“I have been working in or around central banks for over fifty years. To my regret, as I look back on my career, I can now see that I was often guided by an evolving set of false beliefs about how an advanced economy works and how monetary policy might contribute to its better functioning. I was at various times an advocate of targeting the exchange rate, of targeting the natural rate of unemployment, of targeting monetary aggregates and, more recently, of pursuing the near-term stability of some index of consumer prices. Indeed, a summing up of my career, prior to joining the Bank for International Settlements (BIS) in 1994, might well have been ‘I’m sorry, it seemed like a good idea at the time’.” William White, 2023.
Microsoft Word – WP_210 White Monetary Policy final.docx (ineteconomics.org) William White.
One of our favourite quotes, ever, and a wonderful note, aligning well with our discussions last month on the Butterfly Effect. Bill White, who we have dubbed the Poet Laureate of Economics, is a treasure.
https://convex-strategies.com/2024/02/16/risk-update-january-2024-butterfly-effect/
We quoted from Bill’s paper back in our August 2023 Update – “Compounding, Imbalances and the Arrow of Time”.
“Perhaps the most effective way of showing the need for fundamental monetary reform is to point out the negative implications of the monetary policies followed by the major central banks in the advanced economies over the last few decades.
First, the general adoption of a positive (+2%) inflation target has prevented the downward adjustment or prices that would be the natural product of increases in productivity and positive supply shocks. Second, the recurrent use of monetary easing to spur demand and raise inflation has become increasingly ineffective. Current monetary policy faces a fundamental problem of temporal inconsistency: solving today’s problems also makes tomorrow’s problems worse. Third, stimulative monetary policy has had a variety of unintended and unwelcome consequences that can only worsen; credit “booms and busts”, potential financial instability, fiscal unsustainability, a progressive loss of central bank “independence”, growing inequality of wealth and opportunity and a slower growth rate of potential output. Fourth, as the threat posed by these unintended problems have cumulated over time, “exit” and the “renormalization” of policy has become ever harder to achieve.
To sum up, the current monetary system has trapped us on a path we do not wish to follow because it leads inevitably to ever bigger problems.” William White, 2023.
In other words, the Butterfly Effect.
Another (now retired from officialdom) gentleman that we have a ton of respect for is Thomas Hoenig, former President of the Kansas City Fed. Tom published another recent note, “Monetary Policy: Narrowing Discretion, Improving Outcomes”, that is right up our alley.
Monetary Policy: Narrowing Discretion, Improving Outcomes (finregrag.com) Thomas Hoenig.
“Monetary policy is a primary source of systemic banking and economic crises, and bank supervision cannot insulate the industry or economy from significant macro-policy errors.”
“While no system is perfect, the country would be better served if the Fed’s monetary policy framework was designed using the following principles: 1) transparency, 2) sufficient discretion to conduct policy through an economic cycle, and 3) firm boundaries beyond which policy actions require Congressional approval.” Thomas Hoenig, 2024.
Policymakers don’t know the long-term impact of their interventions. As we discussed last month, they can’t know. Tom suggests, as an example of simple risk heuristic, something like the Taylor Rule.
Regular readers will know that we are advocates that central bankers should act more as risk managers than as shamans, or even manipulators, of the future. In a complex world, the answer to uncertainty is not precision but rather simplicity, what folks like us term as heuristics. A German psychologist by the name of Gerd Gigerenzer (little known inside Sharpe World) is a wonderful resource on the use of heuristics.
This is a great paper by Mr. Gigerenzer, along with Wolfgang Gaissmaier, entitled “Heuristic Decision Making”, that hits spot-on our points about the Butterfly Effect and the nonsense that are the consensus Sharpe World models and practices in finance and economics.
https://pure.mpg.de/rest/items/item_2099042_4/component/file_2099041/content
“As Simon (1979, p. 500) stressed in his Nobel Memorial Lecture, the classical model of rationality requires knowledge of all the relevant alternatives, their consequences and probabilities, and a predictable world without surprises. These conditions, however, are rarely met for the problems that individuals and organizations face. Savage (1954), known as the founder of modern Bayesian decision theory, called such perfect knowledge small worlds. In large worlds, part of the relevant information is unknown or has to be estimated from small samples, so that the conditions for rational decision theory are not met, making it an inappropriate norm for optimal reasoning (Binmore 2009). In a large world, as emphasized by both Savage and Simon, one can no longer assume that ‘rational’ models automatically provide the correct answer. Even small deviations from the model conditions can matter. In fact, small-world theories can lead to disaster when applied to the large world, as Stiglitz (2010) noted with respect to the financial crash of 2008: “It simply wasn’t true that a world with almost perfect information was very similar to one in which there was perfect information” (p.243, emphasis added). And Sorros (2009) concluded that “rational expectation theory is no longer taken seriously outside academic circles” (p. 6).” Gerd Gigerenzer and Wolfgang Gaissmaier, 2011.
