We have pointed to similarities between the Fed’s current rate cutting cycle and the one back in the second half of 1995. Given the length of experience around here, we are regularly asked questions like: “have you ever seen a circumstance where the Fed cut rates, and kept cutting, even as their financial conditions were this loose, and equity indices were at historical highs?” Our answer is easy: “Yes, from July 1995 through January 1996. The Fed cut three consecutive times under those conditions.”
After the Fed’s first cut back in September, we showed the below chart in our September 2024 Update – “Emergence” Convex Strategies | Risk Update: September 2024 – “Emergence” . Since then, most recently again in December, the Fed has cut two more times, thus far a total of 100bps in cuts, all under the circumstances of loose financial conditions and fresh new highs in equity indices. Indeed, the S&P went on arguably its best five-year run ever through 1995-1999.
Figure 1: Fed Chicago Financial Conditions Index (white). Fed Funds Rate (blue). SPX Index (papaya-log scale). Vertical Line July 1995 (white) and Sept 2024 (red). Sept 1987-Dec2024
Source: Bloomberg, Convex Strategies
Easy enough to see what happened after the two highlighted vertical lines; the S&P index went higher, and financial conditions remained loose. What else is it that gives us déjà vu? Well, the US dollar (USD) strengthened and kept strengthening. Using the DXY Index as our proxy for the USD, we can see that it appreciated circa 50% (80.0 to 120.0) post that initial Fed rate cut in July 1995.
Figure 2: USD DXY Index (purple). Vertical Line July 1995 (white) and Sept 2024 (red). Sept 1987-December 2024
Source: Bloomberg, Convex Strategies
What else?
Back-end interest rates went higher. We are sure that everyone has been hearing of late about the anomaly of 10yr yields rising after the Fed has cut interest rates. This is a great visualization showing the behavior of US 10yr Treasury yields the year before and after rate cuts.
Figure 3: US 10yr Treasury Yields Relative Performance Before and After Fed Rate Cuts. Sept 2024 Cut (light blue). Sept 1998 (dark blue). Jan 1996 (fuchsia)
Source: Bloomberg, Convex Strategies
We have highlighted the current cycle, now just three months into the rising 10yr yields, as well as the two periods, 1995/96 and 1998, where longer-dated yields climbed post the Fed’s cutting efforts. It has happened before, the grey lines at the very top coming from the Volcker era, but the other two coloured lines both come from that era of nostalgia, 1995-1999. Déjà vu.
The Fed is not alone in this dilemma. The Bank of England (BOE), protectors of the vast Liability Driven Investment scheme that undergirds UK pension funds, is staring down a problem that is at least as daunting as the Fed’s. The BOE has cut twice since end July 2024 and, we are guessing, isn’t getting the response they were hoping for.
Figure 4: UK 10yr Gilt Yields. Jan 2020-Dec2024
Source: Bloomberg, Convex Strategies
We talk about this a lot. For anybody that was directly involved in the bifurcation events around the globe (Asian Crisis, Russia Default, LTCM collapse, etc.) during 1995-1999, those were formative, and scarring, experiences. Experiences that were very clarifying of Benoit Mandelbrot’s claim that risk is subjective. Or how our friend Hari Krishnan put it, risk is about vulnerability not predictability. To put it in our race car analogy terms, as a driver, your risk is your car not the unknown future curves.
We elaborated on the role that the USD strength against the JPY played in the subsequent chaos over that period in our April 2024 Update – “Wittgenstein’s Ruler” Convex Strategies | Risk Update: April 2024 – “Wittgenstein’s Ruler”.
“If any readers were around for the wonders of the mid to late ‘90s, you might recall a little something that came to be known as the Asian Crisis. One of the telling issues, though not often commented upon, is the buildup to and subsequent unravelling of the currency policies in EM Asia was the strength of USD/JPY from its lows in April 1995 (79.80 where the Fed stepped in to provide a helping hand in intervention) through to the highs in August 1998 (circa 147.50). This USD/JPY strength played a not insignificant role in tearing up managed/pegged currency policies from Thailand in July 1997 through to Malaysia and Russia in Q3 1998 (with shockwaves leading to the downfall of LTCM).
