Jack Bauer, Risk-Aversity, and the Dollar

A common cultural theme, found even in the Bible, is the complicated relationship between fathers and sons. Star Wars, which pits Luke Skywalker against Darthvader, who, in a later episode, we learn is Luke’s father, celebrates its 30th anniversary this year. It was an exciting, even if not new, twist that many boys, of various ages also found liberating. One of the most popular television shows in recent years is “24”.

It features Jack Bauer (Keifer Sutherland) super anti-terrorist agent who recently learned his father was behind numerous terrorists incidents including the murder of Jack’s brother and numerous attempts on Jack’s life as well. Unlike Luke Skywalker, or Oedipus himself, Jack can confront his father, unambiguously, as the Other…just another security threat. Besides some deep-seated sense of patriotism, Jack is incapable of sustained emotional bonds.

Despite his dysfunctional personality and family there are insights we can glean from Jack, and I don’t mean the sado-masochist fantasies of torture and ruthlessness. Rather, how he treats his own and others’ ideas and how he understands risk are instructive.

Jack regards all his ideas and those of his colleagues as hypothesis not as an immutable truth. Like Jack we need to liberate ourselves from the received wisdom we take for granted. Like Jack we should treat our ideas like a lover: hold them dear when we have them, but at the first sign of fickleness, let them go.

This is especially relevant when it comes to conceptualizing risk. Jack is constantly in risky situations. That’s his job. He does not shirk from risk, but he manages his risk, but the same way Sun Tzu would suggest and the same ways investors ought to. The investors who make money in the market do not seem to be right in some objective sense more than people who don’t make money. Instead the difference between the two is disciplined risk management.

As global equity markets turned south, emerging markets tumbled and the low yielding Japanese yen and Swiss franc were among the strongest currencies, risk aversion seems to be competing with the yen-carry trade as the most over-used buzz phrases. What does risk-aversion really mean?

Some observers attributed a shift in the market’s appetite for risk as the cause of the turmoil in the markets in recent days. I experienced it a bit differently. When I went to bed Monday night, my appetite for risk was unchanged, but when I woke up the next morning and saw the nearly 9% slide in the Chinese markets and steep declines in other equity markets, pressure on emerging markets (equities as well as currencies), and strong yen gains against all other currencies, my appetite for risk soured. This is to say, I experienced risk aversion as an effect of the dramatic price swings not the cause.

The way that many use the term, risk aversion is not knowable separate from prices and volatility. When the S&P 500 falls, volatility tends to rise simultaneously. The same is generally true for bonds. As prices fall, implied volatility rises. It also appears generally true in the foreign exchange market. As the yen strengthened over the past few days, implied volatility jumped.

As often used, risk aversion does not add any fresh insight. Prices (for bonds, equity and the dollar) fall, volatility rises and the talking heads say voila investors are becoming risk averse. And when prices recover, which they will, it will be announced that the appetite for risk has returned. Jack Bauer would not use the concept of risk aversion because it is just jargon and is not very illuminating. In addition, it is an assertion that cannot be tested.

The suggestion here is that the insight from Jack Bauer is similar to the insight that George Soros claims is grounded in the philosophy of Karl Popper. Popper’s philosophy (of science) emphasized the importance of making assertions or claims that can be dis-proven (falsified). He also taught a profound skepticism about the reliability of any one human belief.

Recognizing the short-coming of the risk-aversion claims, some observers talk about the market re-pricing risk. This sounds reasonable. All kinds of credit spreads have widened and most equity markets have pulled back from lofty levels. In a more subtle expression than Greenspan’s famous “irrational exuberance” comment, many policy makers have expressed concern about the markets mis-pricing risk, according to their largely academic models.

However, there is good reason to be skeptical of such a formulation as well. For example, the JP Morgan EMBI+ index, which measures the spread of an index of emerging market yields over Treasuries, has widened 20-25 basis points this week from historic lows of about 165 bp. By most measures, except for the very recent past, the spread remains quite tight and tighter than one would expect if risk was truly being re-priced. The problem with the concept is that there is no way to prove or disprove the claim or evaluate it independently of the price action itself.

It is not clear how saying that investors have become more risk averse or are re-pricing risk adds any fresh insight into events than saying that the prices have fallen and the volatility has risen does not. Of course, some analysts have devised indices of risk-aversion, but they seem essentially composites of prices. Ideally, what is needed to make the concept more robust is some way to measure it outside of prices.

The danger is that the concept of risk-aversion is used as a catch-all phrase that renders more serious analysis superfluous. Markets are down because investors have become more risk averse. No further analysis is needed. It conceals more than it reveals. For example, over the past week, and despite mostly stronger than expected data, through Friday March 2, the Canadian dollar fell in five consecutive sessions to reach its lowest level in about three weeks. The 1.33% slide was larger than the decline of the Mexican peso and the Indonesian rupiah. How does that speak to risk aversion? Or consider that the Vietnam’s Ho Chi Minh Stock Index, which was up 47% y-t-d before this week and rose nearly 6% this week.

Except for Jack Bauer, the other characters seem to experience one of two emotions; fear and hubris. It is often said in the markets, two emotions dominate: fear and greed. When it is not simply a short-hand for a decline in the market, risk-aversion seems to be an allusion to the pendulum of investors emotions swinging toward fear from greed. It is a colorful way to describe a change in attitudes, but it is hardly a rigorous way to explain, analyze or forecast market developments.

Risk aversion tells us nothing about the outlook for the US dollar in the week ahead. Should the dollar be bought on safe-haven arguments, with the largest, deepest and most transparent market in the world? Or should the dollar be sold on ideas that the dislocations of the capital markets will make it more difficult to fund the US current account deficit?

We would argue that the US dollar is not the fulcrum upon which the foreign exchange market bends. Until the equity markets stabilize, it is not clear that the foreign exchange market will be able to focus on much else. That said, there are two events to highlight next week. First is the ECB meeting where another 25 bp rate hike is well discounted. Barring a surprise decision to keep policy on hold, ECB President Trichet’s press conference that follows the meeting is more important. The key here is how he guides market expectations for the future trajectory of ECB policy. The market expects another hike in Q2, but Trichet is unlikely to be very committal. There is no sense of urgency to indicate that the end of the cycle is nearing, especially during the current wage round, which the ECB has emphasized as a potential factor in setting monetary policy.

The other main event will be the release of US Feb non-farm payrolls. The current consensus is for about a 100k rise, which would be somewhat less than the recent trend. That said, back month revisions have been so substantial as to render the preliminary estimate nearly insignificant. On balance, assuming that foreign exchange traders can focus on the news stream rather than developments in other markets, the dollar may be on its back foot.

In terms of your appetite for risk, just ask yourself WWJD—What would Jack Do? Don’t ever take the risk of ruin. Question your hypothesis. There is no substitute for disciplined risk management.