You can watch below a short TED Talk clip from Mr. Gigerenzer. We snipped one of his slides from the presentation and show it below.
Figure 1: How smart people make smart decisions
Source: https://www.youtube.com/watch?v=-Lg7G8TMe_A
Really no need to elaborate on that. We all know it to be the case, in the real world, where participants have skin-in-the-game. Gerd uses the example of a baseball player catching a fly ball. The baseball player isn’t solving a bunch of differential equations. Nassim Taleb talks about professors teaching birds how to fly. We have linked before to the wonderful speech from then Bank of England Financial Stability Executive Director, Andrew Haldane, “The Dog and the Frisbee”.
https://www.bis.org/review/r120905a.pdf
“Take decision-making in a complex environment. With risk and rational expectations, the optimal response to complexity is typically a fully state-contingent rule (Morris and Shin 2008). Under risk, policy should respond to every raindrop; it is fine-tuned. Under uncertainty, that logic is reversed. Complex environments often instead call for simple decision rules. That is because these rules are more robust to ignorance. Under uncertainty, policy may only respond to every thunderstorm; it is coarse-tuned.” Andrew Haldane, 2012.
We have said it before, this note is right at the top of our list of ‘papers-we-wish-we-had-written’. This should be the operating manual within central banks and financial regulators.
Unfortunately, the powers-that-be continue to want to “respond to every raindrop”. We have written extensively over recent months about the evolving narrative around justifying the sustaining by central banks of large balance sheets, ie. not unwinding significant chunks of their previous Quantitative Easing (QE) interventions, under the guise of stability driven by larger than past normal bank reserves.
We discussed the ECB’s upcoming ‘Operational Framework’ review, as laid out by Chief Economist, Philip Lane, in our November 2023 Update – “Recession. Yay!” https://convex-strategies.com/2023/12/14/risk-update-november-2023-recession-yay/.
We put it this way back then:
“Mr. Lane is laying out the construct for the upcoming ‘Operational Framework’ review by the ECB, in particular as relates to the use of the ECB’s balance sheet and the role that central bank reserves play in their policy making. For us, what really stands out in the speech, and as relates to the above Hayek quote, is there has been no learning. Yet again, we are assured that the mighty central banks will bring together their ever-expanding set of tools and guide complex disequilibrium economies to the promised future steady state. All the while with no cognizant reflection that their past utilization of these very same tools has anything to do with the current state-of-play.”
Then again last month https://convex-strategies.com/2024/02/16/risk-update-january-2024-butterfly-effect/ we gave the opposing view, as provided by former Bundesbank President, Jens Weidmann and co-author Jorg Kramer. We quoted the authors in that note with this:
“In an extreme case, the central bank is caught in a near-irresoluble dilemma. Either it disregards its price stability mandate and counters a destabilizing increase in government financing costs by further massive government bond buying regardless of the inflation outlook, or it risks a sovereign debt crisis.” Jens Weidmann and Jorg Kramer, January 2024.
Before proceeding further down this path, we would refer readers back to a couple of our past discussions on the broad dynamics of risk. First, our August 2021 Update – “Self-Organized Criticality” https://convex-strategies.com/2021/09/22/risk-update-august-2021/, where we made the economic comparison to the fragility of Afghanistan.
“At what point, ala President Biden and his (misplaced) talking up of the capabilities of the Afghan National Security Forces, should we start to expect assurances that, even should the Fed withdraw their unprecedented monetary support, the market will be able to stand up to the pesky residual solvency fingers of instability? Of course, to some extent, we hear this all the time. We hear how, under Basel III, the banks are stronger and better capitalized than ever! Surely, they don’t need central banks to underwrite the values of the assets that they own. We hear of innovative new life rafts like the Standing Repo Facility that will smooth market function when central banks aren’t around to buy assets from over-levered holders. We hear of permanent standing swap-lines around the world. We hear of central clearing, new more sophisticated margining protocols, more and more reams of regulatory reporting and oversight. The financial system is well trained and well equipped to stand up against any of those un-surrendered solvency issues that may have survived the years of artificial support. Keep your ears open.”
