The Fed has trained the trading-rats all too well, and there isn’t any solution to avoid the unintended consequences of the Fed’s large-scale human behavioral experiment.
The Federal Reserve has been running a large-scale human behavioral experiment since 2008. The outcomes at the moment are in. Let’s start by stipulating that trading-bots are programmed to trade on human behavioral flows, i.e. trends and reactions to policy announcements and other “news” (earnings beats. etc.). In consequence, the robot-trading-rats are responding to the identical stimuli because the human-trading-rats within the Fed’s experiment.
Here’s the experiment set-up. When the trading rats hit the red button, the stock market swoons, and the Fed leaps into motion to “save the market” by injecting trillions of dollars in stimulus and liquidity through various programs reminiscent of buying Treasury bonds. The trading-rats who “buy the dip” are rewarded with hefty gains because the market soars once the Fed “pivots” from “hawkish” to “dovish.”
Trading-rats are smart and so that they realized they didn’t must wait for the Fed to act to reap big gains. Since everyone playing the trading game knows the Fed will pivot dovish once the market swoons, then the trading-rats began front-running the Fed’s pivot, buying every swoon based on their supreme confidence that the Fed would soon “save the market” from crashing.
The Fed is now trapped by the success of its mass-scale behavioral experiment. The trading-rats have such total confidence within the Fed Put, i.e. the Fed “saving the market” once it swoons, because each time they’ve hit the red button the Fed has leaped into motion and released a tsunami of stimulus and liquidity that reverses the swoon and pushes risk assets to latest highs.
In consequence of this feedback, the market never swoons enough to trigger a Fed response because every dip is bought by front-running trading-rats. This may be seen as a hit, because the Fed not has to do anything in any respect to maintain the market elevated, because the front-running trading-rats leap into motion to purchase every dip. The expectation of a Fed “save” is sufficient to keep the market in a comfortably elevated trading range.
The issue is the trading-rats’ confidence within the Fed Put incentivizes a near-infinite expansion of moral hazard because the trading-rats can expand debt and leverage with none limit because the implications (potentially devastating losses) have been taken off the table by the Fed’s “guaranteed” reversal of any swoon in risk assets.
Each trading-rat is targeted by itself debt and leverage, but there isn’t any incentive to measure the systemic risk piled up by the Fed-generated moral hazard. The Fed’s “guaranteed” reversal of any swoon has thus created a perverse incentive to tackle insane levels of risk to extend gains–an increase in risk that now threatens the steadiness of all the economic system.
Nobody believes a crash is feasible since the Fed will reverse the swoon once the trading-rats hit the red button. However the Fed shouldn’t be omnipotent, and the boldness in its omnipotence has morphed into hubris.
The one way the Fed can break this incentive to extend dangerous bets is to deliver a shock when the trading-rats hit the red button. As a substitute of guaranteed gains, the trading-rats receive a shock–massive losses. To re-train the trading-rats behaviorally, the Fed may have to deliver repeated shocks since the trading-rats have been trained to expect Fed goodies each time they hit the red button.
The primary time they receive a shock as a substitute of a treat, the trading-rats shall be confused but will go ahead and hit the red button again. They’ll proceed to hit the red button and get shocked until they realize the principles of the experiment have modified.
Should the Fed randomly deliver treats and shocks, the trading-rats will enter a catatonic-schizoid state of nervous breakdown. The trading-rats will not know what to do, and so that they won’t buy every dip to front-run the Fed, and they’re going to not be confident the Fed will reverse the following crash.
For the Fed’s part, in the event that they keep rewarding the trading-rats for piling on risk, then the system will grow to be increasingly vulnerable to a cascading collapse as a result of insane levels of risk which have been incentivized by the Fed’s “guarantee.”
In the event that they stop reversing every swoon, the market is vulnerable to a cascading crash because the trading-rats are not any longer sure the Fed will bail out their insanely dangerous bets.
Either way, the swoon turns into an uncontrolled crash. The Fed has trained the trading-rats all too well, and there isn’t any solution to avoid the unintended consequences of the Fed’s large-scale human behavioral experiment.
Perhaps the Fed can ask ChatAI to resolve the unresolvable dilemma, but that may reveal the boundaries not only of Fed policy but of ChatAI.
Views:
14