We can’t help but feel a certain amount of nostalgia given the current move of USD/JPY from near 110.00 just 4 years ago to now touching 160 as FX market players continue to revel in the interest rate differential driven incentive to short the JPY. Meanwhile, the more ‘controlled’ currencies in the region have been much steadier against the USD in their respective markets.”
Updating one of the pictures we showed in that note looks like this.
Figure 5: USD Spot FX against JPY (white), CNH (blue), KRW (papaya), THB (purple), IDR (yellow), PHP (light blue), TWD (orange). Vertical Lines July 2024 (white) and Sept 2024 (red). April 2020-December 2024
Source: Bloomberg, Convex Strategies
We have highlighted with our vertical lines July 2024 (white), the month that the Bank of Japan (BOJ) hiked rates, and September 2024 (red), the month that the Fed kicked off their rate cuts with their initial 50bp slash. Pretty easy to see that it likely isn’t working out how they had planned.
After their initial hike, 10yr JGB yields plummeted but, like seemingly everyone else, they started right back higher again after the Fed’s cut in September.
Figure 6: 10yr JGB Yields. Jan 2020-Dec 2024
Source: Bloomberg, Convex Strategies
We can zoom in and take a look at currency performance against the USD since the Fed commenced their rate cuts on September 18th. First a block of Asian EM Currencies.
Figure 7: CNH (blue), INR (papaya), KRW (light blue), SGD (fuchsia), IDR (purple) all vs USD. Normalized. 18 Sept 2024 – 3 Jan 2025
Source: Bloomberg, Convex Strategies
As a general rule, everybody is getting weaker versus the USD. The two that seem to be making the most concerted effort to resist the trend are the CNH and the INR. Both of those fall into the active-managed/quasi-pegged categories. All should recall one of our core aphorisms: “Pegs end badly. All pegs end.” We will come back to this.
Now a block of, supposed, DM currencies. Basically, an across the board debasement, relative to the USD, of between 5% and 10%, in a little over 3 months. Of these, the ECB, SNB, BOE, RBC and RBNZ have all been cutting interest rates.
Figure 8: EUR (white), JPY (blue), GBP (papaya), AUD (purple), NZD (yellow), CAD (light blue), CHF (orange) all vs USD. Normalized. 18 Sept 2024 – 3 Jan 2025
Source: Bloomberg
Currency wars, again?
We pondered this same topic way back in our July 2019 Update – “Currency Debasement Time….Again” Convex Strategies | Risk Update: July 2019 – Currency Debasement Time….again.
It is an interesting note to go back and take a look at, as we were observing then many of the building fragilities that would become the “red circles” (how we highlight extreme levels on historic charts) ahead of what was subsequently dubbed the “Covid Crisis”.
It was about this time that we started naming our big white board, where we note significant events in a timeline which consist mostly of central bank and government policy announcements. The first board that we named was towards the end of 2019. We called it “Peak China”. The subsequent board, board #2 commencing early 2021, was “End of Monetary Stimulus”. We renamed board #3 in September 2022 to “The Hiking Cycle”. In September 2023, we updated board #4 to “The Steepening Cycle”. We haven’t yet transitioned to board #5, still waiting for another couple months of CB policy meetings to go up, but we have a pretty good idea of the new name, “Correlation’s a B!t$h”.
Just a quick update of a picture we use often, that also appeared in that July 2019 update, the ratio of China’s FX Reserves to their M2 Money Supply.
Figure 9: China FX Reserves/M2 Money Supply
Source: Bloomberg, Convex Strategies
We suspect that it is the fragility implicit in this picture that explains the behavior of the PBOC in their lack of adherence to their own formal FX fixing methodologies. Just as we saw over the last 3+ years, during periods of USD strength, the PBOC shuts down their official fixing process and goes back to, essentially, pegging the CNY against the USD. We assume it is out of fear of triggering an avalanche, that they can’t control, of money trying to circumvent their capital control regime and get out. Thus, we get this dynamic, yet again, as their official fixings divert from what their model would declare as the fixing. See above for our thoughts on pegs.
