What if it works?
Regular readers will know that this has long been our favourite question to ask central bankers and government policymakers since the implementation of “inflation” igniting strategies, e.g. ZIRP, QE, YCC and endless rounds of fiscal stimulus.
“Sharpe World” trained economists and central planners have a knack of, at best, looking for first-order effects in their efforts to direct economies and markets. However, they operate with seemingly total disregard for unintended consequences, negative externalities in economist-speak, ignorant to the reality of Butterfly effect dynamics in complex real-world systems. In one way or another, this is what we are always writing about, for example in our so titled January 2024 Update – “Butterfly Effect”.
https://convex-strategies.com/2024/02/16/risk-update-january-2024-butterfly-effect/
“This brings us back to our regular refrain – they don’t know what the impact of their interventions will end up being. More accurately, they can’t know.” Convex Strategies, January 2024.
Whether it was their intent or not (we think it was), the immediate result from the central banking era of the Greenspan Put has been the expansion of money and credit (classical inflation), leading to the inflation of asset prices and, if it works, to inflation of consumer prices. This naturally leads to destabilizing wealth segregation and eventually socio-political fragility – aka the Cantillon Effect.
We don’t know if it is correct, but one of the things we find ourselves pondering, increasingly out loud, is if politics/geo-politics are downstream from economies, and if economies are downstream from markets.
We discussed this at some length in our July 2024 Update – “Chaos” https://convex-strategies.com/2024/08/15/risk-update-jul2024-chaos/. We mentioned in that note the political fallouts in the summer elections in France and the UK. It is probably safe to say that results from neither of those elections have settled in particularly well. The below links are just a small sampling of the reporting around the ongoing, very messy, situations.
https://verfassungsblog.de/frances-shifting-constitutional-landscape/
We can now add to the list Germany with news out over the last week of the collapse of the government coalition, led by Chancellor Olaf Scholz. The collapse was triggered over issues related to “how to plug a multi-billion-euro hole in the budget and revive Europe’s largest economy” according to this Reuters article. Another entrant into the Hunger Games arena.
Germany government collapse: pressure mounts on Scholz to trigger election soon | Reuters
The struggle by disgruntled voters, across western democracies, to overcome entrenched establishment/two-party systems has been ongoing for some time now. One could probably point to 2016 and the surprising(?) results of the Brexit referendum in the UK, as well as the Trump victories in the Republican primary and general election in the US, as a delineation point where the struggle to pushback against the status quo became apparent. That struggle has picked up in 2024, a year of an unprecedented number of elections, with historical rejections of incumbent parties.
“The ‘mother-of-all-election years’ has seen voters in the United Kingdom send the ruling Conservative Party packing. In June, the African National Congress lost its parliamentary majority in South Africa for the first time. Japan’s long dominant Liberal Democratic Party lost its majority in elections just two weeks ago. French President Emmanuel Macron’s decision to call for snap parliamentary elections this summer backfired spectacularly. The three parties in Germany’s ruling ‘traffic-light coalition’ each got a thumbs down from voters in critical state elections last month.”
As of writing, we now know that the struggle against the establishment and traditional two-party structure in the US continues with Donald Trump winning the presidential election there, where he is set to come back for his second term at the helm. We also know that a lot can happen between the US election in early November and the official inauguration in January.
Arguably the biggest shock would be the collapse of LDP rule in Japan, where voters need to overcome what is, in essence, a one-party system! This is just the third time since 1948 that the LDP has lost their grip on governing Japan. The previous two occasions, 1993-1995 and 2009-2012, were short-lived and likely heavily driven by economic circumstances.
This is the kind of stuff that happens “if it works”.
Former Fed Governor, and a prospective future Fed Chair, Kevin Warsh, laid it out beautifully in this must watch interview on CNBC.
