In her novel “The March of Folly”, historian Barbara Tuchman attributes as a quote in reference to Philip II of Spain this absolute gem – “no experience of the failure of his policy could shake his belief in its essential excellence.”
It is hard to imagine a more appropriate tagline for today’s central bankers and their mad clinging to their extraordinary monetary easing largesse. We could lay the above quote clearly on each and every modern-day central banker, but none more so than Bank of Japan’s (BOJ) Governor Haruhiko Kuroda.
We discussed in last month’s Update https://convex-strategies.com/2022/04/26/risk-update-march-2022/ the unique and challenging nature of BOJ’s commitment to maintaining their Yield Curve Control (YCC) policy, pegging the government bond (JGB) yield curve out to the 10yr point at 0%, with a currently imposed band of +/-0.25%. We dubbed it the “most dangerous peg in the world”. In the final week of March, the JGB bond reached its yield ceiling of 0.25%, sparking spikes in USD/JPY FX rates, interest rate swap yields, and most particularly implied volatility on interest rate option markets. The BOJ responded by announcing four consecutive days of unlimited JGB purchases to defend their 0.25% Maginot Line. As you might have guessed, this calmed the market for but a very short time.
A quick update of some of the pictures we showed last month, where the pressure on the 0.25% 10yr JGB “peg” from rising US rates and weakening JPY continued.
Figure 1: JGB 10yr Yield (white). USD 10yr Swap Rate (blue). USD/JPY FX Rate (orange-LHS). Vertical Line=March 28th. Horizontal 0% (white) and 0.25% (red)
Source: Bloomberg
….and a zoomed in version
Source: Bloomberg
Rising global interest rates (led by the USD) as central banks (led by the Fed) normalize monetary policy in the face of historically extreme rises in their respective price stability measures, while the BOJ provides ongoing freshly minted JPY to purchase ever more JGBs, leads to ongoing declines of the value of JPY in the global FX markets.
This has very much kept the pressure on the respective FX and interest rate volatility markets.
Figure 2: JPY 1y10y Swaption Normal Vol (red). USD/JPY 1yr FX Implied Vol. (white) Normalized
Source: Bloomberg
Figure 3: 1y10y Swaption Normal Vol: JPY (red), USD (orange), EUR (purple) Logged
Source: Bloomberg
The BOJ held their regularly scheduled policy meeting on April 28th and the market waited in great anticipation to see how, given the evolving nature of the world (i.e. every central bank in the world is adapting policy in the face of rising consumer prices), they might inch towards their own efforts to start to move away from their monetary extremism. Governor Kuroda, however, went in the opposite direction and turned the monetary taps up to 11 (nod to Spinal Tap https://www.youtube.com/watch?v=4xgx4k83zzc). We are paraphrasing here but, in essence, Governor Kuroda announced that the BOJ would revamp their YCC support of the 0.25% ceiling on 10yr JGB yields to now entail a commitment to buy eligible JGBs at that level in unlimited size, every day, forever – “no experience of the failure of his policy could shake his belief in its essential excellence.” 11!
A couple of quotes from Governor Kuroda’s press conference (English translation) https://www.reuters.com/world/asia-pacific/boj-governor-kurodas-comments-news-conference-2022-04-28/ :
“In March last year, the BOJ clarified that it will allow the 10yr JGB yield to move within +/-25bp, with the target midpoint at 0%. In order to maintain this policy, necessary purchases of JGBs will be carried out without setting a limit on the amount. Even if there is upward pressure on the yield from external factors, it will be carried out every day, except when it is clearly not expected to be bid. The BOJ believes that clarifying its existing stance would help to lower market volatility.”
“I think we can prevent interest rates from fluctuating due to unnecessary speculation. In that sense, there is a possibility that there will be no unsustainable expansion of positions to test 0.25%. What we want to avoid, however, is to prevent interest rates from rising above 0.25% in a stable manner. It does not mean that we want to reduce our purchases of government bonds.”
Our often used, seemingly hyperbolic, query as to what happens if the BOJ were to run out of JGBs to buy, suddenly has become a potential matter of counting down the days. Our internal calculations, based on the data available from the BOJ, has the current holdings by the BOJ of JGBs with remaining maturities out to 10yrs at circa 67%. The amount of buying in the Fixed Rate programs (note, this is separate from the ongoing Fixed Amount purchases in the regularly occurring Rinban purchases) in late March and again in late April, over just eight Fixed Rate operations that were taken up by the market, amounted to a total of roughly JPY 3.5tn. The total available, unowned by the BOJ, portion of the 10yr and under JGB market amounts to approximately JPY 175tn, about 50x what was bought over those 8 days, all prior to the April 28th policy upgrade to unlimited, every day, forever.
