Risk Update – March 2022

When thinking about real world “tail risks” few are more frightening than food shortages and famine. Aside from the obvious direct implications, they tend to be the catalysts behind most socio-political uprisings throughout history. It is not oversimplifying to state that “price stability” or “inflation targeting”, as the core premise of central banking, boils down to this basic issue. If only they could keep that in their sights.

Figure 1: UN Food and Agriculture World Price Index

Source: Bloomberg

The implications of the long manipulation of the global economic sandpile and its inevitable transition towards its critical state, could rightly be described as a coming “perfect storm”. One of the most respected local figures, both in Singapore and abroad, Tharman Shanmugaratnam (https://en.wikipedia.org/wiki/Tharman_Shanmugaratnam), did just that in a recent speech, entitled “Responding to a Perfect Long Storm”, that could have been pulled straight from the syllabus of a course in Self-Organized Criticality.

https://www.mas.gov.sg/news/speeches/2022/responding-to-a-perfect-long-storm

Higher-for-longer inflation is now a near certainty. It complicates what was already an extremely difficult task for central banks, particularly in the advanced world – the task of balancing growth and inflation considerations….The timing and pace of normalisation of interest rates is now a more complicated matter. But it’s broader than just central bank action on interest rates. We have to address a broader set of shocks, that go beyond even what we saw in 1973 with the oil price shock. This time it’s not just oil prices, it’s food, it’s a range of industrial metals, it’s fertilizers and other commodities…..this is an unprecedented situation. The economic models are not going to be very useful in projecting outcomes…. We have to plan for a range of scenarios, but tilted very much towards the downside: higher and more persistent inflation and slower growth.

Translation: Stagflation. If anybody gets the chance, please ask any central banker that you may run into “what is your plan for a Stagflation scenario?” Funny how the endgame results of money printing, in all its centuries of guises, always ends up at the same place: where you need to curtail destabilizing inflation but are in a position where you can’t afford to impair growth. Check mate.

We can add oil prices and interest rates to the above chart of food prices and capture arguably three of the most significant input costs to the global economy. Cleary, significant increases in input costs and almost certainly, at some point, growth killers.

Figure 2: UN Food Price Index (white). Generic First Oil Future (purple). US 2y Swap Rate(yellow-RHS)

Source: Bloomberg

From a market perspective, we can narrow it down to a very fine point – the demand for liabilities is going up, while the behemoth marginal supplier of liabilities, the ZIRP setting and QE printing central banks, are dialing back.

Here is the problem, the Fed, as well as all their blind followers, told us that the rises in their respective measures of price stability were “transitory” and would fall back within acceptable bounds, all on their own fruition. Once the Fed, eventually to be followed by the rest, announced that these price stability measures will not return to acceptable bounds without the direct action and intervention of their own policy measures, i.e. dramatically new information, the obvious question is “What will it take?” As we have discussed ad nauseum, it is likely not an unreasonable perspective to think that historically extreme negative real interest rates may not be an appropriate, or at least sufficient, tool to accomplish this task.

Figure 3: US Fed Funds Rate (orange), Wu Xia Shadow Rate (green), CPI yoy% (blue), 2yr Swap Rate (yellow), Taylor Rule Estimate (red)

Source: Bloomberg

A brief history of how the Fed got to where we are goes something like:

  • In November they announced their definition of inflation would no longer be considered “transitory” but would now be considered as “persistent”. They kept interest rates at 0% and continued with QE purchases but set a timeline to run down purchases by June.
  • In December they announced that all their conditions around employment and price stability had been met or exceeded. They kept interest rates at 0% and continued with QE purchases. They announced they would accelerate their timeline to run down purchases by March.
  • In February they admitted they should have responded sooner. They kept interest rates at 0% and continued QE asset purchases, sticking with their target of March for ending purchases.
  • In March they hiked the Fed Funds rate 25bp (look very closely at the orange line in the above chart, you can just see it) and ended their QE purchases as planned. They did not announce any plan for reducing the size of assets held on their balance sheet, thus continuing to reinvest any natural runoff of their holdings.

The market, as you might imagine, responded with a “what difference is that going to make” attitude and immediately started pricing in much more aggressive expectations of near-term rate hikes. Apologies to regular readers, but we can’t help but go back to the quote from Arthur Burns that we have used several times before:

In principle, no matter how high the nominal interest rate may be, as long as it stays below or only slightly above the inflation rate, it very likely will have perverse effects on the economy; that is, it will run up costs of doing business but do little or nothing to restrain over-all spending……In many countries, however, these rates have at times in recent years been so clearly below the ongoing inflation rate that one can hardly escape the impression that, however high or outrageous the nominal rates may appear to observers accustomed to judging them by a historical yardstick, they have utterly failed to accomplish the restraint that central bankers sought to achieve.

