“…being accommodating toward anyone committing a nefarious action condones it.” Nassim Taleb in the Prologue of “Antifragile: Things that Gain from Disorder”.

We like to think that we live up to the principle implicit in the above quote. As regards Sharpe World!™, we will not accommodate it. We do not condone bad actions and practices in the worlds of economics and finance.

In this spirit, we link the following speech by outgoing Bank of Japan Deputy Governor Masazumi Wakatabe. Deputy Governor Wakatabe is not a particularly relevant player in what passes currently as BOJ monetary policy and whose term is expiring shortly anyway. The point of linking to his speech isn’t to give insights to actual policy, past or present, but rather to highlight a very succinct, and far too common, example of modern-day bad practices in monetary policy.

https://www.boj.or.jp/en/about/press/koen_2023/data/ko230228a1.pdf

Mr. Wakatabe titles his speech “Seven Reflections on Japan’s Economy, Monetary Policy, and the Bank of Japan.” Our focus is on Reflections #6 and #7, but we need to throw in a couple of earlier quotes to a) set the mood and b) because they are so good.

Reflection #1: It is all about teamwork.

“Central banks are like sophisticated machines, precisely designed and meticulously executed.”

We will leave that one for readers to consider without further comment.

Reflection #2: Expect and prepare for the unexpected, but do not expect perfect foresight.

“During my term, a series of exogenous shocks have hit the Japanese economy…..In the end, what central banks can do is inject liquidity into the markets, and control money and interest rates for the economy, but we have to be nimble….We cannot foresee everything, so we must keep learning from new situations.”

This is, of course, reminiscent to the opening of Fed Chair Jerome Powell’s August 2021 speech that we highlighted in our own August 2021 Update (https://convex-strategies.com/2021/09/22/risk-update-august-2021/). We noted at the time:

“Chair Powell leads straight off with the classic misunderstanding (or is it misrepresentation?) of the relevance of history, opening his comments with ‘Seventeen months have passed since the US economy faced the full force of the COVID-19 pandemic’. The fragility of the US economy did not suddenly materialize in March 2020, no more so than the fragility of Afghanistan only arrived with Biden’s announcement of the final withdrawal date. In the world of sandpiles, history matters. Chair Powell mentioned nothing about the last 14 years of QE surges, nor the aborted attempt at normalizing policy that was suddenly halted in late 2018, nor about the subsequent return to rate cuts and balance sheet expansion in 2019. Nope history now starts with the pandemic.”

https://www.federalreserve.gov/newsevents/speech/files/powell20210827a.pdf

Much like his far more prestigious Fed counterpart, Mr. Wakatabe believes all outcomes, to date, are the result of unforeseen exogenous shocks. He then sees his job as setting policy that will precisely determine future outcomes, all the while totally unaware that past policy measures may have had a role in the (totally ignored) historical path that has led us to today.

It is really Reflection #6 that gets into the ‘nefarious’ element. He titles this one; “Communication is absolutely necessary, extremely important, but really difficult.” It is here that Mr. Wakatabe drops in his raison d’etre for the speech, perhaps even his career as a central banker overall.

“The key to modern monetary policy is expectation management.”

There you have it. Brings back memories of outgoing BOJ Governor Kuroda’s infamous Peter Pan analogy, memorialized by the Financial Times with this all-world picture (https://www.ft.com/content/3058605a-0a5d-11e5-82e4-00144feabdc0).

The trick for a modern central banker is to get us all to believe we can fly. This comes down, according to Wakatabe, to communication.

“Communication with the general public is particularly important since their perception plays a key role in anchoring inflation expectations, and thus, affects the actual evolution of inflation.”

With the right communication, the general public should not doubt that they can fly.

“There is no consensus yet on the best practice for central bank communications with the general public. But it is clear that a one-size-fits-all approach in communication strategy is not appropriate. We should keep in mind that the general public are not experts in central banking or monetary policy.”

Oddly, he is able to discern that a vastly diverse general public might not be best influenced by a “one-size-fits-all approach in communication strategy”, but is unable to fathom that his unwavering target of a one-size-fits-all monetary policy objective might also not be entirely conducive to the disparate circumstances of that same general public.

Of course, Mr. Wakatabe is well aware of the primary challenge in dealing with the general public. They aren’t that bright.

“We should keep in mind that the general public are not experts in central banking or monetary policy. We need to avoid highly technical jargon and devise clear and concise explanations.”

