“I guess I’d say this, uncertainty is with us all the time. It’s, it is human nature apparently to underestimate the, how fat the tails are in a way, that the possibility, we think of things in a normal distribution and in the economy it’s not a normal distribution. The tails are very fat, meaning things can happen way out of your expectations, it’s never not that way.” Federal Reserve Chair Jerome Powell, January 2025.
Transcript of Chair Powell’s Press Conference January 29, 2025
Chair Powell singing straight out of our hymnal! We would like to commend him, and thank him, for his honesty. Inevitably, however, Chair Powell was unable to sustain such transparency throughout the entirety of the press conference. We share maybe the two most egregious deviations.
First, in response to a question noting that mortgage rates have risen by a full percentage point since the Fed commenced rate cuts in September, Chair Powell brushed away the suggestion that the rising back-end interest rates could somehow be related to their own loosening of policy rates.
“So, as you know, as we’ve reduced our policy rate 100 basis points, longer rates have gone up. Not because of expectations, not principally because of expectations about our policy or about inflation, it’s more a term premium story. So, and it’s long rates that matter for housing. So, I don’t think, I think these higher rates are going to, they’re probably hold back housing activities to some extent if they’re persistent. We’ll have to see how long they persist. So, we are, we control an overnight rate, generally it propagates through the whole family of asset prices, including interest rates, but in this particular case, it’s all happened at a time when for reasons unrelated to our policy, longer rates have moved up.” Jerome Powell, January 2025. (Our highlights in bold.)
If term premium is not about expectations of future interest rate policy or future inflation paths, then we don’t know what it is. It boggles our mind that (supposedly) intelligent financial journalists don’t follow up on these sorts of statements. We would desperately like to know what Chair Powell thinks term premium is! The final statement that we have highlighted wouldn’t pass silently in Macro-Econ 101 but, in a room full of the crème de la crème of financial journalists, it goes unchallenged, and we move onto the next topic.
The other egregious spin was in regards to a question hinting at the impact of Average Inflation Targeting (AIT), as laid out in the August 2020 revised “Statement on Longer-Run Goals and Monetary Strategy”, and commonly pitched to the public as “letting inflation run hot” or “waiting to see the whites of the eyes of inflation” and the role such policy played in the subsequent historical overshoot of the Fed’s price stability mandate.
“That’s what we said. That was, turned out not to be relevant to what actually happened. There was nothing moderate about the overshoot. It was, it was an exogenous event, it was the pandemic, and it happened and our framework permitted us to act quite vigorously and we did once we decided that that’s what we should do, the framework had really nothing to do with the decision” Jerome Powell, January 2025.
Chair Powell throws out the now standard central banker Orwellian rewrite of history on this topic. Their newly revamped policy, AIT, layered on top of ongoing efforts of ZIRP and QE, all unprecedented and explicitly intended to reignite inflation, had nothing to do with the subsequent reigniting, well beyond expectations, of inflation. Give us break.
Figure 1: US CPI Index. Vertical Line August 2020. 1987-2024
Source: Bloomberg, Convex Strategies
We are on record that, in our opinion, AIT should be removed in this year’s upcoming 5-year review of the “Strategy Framework” and really should come with an apology, but we wouldn’t advise holding your breath. It would be an additional bonus if something was noted about QE becoming an ‘in case of emergency’ only tool as well.
We wrote at some length on the upcoming review back in our November 2024 Update – “Rationality Wars” https://convex-strategies.com/2024/12/16/risk-update-november-2024-rationality-wars/, should anybody want to review our thoughts.
In the end, the Fed decided to hold policy unchanged at the latest FOMC meeting. Nobody really knows if that is because they felt like the economy didn’t need any more loosening from their front-end rate cuts or if the economy didn’t need any more tightening from the impact on back-end rate increases.
Figure 2: US Fed Funds Rate (white) and 10yr Tsy Yield (blue). 2015-2024
Source: Bloomberg, Convex Strategies
Meanwhile, on the other side of the Atlantic, the ECB powered ahead with their fifth rate cut since June of 2024, cumulatively 125bp of cuts from the peak.
“The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. In particular, the decision to lower the deposit facility rate – the rate through which we steer the monetary policy stance – is based on our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission.” Christine Lagarde, January 2025.
Figure 3: Eurozone HICP yoy% (blue) HICP Core yoy% (papaya) vs ECB Deposit Rate (white) 2000 – Jan2025
Source: Bloomberg
During the Q&A session, President Lagarde fielded a number of questions around her perception of the current policy stance. She made it very clear that, while they are technically data dependent, the direction of movement is evident. Rates will go lower; it is just a question of pace and scale. She brushed aside any suggestion, as has been hinted by fellow ECB Council member Isabel Schnabel, that they may be approaching an end to their lowering, aka normalising, of interest rates.