Arthur Burns, 1979.

Presumably, modern central bankers believe either that they have created such a significantly fragile system that they will bust the whole thing long before they get to positive real rates, or that somewhat less negative real rates will be enough to curtail unbounded pricing increases.

Thus far, market pricing of expected future higher policy rates seems to be having little impact on near-term inflation expectations. Below we show the 1yr ahead NY Fed Expected Inflation Rate and the 1y1y forward swap price of US interest rates, along with the Fed Funds Rate. You can see that, despite the aggressive repricing of forward interest rates, there has been little slowing of the forward inflation expectations which are expanding well above the Fed’s random 2% target. Point being, even if the Fed follows through with hikes as implied by market pricing over the next year, implying as much as another 200-250bp of rate hikes, and the current inflation level of 8.5% (March yoy% CPI) subsides to 6.5% as indicated in this Inflation Expectation number, we are still left with historically extreme negative real interest rates. If the ‘inflation’ is indeed not transitory and does require central bank intervention to pull it back down, will negative real rates in the region of 3-4% do the trick?

Figure 4: US Fed Funds Rate (orange), 1y1y Fwd Swap Rate (white), NY Fed 1yr Inflation Expectation (blue)

Source: Bloomberg

As badly as the Fed has trapped themselves, the ECB has taken it to an even greater level. They are still claiming that their equally bad price instability (arguably worse) requires no near-term adjustment to their all-time accommodative policy setting. We promised last month that we would update on the ECB’s ongoing prowess as economic forecasters once we got their revised quarterly projections in March. We mocked the ECB back in October https://convex-strategies.com/2021/11/19/risk-update-october-2021/, when their September projections for Q4 average monthly HICP yoy% were shockingly unrealistic but, nevertheless, stoutly defended by President Lagarde:

“We really looked and very deeply tested our analysis of the drivers of inflation, and we are confident that our anticipation and our analysis is actually correct.”

We did the same again after their December forecasts for Q1’22 HICP projection. Their March projections, however, have taken their credibility to a new low. We revive below our adaptation of their history of quarterly projections versus the realized actual numbers.

Figure 5: Eurozone HICP yoy% change (blue) vs ECB quarterly forecasts through March 2022

Source: Convex Strategies, Bloomberg

In March the PHD laden Economics Team at the ECB, led by Philip Lane, forecast Q1 monthly average HICP yoy% change at 5.6%. Bear in mind that they already had to hand the January yoy% of 5.1% and the February yoy% of 5.9% and the previous 11 months in the series leading up to March. Very simple math allows us to backout that in the very month of March they forecast for March yoy% to come in at 5.8%. We now know that the actual number has come in at a hefty 7.5%. A miss of 1.70% on a three-week forward projection horizon. A margin of error that forces us to once again ask, are they really that incompetent, or are they intentionally misrepresenting their projections? Which one does more damage to their credibility?

What about this price index in figure 6, the explicit price stability target for an exclusively inflation targeting central bank, screams maintaining -0.50% policy deposit rate and massive levels of asset purchases? They have lost the plot.

Figure 6: Eurozone HICP Index

Source: Bloomberg

The ECB is merely at the stage of admitting that their measure of inflation has exceeded their expectations, yet they still anticipate it returning to their random target of 2% very soon (see figure 5 for latest projections). Meanwhile, they are sticking with a negative nominal policy rate and ongoing asset purchases until Q3 of this year. Maximum accommodation in the hottest price and employment environment in their entire history. One word comes to mind: Madness.

Figure 7: Eurozone ECB Deposit Rate (orange), Wu Xia Shadow Rate (green), HICP yoy% (blue), 2yr Swap (yellow), Unemployment Rate (red/inverted)

Source: Bloomberg

We will ask yet again; what is the purpose of their historically extreme loose policy setting? Is it to stimulate inflation? Do they believe in the effectiveness of their policy to stimulate inflation? If so, they should put a stop to it and normalize policy immediately. If they believe their policy will not stimulate inflation, they need to stop it immediately and explain why they acted as they did in the first place. What is the purpose of these unprecedented policies? What are the conditions for some sort of normalization? Are their purported measures of HICP and Unemployment Rate even remotely relevant to their decision making? If they can’t forecast March 2022 yoy% HICP with three weeks left in the data series, how is it they put any credence in their 2023 and 2024 forecasts?

