This year’s Nobel prize in economics was awarded to Richard Thaler, a pioneer of behavioral economics. But there is a tale told by a lesser known Nobel laureate, Kenneth Arrow. As a World War II weather officer, he was tasked with analyzing the reliability of the army’s long-range weather forecasts. His conclusion: statistically speaking, the forecasts weren’t worth the paper they were printed on. Captain Arrow sent along his report only to be told, ‘Yes, the General is well-aware the forecasts are completely unreliable. But, he needs them for planning his military operations.’
Okay, maybe you don’t actually need a Nobel prize to know that rationality in the decision-making department is often lacking. Case in point: the capital markets. While subtle and ingenious in construction, the capital markets are, nonetheless, driven by the mass action of millions. They are a reflection of ourselves and necessarily express both the summit of our knowledge as well as the pit of our fears, and everything else in-between. And, this brings us to the subject at hand: Gresham’s Law. Sir Thomas Gresham was a financier in the time of King Henry VIII and his name is, of course, attached to the principle that ‘bad money drives out good money.’ Coin collectors of a certain age are familiar with the near immediate disappearance from circulation of all silver American coins once Congress had mandated the use of base metals beginning with the 1965 vintage. While all coins – silver and copper alike – carried identical legal tender value, it was the silver coins that vanished. Perhaps you are wondering what this has to do with bond investing? Everything!
Consider the state of financial markets as witnessed by metrics of implied volatility:
This post was published at Zero Hedge on Nov 19, 2017.