If you are a new visitor to these pages and want to get some historical perspective on how we see the world, this note is a pretty good place to start.
Secondly, we harken back to our September 2022 Update – “Is Sharpe World Closing?” https://convex-strategies.com/2022/10/18/risk-update-september-2022-is-sharpe-world-closing/. This is our version of what formal economists refer to as “fiscal dominance and financial repression” – aka “who’s gonna own the 40?” – and a nice hub where we link five previous Updates in which we had discussed official regulatory reviews of where they (the regulators) think the risk is hidden. We put it this way back then:
“Readers should be familiar with our concept of ‘uncapitalized tails’, risks that through negligence and poor risk/accounting practices end up not being supported with appropriate loss absorbing capital. Likely the most well known uncapitalized tails of modern times were the holding of tranched mortgage securities on bank balance sheets. They were a key factor in the unravelling known as the Great Financial Crisis (GFC) and led to the government bailouts of pretty much the entire global banking system. The Sharpe World maths and accompanying regulation, paired with the undeniably flawed fiduciary incentive structures, allowed for a total mis-accounting of the risk of these instruments, the application of nearly unlimited leverage, and a total dearth of capital to absorb the inevitable losses when they arrived.”
With that groundwork in place, we would pose the question, so artfully coined, by our friend Ben Hunt – “why are we reading about this now?”
That brings us back again to the issue of Quantitative Tightening (QT), central bank balances sheets, and bank reserves. This topic just keeps coming up, again recently in the form of a quite extensive academic paper authored by Wenxin Du, Kristin Forbes and Mattew Luzzetti, and published by the Chicago Booth School for the US Monetary Policy Forum (USMPF) 2024 event.
We won’t spend much time going into this in detail, other than to say it paints a somewhat distorted, rosy, picture of the relative trade-offs between QE and QT.
We will, however, share with you the seemingly matched bias commentary from a couple of Fed officials that served as ‘discussants’ on the paper at the USMPF event.
First up, President of the Dallas Federal Reserve, Lorie Logan.
Lorie’s review of the paper gets right to the authors’ main point:
“The paper mainly emphasizes an asymmetry in magnitude: by and large, the effects of QE as measured in the simple framework of this paper are notably larger than those of QT.” Lorie Logan, March 2024.
This is a classic example of comparing numerators, without equalizing the denominator. Far too common in Sharpe World.
The other distinguished discussant is Federal Reserve Governor Christopher Waller. He gives, if we may be honest, an even more superficial review than President Logan.
“The authors’ findings that QE has asymmetric effects compared to QT is not a puzzle but an indication that central banks timed QE and QT in the right manner such that society was better off.” Christopher Waller, March 2024.
The authors and the two distinguished discussants all barely mention, and essentially brush aside, the somewhat obvious denominator issue, that being the stark differences in how QE and QT were instigated. QE, in its initial phases, was sudden and unexpected when announced. QT was long-signalled and telegraphed. QE was aggressive and proactive in its implementation, with CBs coming to market and actively buying securities. QT was passive and slow with CBs, generally, just not reinvesting some preset portion of the proceeds of maturing securities, ie. ‘runoff’. QE, at initiation, was large in quantum and fast in execution. QT was small in scale and slow in pace.
The authors show the absolute net increase across a handful of central banks, but start at the end of 2019, despite having noted that only the Fed had made any attempt to QT post the initial 2008 onwards QE expansions.
Figure 2: Central Bank Balance Sheets. Dec2019-2023 and projections to 2025
Source: University of Chicago Booth Business School/USMPF 2024
We would argue, a more honest representation would be to show the entire lifecycle of QE going back to 2008, as well has showing it on a logged basis to represent the relative scale at a given point. For the US that would look like the below and makes our criticism of the not like-for-like denominator pretty obvious.
Figure 3: Federal Reserve Balance Sheet. 2008-Feb2024 (logged scale)
Source: Bloomberg, Convex Strategies
As we have touched upon in our previous discussions on this subject, there are a couple of recurring themes that keep coming up that are worth noting.