Fortunately, for the masses, this point comes with some visual aids of just how the BOJ is communicating to them.

Source: Bank of Japan website boj.or.jp

We see that as just a stupendous example of how the lab-technician Phd Economists, in the halls of policymaking power, see the individuals that make up the participants in the economy. We are all merely generic units in their models that need to be ever so firmly encouraged to all simultaneously, just ever so slightly, lean to the left in order to keep the country from toppling to the right. If only we would all just listen and understand, their intentions would come true.

As we have discussed at length (just one of many past updates: https://convex-strategies.com/2022/12/15/risk-update-november-2022-fools-or-liars/), they maybe are not ridiculously bad forecasters, they may be intentionally misleading.

Finally, in Reflection #7; “Learn from the past, and prepare for the future.”, we get into his discussion around explaining, or more accurately explaining away, inflation. This, again, has some uncanny parallels to the similar explain-it-away efforts from Chair Powell that we highlighted back in August 2021. And that we noted so many times in the efforts of the ECB. And the RBA. And the BOE. Not to say that history repeats, but how did that work out for those central banks?

Deputy Governor Wakatabe provides this graph showing a couple of their price stability measures, noting the average of the year-on-year change over the past 10 years, the period of Kuroda’s now-ending term, is just 0.5%. His conclusion is that, while they have clearly exited deflation, they are still far from achieving their target of 2% sustained annual change on their chosen metric of CPI (less fresh food). The fact that the most current period, as of January 2023 per his chart, is at 4.2% receives no mention, whatsoever.

Source: Bank of Japan website boj.or.jp

Again, we heard some version of this argument from all the BOJ’s global peers.

The US CPI 10yr average yoy % change reached 2.9% before they got around to their first policy rate hike in March 2022. They have subsequently hiked Fed Funds by 450bp.

Figure 3: US CPI yoy % (white). US Fed Funds (blue). US CPI Average 10yr prior to first hike (fuchsia)

Source: Bloomberg, Convex Strategies

The Eurozone HICP 10yr average yoy % change was just 1.4% when they finally got around to their first hike, granted simply hiking their Deposit Rate UP to 0.0% in July 2022. They have now hiked a cumulative 300bp.

Figure 4: Eurozone HICP yoy % (white), ECB Deposit Rate (blue), Eur HICP Average 10yr prior to first hike

Source: Bloomberg, Convex Strategies

Australia’s CPI 10yr average yoy % change reached 1.9% prior to the RBA’s first hike of their policy rate in May 2022. They have thus far hiked a total of 350bp.

Figure 5: Australia CPI yoy % (white), RBA Policy Rate (blue), Aus CPI Average 10yr prior to first hike

Source: Bloomberg, Convex Strategies

UK CPI 10yr average yoy % change was circa 1.8% before they commenced their hiking cycle in December 2021 (if you count the meagre 10bp hike as worthy). The BOE’s Bank Rate has been increased 390bp, thus far.

Figure 6: UK CPI yoy % (white), BOE Bank Rate (blue), UK CPI 10yr Average prior to first hike (fuchsia)

Source: Bloomberg, Convex Strategies

Deputy Gov Wakatabe and his boss have the current 10yr average of their preferred target measure running at 0.7% and have yet to allow interest rates to commence an adjustment.

Figure 7: Japan CPI ex-Fresh Food yoy % (white), JGB 2yr Yield as Policy Rate Proxy (blue), Japan CPI ex-Fresh Food Average 10yr current (fuchsia)

Source: Bloomberg, Convex Strategies

As all will likely be aware, Governor Kuroda and his current Deputy Governors (Wakatabe and Amamiya) are all on their way out. Stepping into the breach are respected economic professor, Kazuo Ueda, as Governor and BOJ veteran Uchida, along with former FSA regulator Himino, as the new Deputy Governors. These gentlemen will be left to decide if, when, and how to dial back the world’s most aggressive policy stimulus ever seen.

We laid out the current monetary policy stance of the BOJ in last month’s Update (https://convex-strategies.com/2023/02/16/risk-update-january-2023-understanding-is-a-poor-substitute-for-convexity/). As you can see from the above chart, they have had our proxy policy rate, in this case the 2yr JGB yields, in the vicinity of 0% for over 20 years and we know they have purchased coming up on 1 quadrillion JPY worth of bonds and other assets. They continue to date with negative policy rates and unlimited potential buying of bonds.

