How to think about the macro-investing project? In my December paper, I conceived it in terms of exploring a landscape. I have been thinking some more about this metaphor. The landscape of ways to approach the markets is large, and rugged; in other words, there are many different ideas about it and each set of ideas is quite complex, so it is possible to “climb a hill” by honing one’s understanding of them. A problem, however, is that not all the peaks are above the zero point in terms of expected return.
I have explored this landscape and settled on an approach that I think will work. Many people never do this, but remain eclectic. Why is it better to settle on an approach? Because it removes the need to explore the rugged landscape, which is exhausting. I am trying to improve, at present, in the dimensions of a) ability to model the current situation, b) knowledge of modelling approaches and c) knowledge of the markets. That is still a lot to do, but in all three cases the landscape is probably a smooth hill whose gradient decreases as you climb (i.e., the marginal return to extra study decreases). It is not necessarily clear what to study in order to maximise one’s rate of improvement, but it is clear that any study in any of these dimensions is likely to take one upward rather than downward. In contrast, if one is also trying to improve in the dimension that is rugged, one’s overall ability might easily go down as well as up.
I have been playing with models of the behaviour of the RBA, in an effort to decide whether there is a good argument for shorting AUD/USD. The RBA roughly follows a Taylor Rule but more closely follows the path of unemployment, which suggests that rate increases are unlikely if the unemployment rate continues to increase. AUD/USD is falling as US rates increase, reducing the interest-rate differential, which exposes a risk in the trade, which is that US rates could fall again; however, with Australian rates only recently having been cut again, and the currency near its highs since the current cycle on interest-rate cuts began, even if US rates were to return to their recent lows it would be unreasonable for AUD/USD to break its recent highs. There would be a good reason for shorting the market if it returned to those highs.
I would like to have a model of everything; and, thinking about it, I would like to have several models of everything. It is tempting to try to find the best model, but it is probably better to have several models for any given forecasting attempt, because different models will pick up different aspects of reality. For example, US equities can be seen as moving with earnings, with a credit spread attached; or they can be seen, in the post-GFC world, as being closely related to inflation expectations. Both models have sound empirical and theoretical backing. When the two models give the same view of the situation, one’s confidence in that view is naturally increased.
I do not understand why the Japanese government has unveiled a budget that has lower spending than the year before. This does not cohere with what appeared to be a plan to revive the economy via a combination of fiscal and monetary stimulus. Perhaps the details will become clear. Certainly, public works spending is being increased, by 15.6%, but at the cost of cuts elsewhere.
I suppose this coheres with Noah Smith’s view that Abe’s new spending is about channelling benefits to the traditional supporters of the LDP in the construction industry, and not about macroeconomic policy. The view of Abe in the commentators I read was that he was a generally bad chap, about to do the right thing (i.e. coordinated fiscal and monetary expansion) economically for a vaguely suspect mixture of reasons. Among that mixture, perhaps there is the commonly-held view that the paradox of thrift is too much for voters’ little brains to cope with (a view that I do not share!). Does Abe want to pose as a “sound” fiscal hawk while lavishing expenditure on his allies? I suppose that would not be a great surprise.