- QE, when it was originally implemented, was considered “unconventional”. We are told that is no longer the case and it should be considered a standard piece of the CB’s policy toolkit.
- As we discussed last month, going back to Ben Bernanke’s 2012 Jackson Hole speech, QE from the beginning was sold as not being inflationary because it would always be temporary. Now, with the discussion of permanently larger central bank balance sheets, that is no longer the case. Oddly, there is no equivalent discussion that it then might indeed be inflationary.
In what we imagine is a surprise to absolutely nobody, the dignitaries from the Bank of England also got in on the act of laying out the go-forward narrative of balance sheet sizing and weak efforts at QT.
First Governor Bailey gave a speech entitled simply, “Banking Today”.
Loughborough lecture: Banking today – speech by Andrew Bailey | Bank of England
Not wanting to be left out, Governor Bailey jumped on the permanent balance sheet express train.
“Before the financial crisis, the major UK banks held £10 billion of reserves at the Bank of England. Today, they hold £467 billion, a substantial part of the stock of high quality liquid assets. It’s fair to say that the pre-crisis number did not adequately take account of financial stability needs. Today’s number includes reserves created as a product of so-called Quantitative Easing. By undertaking QE, the Bank increased the supply of reserves for monetary policy purposes. QE is an asset swap – the central bank provides cash reserves or money in return for buying less liquid assets. We thus increase the liquidity of the financial system and its capacity to support activity in the economy. QE therefore increased the stock of reserves for monetary policy purposes, but its important to remember that there is another reason for banks to hold reserves, namely financial stability.” Andrew Bailey, February 2024.
We will withhold our comments on any suggestions of hypocrisy from Governor Bailey’s multiple references to Walter Bagehot. As a whole, this speech falls in that category of not being a particularly worthwhile read other than as a peak at the growing similarity of narrative around the transition from QE being, at initiation, a temporary central bank asset side monetary policy tool, to now becoming a permanent liability side financial stability monolith.
With apologies, one last link to yet another Bank of England piece on this topic. This one comes from Deputy Governor, Dave Ramsden. It is gets into the weeds on the technical aspects of BOE’s role in the bond markets but, in the end, Mr. Ramsden is driving home the same core point, in essence, all is well, but the balance sheet is going to be a lot bigger than it was before we commenced QE, ergo a chunk of QE will end up being permanent.
Ok, enough already, you don’t have to beat us over the head. We believe that balance sheets will not return to past levels of normal size. Not all the troops are going to be withdrawn. That gives us at least one clear answer to ‘who’s going to own the 40?” The central banks, again. Financial repression.
But what else are they telling us? A couple of pretty significant things.
First up, ISDA, presumably on behalf of the big banks, issued the below letter to the full slate of bank regulators in the US; the Federal Reserve, FDIC, Office of the Comptroller of the Currency.
https://www.isda.org/a/h3sgE/ISDA-Submits-Letter-to-US-Agencies-on-SLR-Reform.pdf
“To facilitate participation by banks in U.S. Treasury markets – including clearing U.S. Treasury security transactions for clients – the Agencies should revise the SLR to permanently exclude on-balance sheet U.S. Treasuries from total leverage exposure, consistent with the scope of the temporary exclusion for U.S. Treasuries that the Agencies implemented in 2020.”
SLR stands for Supplementary Leverage Ratio. It is the broadest capital requirement and is a measure of capital to total assets. It might better be referred to as a Gross Leverage Ratio. It counts, on the slimmest of capital requirements, even those sneaky 0% RWAs (Risk Weighted Assets). It was the one thing post GFC (Global Financial Crisis) that Basel rules implemented that actually made banks somewhat safer. As soon as it got tested, in March 2020, the Fed gave banks an exemption from it. The banks (assuming we consider the banks and their regulators as separate actors) now want the exemption made permanent. The letter makes it clear what is the relevant issue here.
“It is important that banks have capacity to absorb a continued high volume of U.S. Treasury issuance, with the market projected to grow to exceed $35 trillion in the next five years, as well as to facilitate access to cleared U.S. Treasury markets (including cash as well as repurchase and reverse repurchase transactions (together, “repos”) and related derivatives markets.”
Answer #2 to “who’s going to own the 40?” The banks, again. More financial repression.