Figure 4: 10yr JGB and 0.25% peg line
Source: Bloomberg
Crazy? RBA Governor Philip Lowe was cognizant of this very issue in the management of their own version of YCC. He put it thusly after (involuntarily) deciding to cease defending the YCC ceiling in October last year: “If we had sought to pin the yield on the April 2024 bond at 10 basis points in the face of these developments, we would have ended up holding all the freely tradable bonds in the bond line, so that trading in that bond would cease. This would have further diminished the usefulness of the target.”
Let the countdown commence.
Governor Kuroda, just like all his central banking peers in their slow transitions away from extreme easing forever, has continued to stress that “inflation” is different in Japan. It isn’t particularly hard to make an argument that Japan, far more so than the likes of Australia or the Eurozone, might indeed be in a different circumstance. We, of course, are not in the business of predicting what will happen, what markets or central banks may or may not do. Maybe Governor Kuroda and his team of BOJ economists are correct that Japan’s exposure to global trends of price instability is different. Our question, as it was/is for the likes of the ECB and RBA, is what are they going to do if it turns out that it really isn’t that different? What if, like all their global peers, their ongoing mis-forecasts of their own price stability measures continue to prove to be wrong? What if their decades of extraordinary monetary measures, with the explicit stated intent of pushing up their measures of inflation, against all their own expectations, actually succeed?
Figure 5: CPI yoy% changes: US (white), Eurozone (blue), Australia (orange), Korea (purple), Tokyo (red), Japan (light blue)
Source: Bloomberg
Just to note, we have included the Tokyo Area CPI given its April numbers are already out, unlike the Japan overall number. All can see how closely they track and should note that the forecast for the Japan April number is also 2.5%.
Throwing in the PPI numbers raises even more questions as to whether Japan is, somehow, different.
Figure 6: Japan PPI yoy% (yellow). Tokyo CPI yoy% (red)
Source: Bloomberg
Figure 7: PPI yoy% changes: US (white), Germany (blue), Korea (purple), UK (green), Japan (yellow)
Source: Bloomberg
Fed Chair Powell swore up and down that it was transitory in the US. We quoted Chair Powell in our September 2021 Update from the post-FOMC press conference, “So, as you can see, the inflation forecasts have moved up a bit in the outyears. And that’s really, I think, a reflection of—and they’ve moved up significantly for this year [our note: 4.2% conservatively forecast for the year]. And that’s, I think, a reflection of the fact that the bottlenecks and shortages that are being—that we’re seeing in the economy have really not begun to abate in a meaningful way yet. So those seem to be going to be with us at least for a few more months and perhaps into next year. So that suggests that inflation’s going to be higher this year, and a number—I guess the inflation rates for next year and 2023 were also marked up, but just by a couple of tenths. Why—those are very modest overshoots. You’re looking at 2.2 and 2.1, you know, two years and three years out. These are very, very—I don’t think that households are going to, you know, notice a couple of tenths of an overshoot. This just happens to be people’s forecasts”. Which we translated for the Orwellian speak as “let them eat cake”.
Figure 8: US Fed Funds Rate (white), CPI yoy% (blue), Unemployment Rate (orange-LHS inverted), USD 3m3m Forward Interest Rate (red)
Source: Bloomberg
ECB President Lagarde and her crack Chief Economist Philip Lane have continually forecast a near immediate return to their 2% target level. Chief Economist Lane gave us this bit of expertise as recently as February this year, “Many of the factors that are now driving inflation rates up will play less of a role in 12 or 18 months. The economy is not in an overheating zone. We think that most of this inflation will fade away.”
Figure 9: ECB Deposit Rate (white), Eurozone HICP yoy% (blue), Eurozone Unemployment Rate (orange-LHS inverted), EUR 3m3m Forward Interest Rate (red)
Source: Bloomberg
RBA Governor Lowe was adamant that Australia’s price stability circumstances were structurally different. Shame on all of them. Meanwhile, they all carried right along with the most extreme inflationary policy settings in the institution’s history.
