We explain a classical experiment for which the Russian researcher Ivan Petrovich received the Nobel Prize in Physiology / Medicine in 1904. We explain modern central bank experiments for which Stockholm will hopefully not award a Nobel Prize and which actually belong in the realm of financial satire.


The Pavlovian Dog

The Russian researcher Ivan Pavlov observed that the owner’s footsteps triggered salivation in dogs even when no food was in sight.

He then devised the following experiment: he gave dogs food and either shortly before, during or shortly after that, he rang a little bell. Dogs trained in this way reacted to the sound of the bell by salivating, even when no food was being given. Pavlov referred to this phenomenon as conditioning. Of course, untrained dogs did not respond to the ringing of a bell with salivation. The reaction, salivating foot to the ringing of a bell is rational if the Pavlovian dogs live in a world where a bell rings when the dogs are fed. If the bell rings and the dogs are not fed, they get angry…

In the past, bad news was bad news

In the past, bad economic or financial news was “bad news” for the financial markets.

Central banks turn bad news into good news

In response, central bankers devised the following experiment: they opened their money-locks so much when bad news came in, they lowered interest rates so much and bought so many assets (balance sheet expansion) until, in the interpretation of the original bad news, it finally turned into excellent news that led to a further rise in the stock markets.

The Pavlovian Investor

Investors trained in this way have already reacted to bad news with panic buying (otherwise you would miss the melt-up), even when the central banks had not yet taken any action.

“The thinking appears to be to be the virus impact will not last, it’s not spreading outside China as fast as feared and above all, central banks can step in – slower growth will bring more stimulus, or at least lower interest rates for longer. That makes shares more appealing. The virus causes a near-term demand shock, of course, but it’s a problem easily solved by central bank liquidity, is the message from research notes”.  (Quote from a market commentary from 14.02.2020 – Source: Reuters)


As long as central bank reaction function remains the same, investor reaction is rational

The current reaction of investors to interpret bad news as “good news” from the point of view of the financial markets, as overcompensatory central bank measures are expected, is rational as long as central banks react so aggressively to bad news that it eventually (from the point of view of the financial markets) becomes good news.

If bad news occurs and investors do not receive interest rate cuts, balance sheet expansions, “underperformance threats” in the case of conservative investment strategies, …

Alfred Nobel wanted the Nobel Prize to be awarded to the person whose discovery last year brought the greatest benefit to humanity.


This post was automatically translated

Thomas Härter
Chief Investment Officer Aquila