By Artemis Capital Management Excerpted at ZeroHedge
The rise of central banking is the death of empiricism. The Federal Reserve is arguably the most powerful organization on the planet and is the economic rudder of the global economy. The decisions made by its members effect anyone touched by capitalism from the garment worker in Bangladesh all the way to the investment banker in London. By design, board members are not democratically elected and independent from the oversight of the executive and legislative branches of the US government. The voting membership of the Federal Open Markets Committee is dominated by members with predominantly academic or policy backgrounds (Yellen, Evans, Fischer, Lacker, Williams, Brainard, Tarullo, and Powell) with the remaining deriving their experience as Wall Street economists (Dudley, Lockhart)(32). This means the most powerful economic body on earth has little diversity in its intellectual ranks.
No FOMC board member knows what it means to be an entrepreneur. No FOMC board member has a record of accomplishment as a great investor. No FOMC board member has started or run a successful global business. No FOMC member has led a corporation through a crisis. It may be time to consider whether economic leadership dominated by academic theory as opposed to empiricism is making things worse. I don’t claim to have the answers, but the empiricist knows what they do not know, and this is more than I can say for policymakers today.
Global central banks have made a Faustian bargain with our economic soul selling our future for a false stability today. At this stage, absent continuous intervention, a large deflationary crash in the global economy is inevitable. The greatest risk is that if central banks continue a policy of competitive devaluation and hyper-asset bubbles the end result will be an even more devastating crash, followed by sovereign defaults, and then class warfare. The next Lehman brothers will be a country. The real ‘shadow convexity’ will not come from markets but political unrest or war. Never forget that Hitler rose to power by harnessing the anger of a humiliated German middle class and abusing constitutional authority granted from a decade of economic devastation and money printing.
The Federal Reserve is better off ending the Prisoner’s Dilemma by engineering a painful but manageable global recession today rather than risk an uncontrollable tragedy tomorrow. Absent such drastic actions, volatility will manifest itself first through hyper-asset explosions on the right tail, followed by a deflationary crash and sovereign default on the left tail. It may already be too late. History shows us that economic recovery from a depression has never been successfully engineered without major debt reduction, devaluation, default, hyperinflation, political revolution, or world war. To this extent, it is very likely this Prisoner’s Dilemma will end in one or more of these outcomes.
Peace is not the absence of conflict. Global Central Banks have set up the greatest long volatility trade in history. It is impossible to know with certainty when the volatility will fully manifest but the cost of holding the trade is far less than exponential pay-off. The longer the delay the bigger the payout will be. What is known is that at some point in the future a government or central bank will be asked to step up to a crisis and will either be unwilling or unable to do so, economically or by populist revolt. The markets will re-leverage in anticipation of policy support that will not materialize… the spell will be broken… and the collapse will be epic. You need to own volatility on both the right and left tail of the return distribution before that day happens. When markets are euphoric buy optionality to protect against deflation … when markets are crashing buy optionality to protect against hyper-reflation.
More important when volatility doubles… don’t short it… keep buying it until it quadruples. Buy the fear and you will be protected from the horror.
Do this consistently and dynamically and your portfolio will become a global macro straddle that, when combined with traditional asset classes, will result in a profile that is positively exposed to all forms of crisis. You do not know it yet… but your greatest asset are the risks the world is hiding from you. You need to assemble a collection of the most dangerous outcomes in the global economy… and try to make them do some good.