Former Fed Governor Kevin Warsh: The Fed doesn’t seem to have a serious theory of inflation
“When they kept interest rates near zero, for a decade, and did QE, where the central bank are buying the bonds of the Treasury Department in crises, and they decided to make that more or less a permanent feature, it is the Fed that wandered into politics on a permanent basis. In a period of free money, what was the sign to congress? You can spend all the money you want, and so they did.”
This reflects perfectly our refrain that the Fed, all central banks really, gave up any hope of independence when they went to 0% (and below) interest rates and decided to implement permanent QE. The end state of their actions was inevitable: an endless loop of fiscal dominance and financial repression.
Mr. Warsh throws out another gem that rings as if he has been reading our Updates!
“They (the Fed) don’t seem to have a serious theory of inflation, that’s theoretical and empirical. It is not obvious that they acknowledge what their role is in prices. Instead, it has something to do with wars and pandemics.”
How many times have we said that! They are forever telling us that they have perfect control over future outcomes yet had no impact on historic failings. Classic.
Former Bank of Japan Governor, Masaaki Shirakawa, mirrored these sentiments yet further in a wonderful Opinion piece for Nikkei Asia.
Japan government must remember commitment to fiscal side of BOJ pact – Nikkei Asia
“In this precarious situation, maintaining both price stability and fiscal or financial market stability is a daunting task. Given that the inflation rate has been above the 2% target for the past 30 months, restoring price stability calls for a rate hike that might threaten fiscal or financial market stability. On the other hand, an attempt to avoid overt fiscal instability or financial market turbulence, at least in the short-run, calls for a continuation of monetary easing, which will undermine price stability.”
“After seeing the slow normalization process, I have now come to think that one of the most serious costs of quantitative easing is making its exit difficult. Slowing the process of monetary policy normalization is like kicking the can down the road, which makes the size of potential turbulence larger.”
He really does say it so well.
We can get a clear look at the ongoing issue of fiscal dominance from the latest Treasury Borrowing Advisory Committee (TBAC). We have pulled a couple of pictures out of the TBAC presentation to the Secretary that make the point quite evidently.
TreasuryPresentationToTBACQ42024.pdf
Figure 1: US Cumulative Budget Deficits by Month for Fiscal Year 2022-2024
Source: TreasuryPresentationToTBACQ42024.pdf
The deficit just keeps on growing, and the bond issuance will keep on following. Below we can see, even the government’s own conservative estimates, the deficit projects out to 2034 still running in 5%-7% range.
Figure 2: US Budget Deficit Projections to 2034
Source: TreasuryPresentationToTBACQ42024.pdf
Secretary Yellen has held her duration issuance plans steady for the next quarter so our fiscal dominance visual remains the same, for now.
Figure 3: Fiscal Dominance – US 5yr Treasury Issuance Size
Source: Bloomberg, Convex Strategies
It is difficult to see the issuance size coming back down any time soon. The ongoing deficits and the reinforcing loop of interest costs seem likely to continue to support the need to compete in the Hunger Games arena.
Figure 4: US Govt Interest Expenditure
Source: Bloomberg
Charles Calomiris, one of our favourite voices on the subject of fiscal dominance, recently did a very worthwhile interview with Mike Green.
Entering the Fall 2024 | Founding Fathers’ Perspective on Fiscal Dominance
Charlie lays it all out very simply. The situation just is.
“The long-run implications of a policy finally became pressing.”
“There is going to be a failed Treasury auction.”
As Charlie has talked about in his paper that we have linked to several times in past Updates (e.g. June 2024 Update – “Hunger Games II” https://convex-strategies.com/2024/07/16/risk-update-jun2024-hunger-games-ii/), the path of least resistance is ever more financial repression. His version of that is via increased banking reserves at zero rates. What he terms as “taxing the banking system”.
Is the Fed already influenced by the fiscal dominance issue? They just threw in another 25bp cut of the Fed Funds Rate, as financial conditions stay loose, and asset prices make ever new all-time highs.