What has it achieved? Well, per our measures, it has lifted the 40yr average of their chosen price stability measure from 0.6% to the current 10yr average of 0.7%. Yeehaw!

Figure 8: Japan CPI ex-Fresh Food yoy % (white) and its 40yr Average (fuchsia)

Source: Bloomberg, Convex Strategies

One can only ponder how much priming an economy, that runs at a 40yr average of 0.6%, will need to get it up to a sustained level of 2%. The BOJ seems unusually committed to finding out. The obvious question that the above chart begs asking is, once you break the seal, will you be able to moderate the flow? The other institutions laid out above have found it to be an uncomfortably challenging task.

Along with these sorts of big existential questions, incoming-Governor Ueda and his team will immediately face the complications, also left by their let’s-not-clean-up-our-mess-before-we-leave predecessors, of the remnants of their attempts to “restore market function” in the December and January Policy Meetings. The below chart is of the yields of three JGBs. Gist being, the current on-the-run 10yr JGB yields right at the 0.50% BOJ ceiling. The previous on-the-run 10yr JGB, which BOJ ended up owning north of 100% of the outstanding issue and is now subject to brutal short squeeze and repo pain, is yielding 0.04%. And a now 9yr JGB, that was never eligible for the post-March 2022 Fixed Rate Operations, is yielding 0.60%.

Figure 9: 10yr on-the-run JGB Yield (blue), 10yr most recent on-the-run JGB (orange), 9yr JGB (white)

Source: Bloomberg

What would be seen as normal market function has not been restored.

We look forward to Governor Ueda’s first policy meeting in late April, though we might advise setting aside with the formality of regularly scheduled meetings and getting on with the post-Kuroda era as quickly as possible.

Core to our criticism of the forecasting, planning and controlling efforts of today’s crop of central bankers and economists is their glaring inability to foresee (or model, in their case) anything past first order effects (usually based upon said first order assumption being hard coded in their model!). Both out-going Governor Kuroda, as well as incoming Governor Ueda, have remarked that the benefits of their policies, including Yield Curve Control (YCC), outweigh their side-effects. Of course, they never volunteer, nor are they asked about, specifics of what the quantifiable benefits and the perceived side-effects are. The financial press-corps is no stronger in Japan that it is in the other major economies around the globe.

Courtesy of our sage friend Jim Grant, the below research piece was brought to our attention. It seems that our criticisms of central banks may need to be softened.

https://www.frbsf.org/wp-content/uploads/sites/4/wp2023-06.pdf Federal Reserve Bank of San Francisco. “Loose Monetary Policy and Financial Stability”

We quote the entire “Conclusion”:

“This study provides the first evidence that the stance of monetary policy has implications for the stability of the financial system. A loose stance over an extended period of time leads to increased financial fragility several years down the line. The source of this fragility is associated with swings in those financial variables that have been identified by the literature as harbingers of financial turmoil.

Policymakers should take the dangers imposed by keeping policy rates low for long seriously, and thus weigh the potential short-run gains of loose monetary policy against potentially adverse medium-term consequences. Such policies increase the risk of financial crises and thus the risk of high social, political, and economic costs.”

We might question their bold claim to being the “first”. The likes of Messrs White and Borio, not to mention Hayek and Mises, might take some exception.

While we may mock this note for going through mathematical contortions in an attempt to provide evidence to something that is common sense to anybody without a Sharpe World Phd., it is actually a very worthwhile read and links to an endless swath of worthwhile research on the subject. One sentence that caught our eye:

“When interest rates are relatively loose, financial intermediaries have incentives – or are even required – to search for yield and thus risk.”

A nice little nod to the implications of Sharpe World regulatory constructs. Self-Organzed Criticality (Sandpile Theory) might be a useful topic for these authors to study up on, then come back with Part II of this paper.

What is the modern-day result of all this? It is the uncapitalized tail of risk, courtesy of Sharpe World regulatory and accounting practices, behind the gargantuan holdings of government debt. The unrecognized global losses on, supposedly, riskless duration assets, held by folks who don’t have to mark-to-market, has to be an absolutely staggering number. Banks, pension funds, insurers, asset managers, endowments, SWFs, and maybe most obvious of all, central banks.