Figure 10: Daily Divergence of CNY Fix vs Modeled Estimated Fix. June 2018-Dec 2024
Source: Bloomberg, Convex Strategies
There is the one thing, of course, that stands out as different this time around. That being the giant elephant in pretty much everybody’s living room – too much debt! One of the things that stands out in that 1995-1999 window was the rarest of occurrences in the US, a declining Debt/GDP ratio.
Figure 11: US Federal Debt/GDP (log-scale). 1980-2024
Source: Bloomberg, Convex Strategies
Thus, despite the rising 10yr yield subsequent to the Fed rate cuts in late 1995 and again in late 1998, the burden of interest cost on the government was nothing at all like we are enduring today.
Figure 12: US Gross Federal Debt (purple) and Interest Payments (papaya). US Tsy 10yr Yield (yellow) 1980-2024
Source: Bloomberg, Convex Strategies
We might argue that this is the core challenge facing the incoming Trump administration and, given the universality of excess debt around the globe, really the key to the whole existing global monetary system.
Stephen Miran of Hudson Bay Capital penned a fairly comprehensive research note on some of the discussions around anticipated Trump administration global policies in “A User’s Guide to Restructuring the Global Trading System”.
638199_A_Users_Guide_to_Restructuring_the_Global_Trading_System.pdf
We don’t necessarily agree with all of Stephen’s assumptions and conclusions, but this is a very worthwhile read to get an idea of how at least some factions within the Trump team are thinking. One thing that we think is worth particular attention is the discussion around the views of Scott Bessent, Trump’s Treasury Secretary nominee, as regards segmenting countries around the globe “into different groups based on their currency policies, the terms of bilateral trade agreements and security agreements, their values and more”.
He goes on to quote Mr. Bessent:
“more clearly segmenting the international economy into zones based on common security and economic systems would help …. highlight the persistence of imbalances and introduce more friction points to deal with them.”
This note is a great follow-up to the Russell Napier note that we linked to in last month’s Update Convex Strategies | Risk Update: November 2024 – “Rationality Wars”
America, China, and the Death of the International Monetary Non-System – American Affairs Journal
Russell’s point, overly simplified, is – will the US and China be able to sit down and amicably negotiate a new global monetary system or will one side or the other try to unilaterally impose their will. The potential for volatility, as the decades of accumulated imbalances are targeted for correction, seems obvious.
Fortunately, we have a fresh consultation report from the Financial Stability Board (FSB) to help remind us where at least some of the fragility exists. The consultation report is titled “Leverage in Non-bank Financial Intermediaries”. As usual, the FSB walks a fine line between warning of structural risks and offering up solutions that seem intent on forever expanding moral hazard in the system.
Leverage in Non-bank Financial Intermediation: Consultation report
Just a few blurbs from the summary:
“This work is part of the broader FSB work programme on enhancing the resilience of NBFI, which is intended to ensure a more stable provision of financing to the economy and reduce the need for extraordinary central bank interventions.”
“Certain factors, which include interconnectedness, concentration and liquidity imbalances can amplify vulnerabilities related to leverage and accelerate and magnify disruptions that leverage can generate withing the financial system.”
“Authorities should select, design and calibrate policy measures as necessary to give them confidence that underlying vulnerabilities and financial stability risks arising from NBFI leverage would be sufficiently addressed.”
The gist is, they want these NBFIs to use their access to leverage to buy up all the government debt but not blow up the whole system every time a shock comes along. Regular readers will know that this is a running theme in these pages, maybe best summarized in the September 2022 Update – “Is Sharpe World Closing?” Convex Strategies | Risk Update: September 2022 – Is “Sharpe World” Closing?
Inside this note we linked to five of our past Risk Updates where we had previously discussed the efforts of various regulatory bodies to tell us how they were making the system safer. We closed this note pondering the risk of the powers-that-be closing the exit gates of Sharpe World, attempting to trap the capital that they need inside their own systems to absorb the incessant bond issuance of profligate governments. This is where we, like Russell and Stephen, ponder ever more financial repression and growing risk of capital controls as the various players battle for ever scarcer supply of liquidity to buy their mountains of debt. We have dubbed this dilemma “The Hunger Games”.