We discussed these issues at length back in our October 2023 Update – “The Hunger Games” https://convex-strategies.com/2023/11/17/risk-update-october-2023-the-hunger-games/.
We showed these two pictures then that make the issue pretty clear.
Figure 4: TBAC Report on Treasury Buyers Q# 2022 0Q2 2023
Source: TBAC Report, Federal Reserve
Figure 5: US Bank QoQ Change in Debt Securities Held
Source: TBAC Report, FDIC
And here is the updated version of the FDIC chart on unrealized losses in the banks’ HTM and AFS portfolios.
Figure 6: US Bank Fair Value of Securities Portfolios. 2008 -2023
Source: FDIC
No wonder they want the SLR exemption made permanent.
Along very similar lines, Fed Chair Jerome Powell dropped this little nugget, as relates to the anticipated increase in bank capital requirements in what is known as “Basel III endgame”, at the recent House Financial Services Committee hearing:
“We do hear the concerns and I do expect there will be broad material changes to the proposal.” Jerome Powell, March 2024.
Anticipation is that the previously discussed increased capital requirements will be broadly watered down.
As we asked above, why are we hearing about all this stuff now? Maybe it is just a coincidence but, as we have previously noted, the Bank Term Funding Program (BTFP) that was put in place in the aftermath of the Silicon Valley Bank (SVB) failure, will cease to provide its subsidized lending against face value of US Treasuries as of March 11th.
https://www.federalreserve.gov/newsevents/pressreleases/monetary20240124a.htm
All the rhetoric really does bring to mind the pre-withdrawal from Afghanistan and the assurances of the well-trained and well-equipped Aghan National Security Forces. What risks are out there that they are so keen to assure us that the system is well prepared to repel?
There is the obvious one, the uncapitalized and unaccounted for holdings of sovereign bonds on the balance sheets of banks, ie what bankrupted SVB. But, maybe, there is also the ever-lurking concern of the massive, and exceptionally vague, pile of poorly measured and accounted for derivative risk.
Take, for example, this absolute gem from the Options Clearing Corporation (OCC).
This may look innocent, and boring, enough as just another Rules Change Proposal from a self-regulatory organization. But a little attention to detail, peels back the curtain on a core principle within the post-GFC world of systemic risk mitigation – that being central clearing of derivatives. OCC declares itself to be the “world’s largest equity derivatives clearing organization”. OCC is what is known as a Systemically Important Financial Market Utility (SIFMU) and is under the regulatory purview of the SEC, CFTC, and the Fed.
Figure 7: The Options Clearing Corporation (OCC)
Source: theocc.com
For those that want to get into the weeds on the inner workings of a Sharpe World risk methodology this is truly a rare gift that puts it right out there. The gist of the ‘proposed rule change’ is to hardcode into the SEC’s rules, that OCC operates under, an existing OCC margin practice (thus outside the current rules). That margin practice is how they circumvent their own margin requirements, ‘regular control’, during times of stress and high volatility, ‘high volatility control’, in order to prevent ‘procyclicality’. At least that is their opinion.
“OCC has established a proprietary system, the System for Theoretical Analysis and Numerical Simulation (STANS), that runs various models used to calculate each Clearing member’s margin requirements. One of the OCC’s margin models generates variance forecasts for the returns on individual equity securities, the result of which OCC then includes as one of the inputs to the margin calculation. As discussed in more detail below, OCC has observed that this particular model may produce results that are “procyclical,” which means that changes in margin requirements produced may be positively correlated with the overall state of the market and, if not appropriately addressed, could threaten the stability of its members during periods of heightened volatility. For example, procyclicality may be evidenced by increasing margin in times of stressed market conditions and low margin when markets are calm. A sudden, extreme increase in margin requirements could stress a Clearing Member’s ability to obtain liquidity to meet its obligations to OCC, particularly in periods of high volatility. If that Clearing Member subsequently defaulted, the resulting suspension and liquidation of the defaulting Clearing Member’s positions could result in losses chargeable to the mutualized Clearing Fund. Charging a loss to the Clearing Fund may result in unexpected costs for non-defaulting Clearing Members, stressing their ability to obtain liquidity to meet their own financial obligation in stressed market conditions.”
Read that carefully (and probably read it again) and think about the supposed role that central clearing is meant to play in the global regulatory regime of mitigating systemic risk. In other words, putting any one Clearing Member at risk during stressed environments, could put the whole system at risk, thus the regular margin methodologies need to be circumvented during times of stress. All Clearing Members are deemed too interconnected to fail, so we reduce their margin requirements, from what is the current rules, when stress and volatility are high.