The RBA finally came around to the conclusion that their skyrocketing measures of price stability were not likely to revert to target while maintaining historically accommodative monetary policy and surprised the market with their first 25bp policy rate hike. Governor Lowe explained their sudden rejection of all that they had been saying for the last year with a simple “interest rates are normalising much quicker than we thought was going to be the case” and a rather bland “from a forecasting perspective, that’s embarrassing, and we should forecast this better”. Doh!
Figure 10: Australia RBA Policy Rate (white), CPI yoy% (blue), Unemployment Rate (orange-LHS inverted), AUD 3m3m Forward Interest Rate (red)
Source: Bloomberg
As we have discussed, once they admitted that they needed to proactively do something about the price instability, the market quickly carried on pricing what that might mean in terms of getting to something that is not significantly negative real rates.
That brings us back to Japan, arguably the last of the developed markets, now that the ECB has conceded that they will be ending asset purchases and commencing hikes this year, with policy taps still at maximum accommodation and blanket promises that it will forever be so.
Figure 11: Japan BOJ Policy Rate (white), Tokyo CPI yoy% (blue), Unemployment Rate (orange-LHS inverted), JPY 3m3m Forward Interest Rate (red)
Source: Bloomberg
Are all these central banks maintaining unprecedented levels of accommodative policies, through historically extreme negative real rates, because they believe it is the appropriate policy setting relative to the circumstances of their current price stability mandates? Or, as we regularly suspect, are they stuck on “max-loose” because of the system-fragility/criticality that the decades of their policies have built up, heedless of the unfortunate consequences? It seems pretty clear that it is the latter.
Seriously, how did they expect it would end up? How did central bankers think years and years of ZIRP, NIRP, QE, Twist, Liquidity Facilities, QQE, YCC, etc would end? Did they honestly not expect it to inevitably come to a terminus with the system maximally fragile to higher interest rates? Were they not at least slightly suspicious that, at exactly peak financialization, there might be a risk that the need to normalize policy would inevitably appear? One could surely argue that this very end-state was so obviously inevitable that it was precisely their intention. If it doesn’t work, do more. If it works, do more.
The below picture makes it pretty clear the extent to which the Fed has lost control over even these flawed measures of inflation, CPI and PCE Core, since their foolish implementation of Average Inflation Targeting (AIT) in late August 2020. If anybody gets a chance to ask relevant Fed officials about their continuing commitment to AIT, please get them to explain their commitment on the other side. Just as they were committed to running things “hot” to make up for price increases below their randomly targeted trend of 2% per annum, are they now equally committed to ensure that they will allow things to run “cold” to make up for the sustained overshoot on the topside? Do they still think the whole premise of AIT was an appropriate policy innovation? Are they going to commit to the other side, or are they going to end AIT as a part of their crazy lab experiment?
Figure 12: US PCE Core Index (white) and CPI Index (blue), normalized, vs 2% annual trend line (red). Vertical line = commencement of AIT September 2020
Source: Bloomberg
Just as with the yoy% change numbers, the PPI Index shows a similar, arguably scary, story.
Figure 13: US PPI Index (white). 2% annual trend line (red)
Source: Bloomberg
We made the below statement back in February 2021, with the accompanying visual which we have updated through April 2022. The Fed’s chosen measure of PCE Core doesn’t do justice to what is really going on all around us. We still find it stunning how seldom, if ever, we hear anything out of the official mouthpieces about what went on with money supply during the various pandemic responses.
“Global food prices are spiking just as they did prior to the 2008 GFC and the 2011 European Credit Crisis. As if the destabilizing impact of extreme wealth segregation resulting from asset inflation isn’t bad enough, history is particularly unkind to those that can’t control food inflation. The market doesn’t want to hold fixed income securities at the all-time lows of yields because they don’t believe the central banks are truly foolish enough to believe their own propaganda that PCE Core = Inflation. Anybody in their right mind knows that the blue line in the below chart is not representative of true inflation. The market may believe that the Fed will continue to manage interest rates against their misplaced focus on PCE Core, but that will only make true inflation worse, leaving less and less appetite for holding bonds at manipulated artificially low yields.” https://convex-strategies.com/2021/03/17/risk-update-february-2021/
Figure 14: US M2 Money Supply (white) vs Copper (orange), Corn (purple), Shiller 20 Home Price Index (magenta), PCE Core (blue). Normalized. Vertical line = February 2021
Source: Bloomberg
To our point in the above snippet, there has been a notable repricing of fixed income markets since we wrote that. We often fire up the below image and pose the question “what will it look like when the long-term trend of ever lower interest rates finally reverses?” Just maybe, something like we’ve seen since February last year.
