Allison's Ode to the Second Moment


Welcome to the 46th issue of Allison’s Ode to the Second Moment, a newsletter about the opposite of risk.

Risk-Free or Die

The most important, and overlooked, price in finance is the price of risk-free assets. When an investor thinks about moving money into the future, the risk-free rate is the foundation of his or her decision. If an investor can score a 100% return for certain, why bother taking any risk at all? If the risk-free rate is only 0% (or negative), investors may feel pressure to take more risk in order to reach their financial goals.

Risk is a slippery concept that can be hard to define. Here risk-free serves another important role. It defines risk because risk is everything that is not risk-free. The risk-free rate shows up everywhere. It is used to derive the most efficient portfolio, it determines derivatives prices. Yet the risk-free rate gets little attention compared to more exotic risk prices.

I recently spoke with some other financial journalists about the 10 year anniversary of the Financial Crisis. I argued that one cause was more expensive risk-free assets. I was told this was a contentious argument. I’ve heard this response many times from financial and economic commentators. It seems weird to dismiss risk-free so easily. After all, the risk-free price is critical to risk taking and portfolio evaluation.

Now, I have no idea what is going on with the markets these days. Are we heading into bear territory or just a period of high volatility? Who knows? But there if there is one price that can tell us anything, it is the risk-free rate.

We may want to pay attention to this Wall Street Journal story that claims safe asset prices are behaving strangely. I take issue with classifying gold as a risk-free asset. But the article notes that other traditional low-risk assets—the dollar, the yen, treasuries, and dividend-paying stocks—are not exhibiting the same correlations they once did. This is, in part, because of changes in Fed policy and more volatility in the market.
Is this a sign that something nasty is brewing? Maybe, but to understand what’s going on, you need to remember a risk-free investment means different things to different investors. A long-dated treasury is risk free to an insurance company or pension fund but not to a short-term investor.

I suspect the answer lies in how recent economic events impact different market players. Their risk-free rate tells us how they’ll respond and manage risk going forward.

How’s This for Meta?

This is just weird. On VIX funds

The new safe haven is now volatility,” said Christopher Stanton, chief investment officer at California-based Sunrise Capital LLC. “It’s the one thing that’s pretty much guaranteed.

I guess everyone really does have different definitions of risk-free.

Labor Markets

I don’t normally comment on the jobs report because it rarely reveals anything surprising or meaningful about macroeconomic trends. But Friday's was interesting for its relatively low growth. There are more job openings than people looking for work. Wages are going up, but not as much as some people would like.

Gifted economic diplomat and Minneapolis Fed President Neal Kashkari told business leaders in Duluth what to do:

Almost everywhere I go, businesses tell me they can’t find workers. I always ask them the same question: ‘Are you raising wages?’ Usually, the answer is ‘no.’ When you want more of something but won’t pay for it, that’s called ‘whining,’” he told the ninth Regional Economic Indicators Forum (REIF), founded and co-sponsored by National Bank of Commerce. “Until you’re paying more, I know you’re not serious.

This strikes me as a bit insensitive. It is popular to say, based on a few recent studies that claim to upend everything we know about labor markets, that employers enjoy monopsony power and are depressing wages below workers’ marginal value. But does that narrative describe a construction company in Duluth or a McDonald’s franchise owner who operates on thin margins? I buy that some firms have this market power. Maybe they enjoy excessive profits by robbing workers of their value. But applying this story to the entire labor market, for all skill levels, sounds like a bit of a reach.

It is like saying there is only one risk-free asset because everyone faces the same set of circumstances. Employers that hire low-wage workers face different constraints than profitable companies like Apple.

I am also concerned about the labor market and stagnant low-skill wages. But I reckon this has more to do with technology standardizing skills across companies. Standardization means more workplace fissure, outsourcing less-skilled workers. Fissure mean less wage compression and lower rates of mobility. Skill standardization also decreases employers’ incentives to train workers. Workers can take their skills elsewhere.

Rather than cast all employers as greedy capitalists, I think we need a better understanding of how employers view the risk around hiring and training low-skill workers (it is like investing in an asset) and if they face a lower risk alternative.

In Other News

  • Bloomberg sides with pension actuaries in the nerdiest rivalry in the world. One columnist rejects the idea that governments should worry about interest rate risk when it comes to pension liabilities.

  • It turns out that blue-collar women bore most of the costs of NAFTA because they are most likely to leave the labor force.

  • 14% of economists think their job is “socially useless” compared to 8% of the general population.

  • On a personal note, my long-time business partner, Jason Levine, and I are launching a risk consultancy called LifeCycle Finance Partners. We advise on all things risk, especially retirement.

Until next time, Pension Geeks!