This has been going on in some sort of ad hoc manner for some time already, with an unspecified subjective approval process getting run by what they dub the Market Risk Working Group (MWRG). Now, the OCC would like its regulators to hardcode the practice into their official rules. OCC has been implementing these “high volatility control settings” (reduction of margin requirements relative to “regular control settings”) practices for some time, implementing across both of what they term “global control settings”, across all or a class of risk factors, as well as “idiosyncratic control settings”, for individual risk factors.
They give some examples of the implementation of ‘global control settings’, one specifically to do with March 9, 2020, a day when the SPX fell 7.5%, where the MRWG approved a 50% weighting of the margin between regular control settings and high volatility settings which resulted in $20bio less margin being placed than the otherwise $100bio that would have been required (thus, would have been $40bio less if they had gone to the full high volatility control levels). Again, you heard that correct. Their solution to high stress/high volatility is to reduce the otherwise margining requirements.
Most interestingly is their admission that they have implemented idiosyncratic control settings much more frequently. This leads us to Footnote #35.
“35. From December 2019 to August 2023, for example, OCC implemented high volatility control settings lasting various durations (ranging from a single day to 190 days, with a median period of 10 days) for more than 200 individual risk factors.”
Wait. What?
Yes, it would seem that, outside of the existing rule construct, the OCC over a 4-year period has subjectively approved the waiver of their normal margin methodology, aka ‘regular control settings’, and allowed some portion of Clearing Members to flip to less onerous ‘high volatility control settings’ an amazing 200 times. These 200 avoidances of imposing margin that could cause a Clearing Member distress were in place for a median period of 10 days and a maximum of 190 days. Do you feel safer? Will you feel safer when this informal practice gets hardcoded into the standard rules imposed by regulators?
We would sure love to see the minutes of the various MRWG meetings where the requisite control settings did or didn’t get approved for changes. Is there consistency in their methodology of when, or when not, to approve the change in control settings? Does who the impacted Clearing Members are come into the conversation? Are the Clearing Members involved in pushing for the change in settings? To what extent have the regulators been involved in and informed of the process?
Makes one wonder what might be going on at LCH, CME, ICE, LME, Euroclear, DTCC and on and on. Are they applying competent margining methodologies? Are they adhering to their methodologies or waiving them in times of stress to protect Clearing Members from increasing reflexivity in difficult times? Do they accurately recognize and margin against asymmetry and non-linearity of risk? Does ICE, for example, get the asymmetry right for the respective margining requirements between buyers of CDS protection versus sellers of CDS protection?
To give you some idea of the scale, here is a screen from the LCH website just on their SwapClear levels of activity.
Figure 8: LCH SwapClear Volume and Notional Outstandings. March 2024
Source: lch.com
We all remember the LME Nickel incident back in March 2022. They didn’t merely waive margin requirements, they suspended trading across all venues for the better part of a day and cancelled some 8 hours’ worth of executed trades.
Aside from all that centrally cleared stuff, take our word for it, there is still an enormous amount of OTC derivative stuff floating around out there as well, and much of it is of the more complex, more non-linear variety (the clearing houses shy away from complex non-linearity, for good reason). As some may be familiar with, there is a herculean effort going on around the globe on behalf of what is known as OTC Derivative Reporting. The various major regulatory jurisdictions are a dozen years down the ambitious path of collecting detailed information on every OTC transaction that takes place in the world, every day. It is a data collection of unmatched scale and complexity, not necessarily made better by the disjointed efforts applied to the task by the diverse jurisdictional regulators. The claimed point of this monumental effort is so that said regulators can better discern and foresee potential systemic risk build ups. Good luck with that.
Meanwhile, the central bankers tell us that all is well. Tell us that their policy tightening has worked, and we are on a clear path back to their targets of price stability. The market continues to price, in line with central bank guidance, near-future rate cuts in the US and most of the Fed following markets.
There are, however, those niggling things out there that allow doubts to linger. For example, financial conditions still seem somewhat short of being historically ‘tight’.