Figure 5: Fed Chicago Financial Conditions Index (white). Fed Funds Rate (blue). SPX Index (orange-log scale). Sept 1987-Nov 2024
Source: Bloomberg
Our memories from 1995 just keep circulating in our brains. Here is the picture with 10yr Treasury yields instead of S&P Index.
Figure 6: Fed Chicago Financial Conditions Index (white). Fed Funds Rate (blue). US 10yr Treasury Yield (green). Sept 1987-Nov 2024
Source: Bloomberg
So far, the rate cuts have not been good for duration assets. Loose policy has, however, continued to be very good for gold.
Figure 7: Fed Chicago Financial Conditions Index (white). Fed Funds Rate (blue). Gold (yellow-log scale). Sept 1987-Nov 2024
Source: Bloomberg
Our good friend, Grant Williams, reminds of us this wonderful quote from our other good friend, Jim Grant, in this linked interview. As always, with Grant, this is a wonderful interview.
Confusion, Division, Loss of Trust: How The Investment World Has Changed | Grant Williams
“The price of gold is the inverse of trust in the central banks.” Jim Grant via Grant Williams
We borrowed from Jim with our reconstructed version of this quote referencing Bitcoin way back in our December 2020 Update –“Inflation is upon us; 60/40 is dead” https://convex-strategies.com/2021/01/22/risk-update-december-2020/.
We said it this way back then, and our minds haven’t changed.
“…the below chart of Bitcoin versus a debasing USD might be considered early-stage hyper-inflation. At the very least inflation. We like to think of this chart as the report card for central bank competence (it is, of course, on an inverse scale). They should look at this every morning and consider how the world is judging their policies.”
Updating the Bitcoin chart and highlighting the circumstance that we were focused on back in 2020, looks like the below.
Figure 8: XBT/USD (Bitcoin). December 2020 (red oval). 2019-2024
Source: Bloomberg, Convex Strategies
As luck would have it, we caught this too-short interview with the incomparable Jim Grant. Amongst an endless stream of pearls, we grabbed this little quote that very much aligns with our catchphrase of “Who’s going to own the 40?” (the ‘40’ is pulled from the bond holdings in a 60/40 balanced portfolio but we use this aphorism to represent all the misguided holdings of Sharpe World-duped bonds).
Jim Grant on rising bond yields: The market thinks the Fed may have overdone it
“Great excesses characterize great bull market tops and great bear market bottoms. I think the $18.44 trillion (of negatively yielding bonds) was a clarion call that this 40-year bond market was over.”
Figure 9: Notional of Global Debt Outstanding with a Negative Yield. 2012-2024. Peak Dec 2020 (red line)
Source: Bloomberg, Convex Strategies
We don’t know who is going to own all the bonds, but we do occasionally hear from some folks that are saying publicly that it is not them!
For example, Stan Druckenmiller. In this interview Stan is firmly negative on bonds and shares similar views to our own about the capabilities of the Fed.
Stan Druckenmiller on Fed Policy, Election, Bonds, Nvidia
Stan, likewise, throws out yet another quote from mutual friend Jim Grant!
“The Fed is not really data dependent; they are forward guidance dependent.” Stan Druckenmiller quoting Jim Grant.
Stan echoes our oft emphasized point that the Fed (and their many followers) should not obsess over soft landings and fine tunings of the economy. They should be focused on preventing catastrophic outcomes. They really need some grounding in self-organized criticality.
Paul Tudor Jones is not going to buy the bonds.
Legendary investor Paul Tudor Jones: I am clearly not going to own any fixed income
Paul was interviewed by CNBC anchor and Sharpe World mouthpiece, Andrew Ross Sorkin. In one wonderful exchange, Sorkin tries to defend US Treasury bonds with the ‘cleanest dirty shirt’ argument. Paul is having none of it.
ARS: “Life is relative, as some people say. Sure, you can either buy bonds from the US or you can buy bonds from somebody with even a worse situation”
PTJ: “Or you can not buy bonds at all”
Hunger Games!