Figure 15: 10yr Interest Rate Swaps: USD (white), AUD (blue), KRW (orange), GBP (yellow), EUR (purple), JPY (light blue). Vertical line = February 2021
Source: Bloomberg
Back in our December 2020 Update https://convex-strategies.com/2021/01/22/risk-update-december-2020/ we showed a great visual and discussed its implications for the efficacy of the broadly accepted core of the investment world, the 60/40 Balanced Portfolio.
“Should the Federal Reserve, and their committed pack of followers, successfully carry on their efforts, yields and carry will not keep pace with inflating assets. Should the Fed, either voluntarily or involuntarily, cause/allow the bubble to burst, these positions will not protect growth assets. We don’t know if carry will make or lose money in any given period, but we do know that concavity is the bane of compounding. Investors have to consider the opportunity costs in holding instruments that are losing out to inflation while providing no relevant risk mitigating benefit. It is dead capital.
As we keep harping on about, this has obvious implications for, give or take, the entirety of global savings that is managed in some sort of balanced portfolio context. We saw the below great visualization by the brilliant Gerard Minack in a recent John Authers’ Bloomberg Opinion article. As the dots have progressed up and to the left-over time, 60/40 balanced portfolios have enjoyed the truly perfect environment. But what now? In the Minack piece, he discusses the linkage between historically high equity valuations and low interest rates. We might argue that the bigger takeaway from his lovely picture is that there is no upside in holding fixed income securities and, even more obvious, one is not a risk mitigant for the other.”
Figure 16: The Golden Era of the Balanced Portfolio
Source: DataStream, Shiller, GFD, Standard & Poor’s, BLS; Minack Advisors
Implications from the move in interest rates, both for Fixed Income investments on their own as well as Balanced Portfolios overall are obvious. Both are in the midst of their worst drawdowns since the Great Financial Crisis (GFC).
Figure 17: Bloomberg 60:40 Index (white). US Treasury Total Return Index (blue). With Max Drawdowns post March 2009
Source: Bloomberg
As we said so clearly in the December 2020 piece, we don’t know when one market or another are going to perform. We didn’t know rates were going to go up. All we knew was, as Nassim Taleb so succinctly puts it:
“The so-called ‘optimal’ portfolio is in effect the worst of all worlds. It offers scant protection against tail risk and, at the same time, achieves an under-allocation to the riskier assets with higher returns in the long periods of economic expansion such as the past decade.”
We knew that, even during the supposed “Golden Era” for the Balanced Portfolio, investors would have been better off with a barbell approach, with explicit protection through long volatility and a larger allocation to growth assets. If that was the case as interest rates carried on in their path to zero, it was almost certainly the case once, as the Minack picture so nicely displays, you got to zero.
Figure 18: AGW vs Balanced 60/40. March’09-April’22. Scattergram View
Source: Convex Strategies, Bloomberg
As usual, the scattergram tool portrays it so clearly when we compare something like our hypothetical Always Good Weather (AGW) Portfolio (40% SPXT/40% XNDX/40% CBOE LongVol Index) against a traditional Balanced Portfolio (60% SPXT/40% US Treasury Total Return Index).
The AGW, with its explicit downside asymmetry and greater upside exposure (participate and protect), clearly has superior portfolio convexity and positive upside return skew. The implications of that are obvious in the Compounding View.
Figure 19: AGW vs Balanced 60/40. March’09-April’22. Compounding View
Source: Convex Strategies, Bloomberg
When is the right time to address the convexity in your investment portfolio? As soon as possible! The earlier, the better. Better brakes always let you, safely, drive faster. Good brakes allow your investment portfolio to 1) drive faster during the long bull market, 2) navigate more safely and efficiently any unexpectedly sharp corners (the key to even finishing the race, much less winning it), and 3) be in a position to accelerate coming out of the tricky corner. Acceleration and deceleration are convexity, the keys to compounded returns.
We can’t resist showing again our football pitch with the overlay of the standard Gaussian/Normal Distribution and our Entropy Curve.
Figure 20: Normal Distribution vs Shannon’s Entropy Curve: shaded areas per contribution to CAGR
Source: Convex Strategies
The area under the Gaussian/Normal Distribution measures the frequency of returns. It relates to what is “predictable”. The area under the Entropy curve measures the impact of returns. Portfolios should be constructed with a mind to the latter, not the former.
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