Psychology of Negative Consequences

"This is a pleasant fiction, is it not?"
--Lucilla (Gladiator)

Another interesting presentation and Q&A with Kyle Bass. Bass sees Japan as the first to blow from misguided monetary and fiscal policies and his fund has a significant bet in that direction. He thinks that the action in Japan markets over the past few weeks (JGBs down alongside stocks) constitute the initial tremors.

The basic thesis is that once bond markets refuse to fund profligate spending, then the party is over. We've already seen Iceland, Ireland, Greece, Cypress, et al provide a sense of what a 'funding crisis' looks like. Japan, because of its extremely ugly contex, may be the first 'big name' to come apart.

But this KB presentation was not just about Japan. I found two remarks particularly insightful. One occurs around 28 min involving the psychology of negative outcomes and the market consequences when that pyschology reverses.

What he is talking about is the psychology of denial. The biases of cognitive dissonance--overconfidence, loss aversion, endowment effect, etc--that cause people to maintain (or perhaps even escalate) a course of action even though the data suggest a change of course.

That course change always comes, but it is lagged. And when it comes, it comes quickly. Bass presents many historical examples (peso, ruble, credit crisis, Greece, etc) of the speed with which markets react. Things are ok one day and chaos the next. It happens so fast that investors cannot get out of their positions.

The interesting point that Bass makes is that much of the policy intervention has suppressed volatility--which feeds the psychology of negative outcomes to keep people from selling. But this suppression merely builds potential energy that greatly amplifies volatility when the selling commences.

We have now been in the volatility suppression phase for about 4 years. Tick tock...

The other particularly insightful remark happens at about 47 min. Bass suggests that "the central bank is the great enabler of congressional profligacy." Stated differently, without governments buying their own sovereign debt and keeping interest rates artificially low, there is no way that spending and debt would be at their current extremes.

Bass recounts that when he suggests to congresspeople that a bond crisis could result if the US keeps spending like it is, they ask KB where Treasury rates are. And when KB recites the low current rate, the congresspeople say, "We don't see a crisis."

Psychology of negative consequences writ large.

position in SPX, Treasuries