If one applies any expectation of rational thought to the ECB, no doubt a dangerous supposition, you might assume they too find their way to admitting these pesky, way above target, persistent price increases won’t just magically go away as they run all-time stimulative policies. At such a point, much like the Fed before them, they will pivot from extraordinarily loose towards some sort of a path in the direction of normalization, with some potential of eventually having to go to neutral and a now inconceivably slim chance of getting all the way to tight.

For the purposes of battling the divergencies of their price stability measures from their randomly chosen targets, eg. 2%, we would use the old-fashioned concept of “neutral’ being something like a positive 2% real interest rate, maybe even give the benefit of the doubt and accept zero real rates as “neutral”. We can all argue about what may be the most precise way of measuring real interest rates, but by any practical measure the ECB, and the rest, are a very very long way away from that definition of neutral, much less something that would be considered “tight”.

The mad scientists in their central banking laboratories have innovated the concept of “the Natural Rate of Interest” (r*), which amounts to their theoretical estimate of the neutral real rate. As we have gone through the Greenspan and onward era of ever lower policy rates to underwrite an ever more fragile system, the CB’s estimates of r* have been consistently ratcheted ever lower and lower, to the point now where many of that ilk consider it to indeed be pretty near 0%.

We finally got around to reading an interesting, and critical to the consensus, note on the topic that has been sitting on the pile for a few months. The note is quite reminiscent to the Jeremy Rudd piece that we discussed (with an assist from Charles Goodhart) in our September 2021 Update https://convex-strategies.com/2021/10/19/risk-update-september-2021/. We highly recommend giving it a thorough read.

https://www.bis.org/publ/work974.htm

We strongly agree with the BIS conclusion that r* “becomes endogenous, in particular to monetary policy”, if not necessarily with their explanation of how it got there, though there is surely credence to their “hall of mirrors” concept. We have shared our thoughts in any number of different analogies, for example the forest fire analogy where the fire wardens have done such a tremendous job of dousing every small fire that, with each successful effort, they allow the creation of ever greater fire risk, necessitating ever greater effort to douse each subsequent fire before the spread becomes catastrophic. One of our favourites, of course, is the Snickers bar analogy where the doctors prescribe ever greater consumption of Snickers bars to lift-up the flagging energy of the patient, all the while scratching their head at the seemingly unrelated weight-gain that continues to drag on the patient’s energy. We put it nicely, and with a wonderful visual, way back in December 2019 https://convex-strategies.com/2020/01/26/risk-update-december-2019/.

“Referencing our distinguished central banking friends, maybe it’s not “secular stagnation”, but rather an excess of accumulated debt? I go back to our old Snickers bar analogy. You have to be a pretty undiscerning doctor if you think your prescription of Snickers bars, to pick up lagging energy in your patient, has nothing to do with his weight gain and subsequent increased lack of energy. Sadly, there appears to be no accountability for the monetary physicians that have orchestrated the current lack of fitness for economies.”

Paraphrasing our so titled and esteemed “Poet Laureate of Economics”, Bill White, “it’s a debt trap”.

Nevertheless, we do appreciate their information feedback loop explanation, it has a certain Shannon’s Entropy element to it. For example the state “information aggregation is inefficient, but the main source of inefficiency comes from misperception about the quality of information.”

Pieces like this BIS one, as well as the Rudd note, give us hope that, once the Greenspan era of central bank manipulation finally ends, there will be plenty of thoughtful explanations as to why that sort of regime shouldn’t be tried again, ala the fire warden practice prior to all of Yellowstone National Park burning down.

How might we bookend that regime? You can argue back and forth as to when the “Greenspan Put” (broadly defined as cutting rates because stock prices fell, or more generously as responding to the wealth effect shock on the economy of asset bubbles bursting) officially commenced. We like to peg it as the knee jerk response to the October ’87 crash, just because it is easy to remember. From there it grew in relevance over time, spreading throughout the world, adding on ever more innovative ways to push interest rates lower, bring demand forward, and sustain the increasingly fragile sandpile. The tougher question is, what will bookend the era’s end?

We, of course, don’t know that answer and are explicitly not in the business of forecasting how, when, or where fires start. We do, however, have a pretty good view, at times, of where particularly relevant fire risks exist. It usually lines up with where we see the most fervent efforts by self-proclaimed fire wardens. Along those lines, no central banks have piled as deep and hard into market manipulation as the Bank of Japan (BOJ). They were one of the first following along the Greenspan path in the early ‘90s, as their epic credit bubble burst, and have been the petri dish for trying out ever more extreme policy measure to keep the sandpile afloat.