Here is an article from Reuters from just October of last year. It is most notable by understating the issue by some order of magnitude. “Tens of billions” is not even close we would say.

https://www.reuters.com/markets/us/fed-track-tens-billions-losses-amid-inflation-fight-2022-10-28/

Here is a “Policy Brief” from the folks at the Mercatus Center. You can see in the table in figure 10 that the Fed has just over $1 trillion of unrealized market value declines in just the nine-months to September 2022.

https://www.mercatus.org/research/policy-briefs/federal-reserves-balance-sheet-costs-taxpayers

Figure 10: Federal Reserve Balance Sheet Sept 2022 YTD Value Change

Source: Mercatus Center, National Bureau of Economic Research

Truly staggering.

How large are these unrecognized losses in banks? As we quoted above from the folks at the SF Fed, “When interest rates are relatively loose, financial intermediaries have incentives – or are even required – to search for yield and thus risk.” How many banks, the world over, have followed these incentives, even requirements, to load up riskless assets in non-Mark-to-Market banking books? Our simple guess, as ever with systemic risks, would be most of them. If a bank loses money in accrual books and can continue to fund the losses with government guaranteed deposit support, does it make a sound? Sovereign securities are 0% Risk Weighted Assets. No capital needs to be applied to holding them.

We know much the same is true of pension funds. Would we ever have even learned of the challenges of UK LDI Pension schemes if it hadn’t been for the margin calls? The accounting and risk practices would have allowed them to just carry on indefinitely, masking the uncapitalized tails until it was all gone. Leveraging Gilts is risk reducing, apparently.

Optimized wealth management portfolios, aka 60/40, say that owning duration assets reduces the risk of the portfolio. Risk balanced versions, ala Risk Parity, say that leveraging that benefit is even more risk reducing. As we keep asking, as and when the flaw behind all of this becomes ever more apparent, and the implications on end capital holders start to bite, who is going to own the ‘40’?

Here is a version of a picture that we have shown many times before (this version adapted from a presentation we saw from friends at Meketa). This simply shows the historical nature of the correlation between bond prices and equity prices. The negative correlation, that which is the absolute heart and soul of the 60/40 Sharpe World juggernaut, has only existed during the most recent era of unusually low inflation (the pale blue dots) and is now moving back into a positive correlation in line with inflation measures (5yr Annual Inflation %) inching above 3%.

Figure 11: US 5yr Equity-Bond Correlation vs 5yr Annual Inflation %

Source: Meketa, Convex Strategies

Pairing that picture with the one we posted last month, creates a somewhat gloomy perspective around the future prospects of Sharpe World.

Figure 12: Eight Hundred Years of Inflation in the United Kingdom, 1217 to 2016. Revised with 2017-2022

Source: https://personal.lse.ac.uk/reisr/papers/22-whypi.pdf /Millenium dataset of the Bank of England. Convex Strategies.

It is bad enough that economic and financial practitioners of today believe that complex systems should be evaluated on an equilibrium basis, but imagine what happens when you see your role as trying to manipulate the system to your desired equilibrium.

We stumbled upon an absolutely wonderful piece that nicely lays out the foundational shortcomings of Sharpe World methodologies in economics and finance. “Economics in nouns and verbs” is by Brian Arthur, one of the leading minds in the Chaos Economics crowd at the Santa Fe Institute.

https://arxiv.org/ftp/arxiv/papers/2104/2104.01868.pdf

“Equations bias economics toward equilibrium thinking. The reason here is simple. Noun-based economics links nouns to other nouns via systems of relation and balance – equations. It is easier to analyse these if they hold still, so to speak, much as it is easier to study the working of a butterfly if we nail it to a board. And so we purchase understanding by assuming stasis – equilibrium.”

Or, as we put it back in our September 2022 Update:

“In Sharpe World, historical volatilities and correlations always remain constant. Geometric compounding paths are irrelevant. Tails are never fat. Leverage is not risk. Frequency matters more than magnitude. Ensemble averages dominate time averages. Hens lay soft-boiled eggs.”

All in a phenomenal effort to be precisely wrong.

The solution, from an investment portfolio perspective, is no big secret. Nassim Taleb has made a healthy career writing best-selling books on the topic. We even have a catchphrase – “participate and protect”. Package together things that participate on the upside of markets with things that provide asymmetric convex protection on the downside.

We highlight a response from Nassim which mirrors discussions that we have pretty much every day. We agree with all his points, but the one that we seem caught in an endless loop on is his point #3, “The Inseparability of Insurance and Insured.”

