Rational Accounting Man & Yield Curve Distortion

The inherent dangers lurking in the Sharpe World of financial regulation

The lament of a bond salesman

I recorded a chat with David Dredge this week, coming soon to a podcast app near you.

Dredge has fascinating insight into the nature of financial market risks and how investors can best mitigate against them.

His monthly letters are densely composed but always highly informative and amusing, and his podcast interviews are richly embroidered with anecdotes and historical relevance. Who thought risk management could be so interesting?

David talks about his Sharpe World framework, where we meet Rational Accounting Man.

Dredge returns to his model in his latest update, published yesterday, where he says

The usual suspect of manipulating Rational Accounting Man to behave as layers and layers of rules and regulations incentivize him to do. It is, at its core, financial repression. It is how fiduciaries get utilized to own, with maximum fragility creating leverage, government debt. Done with other people’s money, at prices that no reasonable capital owner (Boundedly Rational Agent) would allocate to. It really is the perfect example of how the manipulations, by the keepers of Sharpe World, of Rational Accounting Man, build the fragilities that create the imbalances that generate the busts.

He cites numerous academic studies that show the ideological edifice supporting this Sharpe World of volatility suppression, which treats all unexpected events as exogenous. However, as he says

We will stick with our view that risk is endogenous, and it is the very manipulations of Rational Accounting Man that generates the boom-bust cycle that the great central planners fail to predict. We stick with our simple view of risk. It is not the inevitable but impossible to predict exogenous shocks that define risk, but rather the accumulated building of fragility.

Scott Bessent recently explained that he was hopeful the US banks would be able to buy more of his bonds following the expected relaxation of the SLR, which is currently working its way through the regulatory process. This, Bessent explained, was a good thing as it meant he was less reliant on overleveraged and Yippy hedge fund types.

Part of the deregulation that’s coming in the banking industry will be changing what’s called the Supplementary Leverage Ratio, which will allow banks to buy more Treasuries without a big capital charge. So I would expect that we will have created a new buyer for Treasury securities, a larger, more durable buyer.

What could possibly go wrong?

What Bessent has done here is let the mask slip. He has allowed us to peer into the world of policymaking, which is usually best served up like eating sausages. They are best enjoyed without sight of how they are made.

As Dredge pointed out after the demise of SVB, in Sharpe World,

banks don't go bust by taking excessive risk. Banks go bust due to excessive leverage against what they account as risk-free.

Bessent is seeking YCD, Yield Curve Distortion, by forcing Rational Accounting Man to assume greater balance sheet capacity. After all, as he has said, he is America's biggest bond salesman. What better way to sell financial products that no real money investor wants to buy than to create new buyers? Step forward, Rational Accounting Man. Compulsion is a dirty word, but that is what it amounts to.

Of course, when it goes wrong, neither Rational Accounting Man nor Bessent will suffer the consequences. Indeed, if history is the guide, neither will the banks' customers. Inevitably, it will be the taxpayer.

Source: David Dredge & Convex Strategies

This is one of the points I cover in my always enjoyable weekly chat with Gareth Evans.

Never advice of any kind. Just the musings of an old man trying to preserve capital in a crazy world.