Towards the end, Paul makes his point about as bluntly as he can.
PTJ “I am clearly not going to own any fixed income….It is just completely the wrong price…All roads lead to inflation”
Paul throws in one of the best metaphors for current economic circumstances that we have ever heard, and we are going to use it all the time!
“We are in an economic kayfabe right now.” Paul Tudor Jones, October 2024.
For those unfamiliar, the term kayfabe comes from the world of professional wrestling and represents the concept of presenting staged events as though they are authentic and the effort to deceive the general public as to that truth. What a great way to describe how the high priests of Sharpe World go about their art of deception.
Forward guidance from central bankers. Behavioural manipulations couched in the form of economic forecasts. Expected returns from investment advisors. Simplistic linear regression models and Gaussian distributions. Applications of ensemble averages ignorant of time and breaks of ergodicity. It really is all staged and scripted, and we are pretty sure that they all know it.
In one of his recent memos, Howard Marks puts it ever so politely.
Ruminating on Asset Allocation Howard Marks memo.
“Many investors use computer models to help with these decisions, but the models require inputs, regarding expected returns, risk, and correlations, and most of these are based on history and, thus, of questionable relevance to the future. Correlations between asset classes is particularly difficult to predict. It is often a case of garbage in and garbage out (but with the added comfort of using mathematical models).”
Bonds have been a terrible portfolio complement for a very long time, certainly going back to the advent of QE post the Great Financial Crisis. Does anybody really think, within the present kayfabe, that bonds will magically become a wealth preserving, portfolio benefit, going forward?
The solution, and as we always say, “it’s just math”, has always been adding convexity to your investment portfolio. Change your optimization to focus on the risk and benefits of divergences from the mean of some made-up expectation.
To illustrate we simply compare a hypothetical portfolio of explicit loss mitigation (in the form of the CBOE Eurekahedge Long Volatility Index – EHFI1451 Index “LongVol”) and beta (S&P Total Return Index – SPXT Index) against the US Treasury total return index (LUATTRU Index). After a little trial and error, we have slightly randomly (because it looks good in the scattergram) chosen a weighting of 67% allocation to LongVol and a 33% allocation to SPXT rebalanced annually, for our Barbell convexity-improved alternative to holding bonds. We’ve picked as our start date March 2009, the advent of QE.
Figure 10: Hypothetical Barbell 67% LongVol / 33% SPX Total Return (blue) vs 100% US Treasury Total Return. March 2009-Sept 2024. Scattergram and Return Distribution
Source: Bloomberg, Eurekahedge, Convex Strategies
Figure 11: Hypothetical Barbell 67% LongVol / 33% SPX Total Return (blue) vs 100% US Treasury Total Return. March 2009-Sept 2024. Compounding View
Source: Bloomberg, Eurekahedge, Convex Strategies
The greater convexity and its benefits are plainly visible to the naked eye. And clearly getting even more valuable over recent years
The Barbell has a lower Max Drawdown over the period. -4.0% vs -18.3%.
The Barbell has lower Downside Volatility. 2.0% vs 2.7%.
The Barbell has a more negative Downside Beta. -0.24 vs -0.03.
The Barbell has more positive Upside Beta. 0.23 vs 0.01.
The Barbell has a higher CAGR. 6.3% vs 2.0%.
More return, less risk. Bigger numerator, smaller denominator. More actual diversification benefit to growth assets.
We will close with one last quote from the above linked interview with Grant Williams. Grant is singing from our hymn book. The opportunity cost of forever driving slowly because you don’t have good brakes has been a wealth destroyer, on both wings of the distribution. Get prepared and get active.
Grant Williams 51:17 “Being prepared for it, and it not happening, terrific! That’s a phenomenal outcome. Deciding you don’t need to prepare for it, and it happens anyway, that’s a catastrophic outcome.”
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