(Bloomberg) — Although the idea that markets are totally rational took a battering during the financial crisis, there is still an implicit belief that most actors are rational most of the time. Similarly, the Cold War doctrine of mutually assured destruction (MAD) assumed a stable equilibrium because neither the United States nor Soviet Union, as rational actors, would precipitate a nuclear war given the inevitable consequences. These days politics and markets seem to intersect more closely than ever even as assumptions of rationality begin to fray.
- It normally pays to look through the noise provided by political and diplomatic events because ultimately, it is pretty easy to map the reaction function of the relevant actors and determine that they will do the “right thing.” In such a framework, fading short-term risk aversion episodes usually makes sense
- These days, however, things are becoming less certain. North Korea’s regime seems determined to provoke the United States, with Monday’s missile shot over Japan the latest and most serious provocation. It becomes a little less easy to look through the noise if one starts to view the movie “Team America: World Police” not as a rude puppet comedy but as a sort of visionary tour de force
- The forthcoming U.S. debt ceiling deadline provides another example of a scenario where it has traditionally made sense to assume an element of rationality amongst the relevant actors. Sure, there was a short government shutdown a few years ago, but even then there was a sense that Congress was sensitive to a possible loss of political capital
- This time around, that may not be the case. Even as the president demands funding for the border wall as part of the negotiations, it’s hard to shake the idea that he is not averse to an extended shutdown — premised on the belief (rightly or wrongly) that he can deflect the blame to Congress. The idea of a technical default would be anathema to prior U.S. administrations. Is that the case this time around? That’s less certain
- It feels as if the currency market has already begun to price some of the apparent loss of rationality or predictability — why else would the dollar decline against the AUD, NZD, and ZAR during an apparent period of risk aversion?
- If risky assets like equities and credit start to see the world through the same prism of unpredictability, perhaps that will be the catalyst that finally produces the type of corrections that are the historical norm in financial markets
- NOTE: Cameron Crise is a macro strategist who writes for Bloomberg. The observations made are his own and are not intended as investment advice.
To contact the reporter on this story: Cameron Crise in New York at email@example.com