“Four Points Risk Managers Should Learn from Jeff Holman’s Mistakes in the Discussion of Antifragile”, Nassim Taleb: https://arxiv.org/pdf/1401.2524.pdf

“One should never calculate the cost of insurance without offsetting it with the returns generated from packages that one would not have purchased otherwise.”

The point of explicit risk mitigation is to allow one to participate in more risk. Put good brakes on the race car so you can, safely, drive faster. Financial fiduciaries are experts at ignoring the opportunity cost of sitting with large chunks of their capital tied up in non-participating, non-protecting, investments during a multi-year long bull cycle, to then play the “nobody could have seen that coming” game at the other end.

We’ve adapted one more of the visuals from our friends at Meketa, to again show what we have presented in so many different ways. This one has, along the X-axis, the CAGR of each relevant item and, along the y-axis, the respective average drawdown during periods where the S&P drew down greater than 10%, as a measure of risk. We have run this using January 2005 as the start date. The black circles represent the various underlying instruments. The red crosses represent common portfolio strategies, eg. 60/40 and various absolute return Hedge Fund strategies. The blue triangles are samples of hypothetical convex barbell portfolios, ie “participate and protect” type of strategies.

Figure 13: CAGR vs Performance during large Drawdowns

Source: Meketa, Convex Strategies

50 SPX / 50 Vol – Hypothetical 50% S&P / 50% Eurekahedge CBOE Long Vol

Dream Portfolio – Hypothetical 60% S&P / 20% Gold / 40% Eurekahedge CBOE Long Vol Index (20% in theoretical 2x vehicle)

Always Good Weather (AGW) – Hypothetical 40% S&P / 40% Nasdaq / 40% Eurekahedge CBOE Long Vol (20% in theoretical 2x vehicle)

Private Equity Barbell – Hypothetical 70% TRPEI (The Refinitiv Private Equity Buyout Index) and 60% CBOE Long Vol (30% in theoretical 2x vehicle)

It tells us the same thing. In retrospect, by pairing the strategies that are most negatively correlating during the drawdowns with the best participating strategies, we can show that it might have been possible to generate far superior risk-adjusted returns.

Again, a theoretical simple barbell of 50% S&P Total Return with 50% of the Eurekahedge CBOE Long Vol Index would have hypothetically outperformed the return of the US Bond Aggregate.

Figure 14: Barbell SPXT 50%/CBOE LongVol 50% (annual rebalancing) vs US Bond Aggregate

Source: Convex Strategies

Likewise, one of our theoretical barbell portfolios, the Dream Portfolio, constructed by simply combining 60% S&P, 20% Gold and 40% Eurekahedge CBOE Long Vol Index shows hypothetically better returns than any of the sampled Hedge Fund strategies. Below we use the HFR Fund of Hedge Funds Index as a proxy for actual market returns.

Figure 15: Dream Portfolio (annual rebalancing) vs HFR Fund of Hedge Fund Index

Source: Convex Strategies

If we look at another of our hypothetical barbell portfolios, the Always Good Weather (AGW) portfolio (40% S&P, 40% Nasdaq, 40% Eurekahedge CBOE Long Vol), we can again show how it might have theoretically outperformed a traditional ‘60/40’ equity / bond portfolio.

Figure 16: AGW vs 60/40. (Annual rebalancing on both)

Source: Convex Strategies

Lastly, if we compare that same theoretical AGW portfolio over the same period to just the S&P500 index, we can again show how it might have been possible to compound better hypothetical returns.

Figure 17: AGW (annual rebalance) vs 100% S&P

Source: Convex Strategies

Looking back at the above figures on the historical examples of inflation regimes in Figure 11 and 12, and what they mean for the all-critical Sharpe World bond-equity correlation, it gets increasingly hard to imagine how fiduciaries continue to operate under what we would see as dangerously flawed concepts. When will the end capital owners start asking of their fiduciaries “why are we perennially on the ‘red line’?”. When might the same investors start wondering what has happened to the seemingly foregone wealth that could have been achieved without what can be shown to be the potentially massive opportunity loss of tying up capital in faux diversifying strategies? Lastly when might queries arise around the regulatory accounting methodologies that have been constructed that allow fiduciaries to mask the destruction of compounding year after year?

Sharpe World is nefarious. It should not be accommodated. We do not condone it.

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