Odometer Readings and Negative Interest Rates Back in 2011, researchers gathered data relating to 22 million wholesale used car auction transactions. Their goal was to see what affect mental heuristics (shortcuts) have on price. In particular, they were curious as to whether or not there is evidence of a particular type of inattention known as “left-digit” bias. In other words, they wanted to know if a car’s odometer ticking over to the next big round number had an inordinate impact on the selling price. For example, is there a disproportionate drop in sale prices at 10,000 mile thresholds? Does it matter significantly whether a car has 59,500 miles versus 60,000?
One look at this chart and you have your answer. As irrational as it may be to value that one mile between 59,999 and 60,000 so radically different from the one that lies between 60,000 and 60,001, the evidence clearly shows that we do. The reason is that our brains’ ability to process information is limited. There is only so much information we can retain in short-term memory for the comparison of data, a mental process that requires both ability and motivation to carry it out. So, in that moment when this information becomes available and we are forced to make a quick decision based upon it, we tend to employ heuristics. Often, the result is a suboptimal decision. In the case of these auto auctions, rational participants, the kind that seem to exist only in the imagination of economists, would purposely avoid purchasing the overpriced cars with odometers that read just below the major thresholds. In turn, that would erase the disproportional drops at those levels and you’d have a more efficient market. Alas, we don’t, and that creates opportunity for those who can avoid the bias.
When this data is mapped as a value function (see chart), you can see that although these discontinuities occur, in general, across the full range of odometer readings, mileage has a somewhat linear relationship to value. So, a pattern consistent with rational expectations does emerge.
The reason I bring this up is that a similar phenomenon occurred in financial markets on January 29th,. When the BoJ moved policy rates below zero, our brains perceived it to be new territory, similar to the way it treats the turn of an odometer. However, along the continuum of interest paid by a borrower to a lender, the move from +10 bps to 0 should be treated no differently than the one from 0 to -10 bps.
After all, the incentive to hold Yen denominated assets is not solely a function of the interest rate earned in Japan, but the relative return that can be earned on alternatives as well. A decision to hold one currency is, by default, a simultaneous decision to not own all others. When the BoJ moves its policy rate into negative territory, nothing miraculous occurs as it crosses over that threshold. The interest earned is now 10 bps less than it was on January 28th. It’s really that simple. If expectations for the future trajectory of interest rates in the US are simultaneously lowered as well, the net change in incentive to sell JPY and buy USD may be unchanged, or even made less compelling.
Given the evidence produced by studies in behavioral psychology, like the one related to odometer readings, we shouldn’t be surprised by the irrational reaction to the announcement of negative rates. The spike higher in USD/JPY was to be expected, for it is further evidence of cognitive bias. Bias, by definition is a systematic error in judgment, meaning it is predictable.
When I entered the JPY1 trade on January 15, 2016, one of the Reassessment Triggers stated that if USD/JPY were to trade up to 120.00, I would double the capital at risk on the trade through the addition of another 1 year 10 delta USD put JPY call. In order for that to occur, JPY would need to weaken by 2.5% from where it was when I first wrote that plan. At the time, I had no idea what would drive it higher, but whatever it might be, I had to know it was unlikely to be supportive of the trade. In other words, at the time that I stated my plan to double up if USDJPY went higher, I was assuming that move would be accompanied by news that would have me questioning the view. Truth is, we are all susceptible to irrational behavior, particularly when we must make decisions under emotional duress and/or time constraints. Knowing this, in those moments of lucidity, when we are particularly objective, we should do what we can to help our future selves make better choices when we are most likely to be vulnerable. That is the idea behind the Trade Write-Up and specifically the Reassessment Triggers.
(1) Heuristic Thinking and Limited Attention in the Car Market. Nicola Lacetera, Devin G. Pope, and Justin R. Sydnor. NBER Working Paper No. 17030. May 2011
About the Author For nearly thirty years, Stephen Duneier has applied cognitive science to institutional investment management. The result has been career best returns for experienced portfolio managers who have adopted his methods, the turnaround of numerous global trading businesses, the development of an award-winning $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America and Managing Director of Emerging Markets at AIG International. His artwork has been featured in international publications and on television programs around the world, and is represented by the world renowned gallery, Sullivan Goss. He received his master's degree in finance and economics from New York University's Stern School of Business.
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