One of their latest and greatest policy innovations is commonly referred to as Yield Curve Control (YCC), essentially pegging interest rates out to the 10yr point on the Japanese Government Bond (JGB) curve. Many readers will be familiar with our common refrain that the “10yr JGB YCC, is the most dangerous peg in the world.” We are firm believers in basic laws of nature. One such law goes something like “All pegs end badly. All pegs eventually end.”

(As with most rules, there are inevitably exceptions to the rule. For example, with pegs, the exception is if the peg, and its second order effect of suffering, are imposed by a distant government not answerable to those enduring the suffering. The populations of Hong Kong (Beijing) and Greece (Brussels/Frankfurt) would be examples of this sort of exception.)

No central bank has been in the low rates world as long, nor on the relative scale, as the BOJ. The Japanese Yen (JPY) is the original low yielding funding currency in the world of carry trades. Japan is the birthplace of the structured product world, the fine art of creating the impression of enhanced yield by embedding toxic non-linear short volatility risk. Decades of low rates and unprecedented volatility suppression has made Japan related volatility one of the best “tail-risk” hedges out there, across systemic risk events, over most of the last several cycle ends, whether that be in currency, equity, or credit related structures. The one thing, however, that has sustained, has been their ability to keep interest rates heading lower, then staying low, and eventually pegging the 10yr JGB yield at 0% since 2016.

Figure 8: Japanese Government Bond 10yr Yield. Longer Term

Source: Bloomberg

Figure 9: Japanese Government Bond 10yr Yield. Shorter Term

Source: Bloomberg

It is hard to see in the longer-term view, but if you zoom in you can see that there has recently been a moderate rise in the 10yr yield, squeezing up to 0.25% in the last week of March. Under the current implementation of the YCC peg, the JGB 10yr yield is allowed +/-25bp of freedom around the 0% target. Thus, it roughly reached that limit in the last week in March, raising concerns in the market as to whether the BOJ would stand strong and defend their peg. And indeed, they did! Announcing three consecutive days of unlimited bond buying at 0.25%, as well as doing a couple of rounds of purchases at prevailing market prices to reinforce their commitment. In the end, they only bought circa $25bn worth of bonds over the first couple of days, managing to get the yield to recede back down to as low as 0.21%. Four days later it had crept back up to just below their defend-at-all cost 0.25% level. 4bp, for four days, cost $25bn of JPY printing.

Meanwhile, quite rationally, the USD/JPY exchange rate rose from 115.00 to 125.00 over the month. On the other side of this exchange rate, the Federal Reserve ended their asset purchases (wound down from previously buying $120bn per month) and signalled that they would start allowing their balance sheet to rundown at an expected $95bn per month.

Figure 10: JGB 10yr Yield (white). USD 10yr Swap Rate (blue). USD/JPY Exchange Rate (orange – LHS)

Source: Bloomberg

Doesn’t take much to figure out this is a lose-lose situation. Sure, BOJ can continue to print JPY and buy unlimited amounts of JGBs, even as all the other central banks cease and desist on their own failed experiments into ZIRP and QE. The trade-off is how much imported inflation can the Japanese consumer base tolerate? Japan is a somewhat unique player in this sandpile game in that, relatively speaking, households (circa 66% of GDP) are much smaller borrowers than corporates (circa 117% of GDP) and the government (circa 266% of GDP). That might say something about whether the general population is more sensitive to interest rates or to import prices.

We say that the BOJ’s peg of the JGB is the most dangerous peg in the world because nothing else has had both its level and volatility so proactively suppressed for such a long time. Japan is the birthplace of the short-volatility embedded structured product world. It is the original, and still the most attractive funding leg of carry strategies. Moreover it will be the last central bank providing endless freshly printed liabilities in the world, fuelling, right to the inevitable end, the propping of the sandpile ever higher. The sensitivity to a change in the long-established regime of total suppression, is difficult to fathom. We got a little glimpse into the implications of this when their 0.25% ceiling was challenged, and they stood firm with their 3-day long commitment to unlimited JGB purchases. Many noticed the spike higher in both the USD/JPY exchange rate and the price of its implied volatility. Few noticed the much more significant impact on the implied volatility in the interest rate market.