Figure 9: Chicago Fed Financial Conditions Index 1987-Feb2024
Source: Bloomberg
We are well aware that central bankers and most market mouthpieces prefer to talk about year-on-year rates of change for their various price stability targets, but simply looking at the indices compounding path probably gives a more honest indicator of what is felt in the real world. As we like to point out, looking at it this way eliminates any need to argue about transitory.
Figure 10: US Core PCE Index (white) and Core CPI Index (blue). 2% Trend Line (red dash). 1987-Jan2024
Source: Bloomberg, Convex Strategies
Certain speculative markets would seem to indicate less confidence that the Fed, et al, have restored credibility. Our proxy for the Fed’s report card (inverse scale), good old Bitcoin, continues to thumb its nose at the supposition of prudence from the keeper of the global reserve currency.
Figure 11: XBT/USD
Source: Bloomberg
The same goes for US equity markets with the major indices making new all-time highs in February.
Figure 12: SPX Index (blue) and NDX Index (white). Normalized
Source: Bloomberg
It just doesn’t seem ‘tight’.
Of course, it is even more extreme on the other side of the world over in Japan where there is no pretence of efforts to tighten. The Bank of Japan (BOJ) continues full throttle with NIRP and QQE. In a private conversation with a former official, we were told that it is ok for the BOJ to continue to move very slowly and cautiously towards normalization, just as long as things don’t enter some sort of a non-linear phase. We suggested that, looking at the FX rate, the 10yr yield, the NKY Index and their price stability measure, one could make the argument that that fish has been sashimi’d!.
Figure 13: Japan CPI ex-Fresh Food and Energy Index (white), USD/JPY (blue), JPY 10yr Swap (purple), NKY Index (orange) vs BOJ Policy Rate (yellow). Mar2016-Feb2024
Source: Bloomberg, Convex Strategies
Then we showed him the JPY denominated version of the Bitcoin report card.
Figure 14: XBT/JPY. March2019-Feb2024
Source: Bloomberg
Or if you prefer, the Old School version using Gold.
Figure 15: XAU/JPY. March2016-Feb2024
Source: Bloomberg
Quite a bit of non-linearity when your base is JPY. BOJ’s next Policy meeting is on March 19th, maybe it is time for NIRP to end.
As ever, we end up at the same place. The system is fragile. The folks in charge have a long history of erring on the side of using policy tools to drive money and credit creation (classic inflation) as a means to support fragile economies and financial institutions. They are big fans of asset price inflation and, when pushed into a corner, occasional combatants against consumer price inflation.
From a traditional portfolio perspective, anything along the lines of a 60/40, or some supposedly sophisticated version of such, like Risk Parity or LDI schemes, it would seem likely that they will face the ongoing headwind of higher volatility of price stability measures and continued challenges in the desired negative correlation between bonds and equities. As we often say, even at current levels of bond yields, they will likely be challenged to generate relevant long term real returns.
Figure 16: Total Return Indices for USD (red), EUR (blue), GBP (black) Govt Bonds Deflated by CPI Indices. April 2013-Jan2024
Source: Bloomberg, Convex Strategies
Even the presumed most sophisticated investment strategies are going through a tough time. Here is the link to the wonderful folks over at Markov Processes International and their latest review of Ivy League Endowment performance through FY2023.
Figure 17: Ivy League Endowment 10yr Returns and Std Deviations
Source: Markovprocesses.com
This is the only chart of long term returns that they show, and sadly, as usual, it is against total Standard Deviations as opposed to a useful risk measure like Downside Deviations. They make the point that this representation allows them to make the claim: “higher longer-term returns appear to be associated with higher risk.”
We can quickly chuck a standard hypothetical Always Good Weather (AGW) 40/40/40 (40% SPX total return/40% NDX total return/40% CBOE LongVol index) portfolio into their grid and see what that tells us about risk and returns.
Figure 18: Ivy League Endowments + AGW (light blue) 10yr Returns and Std Deviations.
Source: Markovprocess.com, Bloomberg, Convex Strategies
Our little blue dot representing AGW would seem to discredit their claim that higher risk equates to higher return. AGW, on very similar volatility to their 70/30 benchmark (fuchsia dot), has more return than any of the other higher volatility strategies. In fact, AGW has higher returns than all the rest explicitly because it has less risk! It has far less Downside Deviation (or Downside Volatility), an actual measure of risk, that is the driver of compounding over time. Let us say that again, the best returning strategy earns that status because it is less risky than all the others. Think about it.
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