We don’t know if these imbalances, for one reason or another, are going to suddenly start to correct, triggering another 1997/1998 style ripping apart of heretofore stable currency parities. Or if the Stein’s Law dynamic of insatiable government borrowing will finally come to its inevitable hard stop. Or if, on the other hand, the intended solution of ever greater asset inflation can just keep going and going. What we do know is that, in the realm of fiduciary wealth management, actual risk is the failure to compound wealth over time.
We think of the below slide as a representation of opportunity cost. What has been the foregone compounding opportunity of adhering to Sharpe World orthodoxy and “driving slowly” through holding large swaths of bonds and relying on flawed assumptions about stable correlations as your key risk mitigation tools?
This picture represents a 30-year investment horizon; the last 15 years since 2009 and the next 15 years yet to come. We’ve set as the target return (CAGR) at 9%, simply as that is roughly what a US based 60/40 (SPX Total Return SPXT Index/US Treasury Total Return LUATTRUU Index) has returned over the 15 years with annual rebalancing. We have added some common Sharpe World-style strategies, Risk Parity (S&P Risk Parity Total Return 10v SPRP10T Index), Endowment (Endow Index), and the CBOE Put Write Index (PUT Index) which serves as a decent proxy to absolute return Hedge Funds, albeit before their egregious fees.
We have also included a couple of our favourite sample hypothetical portfolios that replace bonds, and reliance on stable correlations, with explicit negatively correlating protection in the form of the CBOE Eurekahedge Long Volatility Index (“LongVol” EHFI451 Index), an index of active long volatility managers. This explicit protection then allows for greater weightings in upside participating risk. We have “Always Good Weather” (AGW) with 40% in S&P, 40% in Nadaq (NDX100 Total Return XNDX Index) and 40% (2x levered 20%) in LongVol and we have our “Dream Portfolio” with 70% in S&P, 20% in gold (XAU), and 20% (2x levered 10%) in LongVol. These, again, get rebalanced annually.
Figure 13: Opportunity Cost: Hypothetical Relative Performance of AGW (dark blue), Dream (light blue), Endowment (fuchsia), Put Write (orange), 60/40 (red), Risk Parity (brown), vs 9% Targeted CAGR. 2009-2024 realized. Target path 2025-2039
Source: Bloomberg, Eurekahedge, Convex Strategies
Risk, from the end capital owner’s perspective, is divergence from the targeted compounding path and the related likelihood of achieving terminal capital requirements. Strategies below the dotted line have been poor risk managers, driving too slowly during the good parts and too fast during the bad parts. Their lack of positive convexity has impaired their compounding, they are seemingly behind their targeted path and, in our view, are probably not making things better in their plans to try to catch back up. Meanwhile, the two hypothetical strategies with explicit protection and better overall convexity would have managed risk well and built good buffers above the targeted return path. They, if properly constructed, would we believe still have more upside potential participation and better downside protection. They are theoretically set up to benefit from ongoing asset inflation, and to protect from unforeseen corrections to a fragile system.
Risk management isn’t about guessing what the future will look like. Risk management is about building resilience into an investment portfolio such that it benefits from divergences from the expectations. It is about managing the denominator, not just the numerator.
The below bubble chart, using Downside Volatility as an indicator of risk, despite being hypothetical, once again disputes the Sharpe World claim that more risk equals more return.
Figure 14: CAGR vs Downside Volatility, Jan 2010 – Dec 2024
Source: Bloomberg, Eurekahedge, Convex Strategies
As ever, we implore everybody to raise the discussion as to what you and/or your fiduciaries are doing about adding convexity to your portfolio. The objective has to be geometric compounding, has to be about the non-ergodic path over the investment lifecycle. Compounding is about time and avoiding outcomes that are hard to recover from (crashing). The sooner you start driving confidently, knowing you have effective brakes on your race car, the sooner you can start improving the risk stature of where you are on your path to targeted terminal capital.
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