has his own method of connecting dots, one that frequently mentions manipulated markets with apparent glee. What is the difference between insider trading and manipulated markets? Outside the fact that manipulated markets in Libor and metals markets impact billions of people and trillions of transactions around the world, not much that matters.

How can markets be “fairly” determined?

James Montier, for his part, has his own method of connecting dots, one that frequently mentions manipulated markets and financial engineering as he searches for a “fair” value. For his part, the search is for “below normal” interest rates to understand if the market’s “valuation is fair,” a complex and debatable topic. Were market’s “fair” just before the housing and derivatives bubble burst in 2008? When market participants flooded derivatives channels Sunday before the August 2015 market crash, was that “fair.” How can such a concept be determined?

Pointing to one of his proprietary formulas, however, he claims “real rates of -2% real for 90 more years would be necessary in order to reach the conclusion that today’s market valuation is fair!” This event could trigger a statistically significant “6-standard-deviation event even in a world rife with financial repressions, and strikes me as another near impossible thing that investors are embracing as a certainty.” That is certainly a mouth full. While there are commonly acknowledged data points to support this point, Moniter points to an odd statistic, one who’s calculation might be best explained from a formula standpoint. His work “indicates that we would need to believe that real rates of -2% real for 90 more years would be necessary in order to reach the conclusion that today’s market valuation is fair! This would be a 6-standard-deviation event even in a world rife with financial repressions, and strikes me as another near impossible thing that investors are embracing as a certainty.”

A 90 year projection is virtually impossible, some might say, as even questioning a 50-year time horizon on an investment is tricky, particularly when they implode year one of the term structure.

Here James Montier is on point.

Financial Repression You’re wrong again, the odd chart pattern says. Wrong. Wrong. Wrong.

Financial Repression – The impossible can happen, just not six times before breakfast

Just like the Chicago Cubs winning the World Series, the impossible can happen, but the future is often unpredictable. That is the origin of volatility that has statistically resulted in price trends.

Determining fair value for sovereign interest rates is not an exact science as modeling the length of a price trend, but market-based schools typically attributed a correlation with economic activity – potential for government revenue generation — and inflation to various degrees. Some might call this the “natural” interest rate measure, but Montier disputes that “natural” notion through less than clear language:

They eventually concluded that of the roughly 450 bps of decline in real rates between 1980 and 2015, nearly 90% of the decline was explained by structural factors, leaving just 10% “unexplained.” Only the research department at a central bank could manage to exculpate central banks themselves from declining interest rates. However, regardless of whether one believes in will-’o-the-wisps or central banks lowering interest rates, in neither case are these independent of the growth rate of the economy. In “natural rate” models, trend growth is a driving force in determining equilibrium levels, and central banks have been lowering interest rates because growth is low.

In attempting to decipher his logic into markets-based analysis, what can be deduced are references to artificially influenced markets and attempts to determine its influence on a correlated market which is at this point assumed generally free of centrally planned influence. For Montier, this means “reverse engineering the equity markets’ beliefs about interest rates,” a big claim indeed. While he apparently avoids discussion of an interest rate’s correlation to primary economic performance drivers, he does attempt to model a manipulated market – which on a degree of difficulty basis ranks right near the risk analyst’s hall of fame, if such a monster ever existed.

Montier is stepping around land mines to various degrees, if one is to correctly interpret his inferences. He acknowledges a free market with a drug habit to a degree, one he identifies in terms of real negative rates. He wonders when the rubber band of market manipulation might break, which is something akin to enjoying the understanding behind what was the real cause of the flash crash. (Spoiler alert: in one case the electronic eye was manipulated.)

There is a school of economic supply and demand that says a free market driven by participants with an economic motivation might create a reasonably “fair” price discovery function. That price discovery is not always going to be accurate minute to minute, but in the long-run markets have a history of mean reversion to truth given a fluctuating level of optimism as a relative value measure.

That popular optimism is returning amid what James Montier points to an odd economic principle, “helicopter money.” The inference is that money is free, debt doesn’t matter to central banks who can fund infrastructure projects more economically. This is a separation of church and state to certain markets-based fiscal / monetary policy thinking. Montier says the helicopter debate, once thought dead, is now back on track:

Of late, the concept of helicopter money has gained a certain degree of popularity. From my perspective, helicovpter money is really just fiscal policy carried out by the central bank. It has the same effects as a fiscal expansion in that it raises the level of net worth for the private sector. So, should such a policy ever be tried, it is likely to be successful – although why one would want fiscal policy run by unelected technocrats is beyond me. However, the basic point here is that markets priced for secular stagnation are putting a zero probability on fiscal policy being used as a route out of our current malaise.

Central banks in developing worlds have embraced sovereign debt to an unprecedented degree. Does it matter? If it elicits the wrong market-based response it could.

(Click on image to enlarge)

Interest rates Financial Repression