Figure 11: JPY 1y10y Swaption Normal Vol (red). USD/JPY 1yr FX Implied Vol. (white). Normalized

Source: Bloomberg

For some perspective of how that move compares to ongoing volatility repricing in other markets, we can add 1y10y Normal Implied Volatilities for USD and EUR, and log scale the y-axis to get a sense of the relative scale of moves. It is important to keep in mind that the 10yr JGB yield is still pegged at this point. The most dangerous peg in the world.

Figure 12: 1y10y Swaption Normal Vol: JPY (red), USD (orange), EUR (purple). Logged Scale

Source: Bloomberg

As always, all of this discussion of fragility and imbalances brings us back to the same old conclusion. We don’t and can’t know what is going to happen. All we can do is manage our payout functions, structure investment portfolios to perform in parts of the distribution that matter the most, which happen to align to the parts where we can know the least.

We show it over and over in so many ways.

Our Best-Worst Index analysis showing the impact on long term CAGR from missing/eliminating the 10 best or the 10 worst months in a 40+ year time series of beta participation.

Figure 13: Compounding View: SPX Best-Worst Index (1980-2021)

Source: Bloomberg

Which feeds our breakdown of contribution to the long term CAGR.

Figure 14: Contribution to LT CAGR  1980-2021 by 10 best (blue), 10 worst (orange) and remaining months

Source: Bloomberg, Convex Strategies

Or our Concave vs Convex: Target vs Hypothetical view which shows how (not so) hypothetical practitioners might generate those sorts of return streams.

Figure 15: Scattergram View. Concave vs Convex: Target vs Hypothetical. (1972-2021)

Source: Bloomberg, Convex Strategies

Figure 16: Compounding View. Concave vs Convex: Target vs Hypothetical. (1972-2021)

Source: Bloomberg, Convex Strategies

Not surprisingly, the “Theoretical” Best-Worst view looks almost identical to the “Hypothetical” Concave vs Convex view.

Figure 17: Compounding View: Best-Worst Index and Hypothetical Concave vs Convex

Source: Bloomberg, Convex Strategies

We’ve shown how in the real world you can create the sort of convexity that corrects for the failed compounding of those traditional investment strategies that are based on the faux mathematics of modern day finance. Regulary comparing our various Barbell Racers (have good brakes so they can drive faster) against the endless stream of poor performing Balanced Racers (manage risk by driving slowly).

Figure 18: Scattergram View and Return Distribution. Barbell Always Good Weather 40/40/40 (blue) vs Balanced Risk Parity 10%vol (red). Bull Market Period March2009 – December2021

Source: Bloomberg, Convex Strategies

Figure 19: Compounding View. Barbell Always Good Weather 40/40/40 (blue) vs Balanced Risk Parity 10%vol (red). Bull Market Period March2009 – December2021

Source: Bloomberg, Convex Strategies

We’ve shown how the “Real World” can look just like the “Theoretical” and the “Hypothetical”.

Figure 20: Compounding View: Best-Worst Index (left) and Always Good Weather 40/40/40 (blue) vs 0.6x SPX Total Return Index (grey) vs HFRX Global Index (red)

Source: Bloomberg, Convex Strategies

We’ve pulled in Claude Shannon, the father of information theory, who so succinctly sums up the mathematical failings of the Gaussian mafia with the simple quote:

“If something is completely predictable, there is zero information.”

Or, as Nassim Taleb puts it:

“Black Swan logic makes what you don’t know far more relevant than what you do know.”

We can pull it all together, yet again, with our old standard football/soccer analogy of our “Participate and Protect” motto: hire a good goalkeeper and put more goal scorers on the pitch.

Combining our calculations on contributions to long term CAGRs with our football pitch overlayed with a Normal Distribution and a Shannon’s Entropy curve gives a remarkably clear perspective of why positively convex investment portfolios outperform traditional Gaussian based, Modern Portfolio Theory, Efficient Market Hypothesis investment strategies.

Figure 21: Normal Distribution vs Shannon’s Entropy Curve: shaded areas per contribution to CAGR

Source: Bloomberg, Convex Strategies

The ball spends the bulk of its time in between the two penalty boxes, but the outcomes of the match are determined inside the penalty boxes. Investment managers following the Gaussian science are inevitably going to construct concave return strategies, consistently underperforming in the wings where the unexpected occurs. Convex portfolios will perform their best when it matters the most where circumstances are the least predictable and information is the most valuable.

Figure 22: SGD/JPY Investing ‘Seasons’

Source: Bloomberg

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