“But let’s face it: we are currently restrictive. We are not at the neutral rate. This is a debate that is entirely premature.” Christine Lagarde, January 2025.
At one point, President Lagarde referenced this new r*/neutral/natural rate review from the ECB Monetary Policy Strategy team. We won’t bother to go into this, leaving it to reader’s discretion if they want to click down and read it, but will just note that, best case, they don’t know what it is.
As we have long said, if you think your r*/neutral/natural rate is a negative real rate, there must be something structurally wrong with your economy that needs fixing, something that needs more than just forever lower nominal rates.
Turns out, we may not be the only ones that think that way! Bank of Japan (BOJ) Deputy Governor Ryozo Himino very explicitly said the same thing in a recent speech.
Japan’s Economy and Monetary Policy
“I do not think it normal for negative real interest rates to persist once the shocks and deflationary factors are resolved” BOJ Deputy Governor Ryozo Himino, January 2025.
This is a sentiment that we have often heard exists within the inner circles of Governor Ueda’s academic economists’ crowd. We were very pleased to see it so clearly stated in public. Obviously, if this belief were to become the pervasive view within the BOJ, we should expect a bit more effort to adjust from the current state of ongoing negative real interest rates. There may be just a wee chance that folks inside are starting to consider our oft asked question: “What if it works?”
As has been the case ahead of policy actions in the Ueda era, there were indications in the press of the likelihood of another policy adjustment in the days leading up to the January BOJ Monetary Policy Committee meeting. See, for example, this Reuters article.
Rosy wage outlook, weak yen drawing Bank of Japan attention to inflation risks | Reuters
“Prospects of sustained wage gains in Japan and the boost to import costs from a weak yen have heightened attention within the central bank to rising inflationary pressures that may lead to an upgrade in its price forecast this month, sources said.”
Sure enough, and again in line with their quarterly update of projections, the BOJ did raise their policy rate by 0.25%.
https://www.boj.or.jp/en/mopo/mpmdeci/mpr_2025/k250124a.pdf
“In view of these circumstances, the Bank judged it appropriate to adjust the degree of monetary accommodation from the perspective of sustainable and stable achievement of the price stability target of 2 percent. Real interest rates are expected to remain significantly negative after the change in the policy interest rate, and accommodative financial conditions will continue to firmly support economic activity.”
They provided us all with this nice visual summary. As seems to be becoming the norm, the policy adjustment aligned with the quarterly update on projections and was supported by higher revisions in the forecasts for their price stability target reference, Core CPI (all items less fresh food).
https://www.boj.or.jp/en/mopo/mpmdeci/mpr_2025/k250124b.pdf
Source: https://www.boj.or.jp/en/mopo/mpmdeci/state_2025/index.htm
The official statements still note their desire to maintain “significantly negative” real rates and “accommodative financial conditions”. Officially, the stance persists that “IT WILL NOT WORK!”, even as it appears to be working.
Why do we say that? Well, here is the full revised outlook report.
https://www.boj.or.jp/en/mopo/outlook/gor2501b.pdf
Figure 4: BOJ Revised Forecasts as of January 2025
Source: https://www.boj.or.jp/en/mopo/outlook/gor2501b.pdf
Governor Ueda’s first policy meeting was in April 2023. At that meeting we had realized Fiscal Year 2022 Core CPI at 3% and they came out with projections for FY’23 of 1.8%, FY’24 of 2%, and FY’25 of 1.6%. We have since realized FY’23 at 2.8%, now projecting FY’24 with just a couple of months remaining at 2.7%, projecting FY’25 at 2.4%, and projecting FY’26 at 2%. The revised set of projections is the first time since the acceleration in inflation that the furthest out forecast, FY’26 in this case, has reached 2%. We will just add in that, in April 2023, the USD/JPY FX rate was circa 135.00. It’s working.
Figure 5: Japan Core CPI Forecasts and Realized. 2010-2026
Source: Bank of Japan, Convex Strategies
We can get a little bit of a sense of a similar attitude from some of the unattributed comments published in the Summary of Opinions at the Monetary Policy Meeting.
Summary of Opinions at the Monetary Policy Meeting on January 23 and 24, 2025
“The negative impact that the yen’s depreciation has had on households and firms, through various cost increases, has been caused by the accumulated effects of the yen depreciating in the medium to long term, rather than short-term fluctuations in exchange rates”
Regular readers will know that our definition of “working” in our discussions with friends at the BOJ has always been the simple metric of rising measures of CPI and a weaker yen.
“Real interest rates are expected to remain significantly negative after the policy interest rate hike. If economic activity and prices remain on track, it will be necessary for the Bank to continue to raise the policy interest rate accordingly, so that the negative range of real interest rates will shrink.”
They don’t attribute who says what in these summaries but, given the comments in the above speech, we think that this sounds suspiciously like Deputy Governor Himino.
“With economic activity and prices remaining on track, risks to prices have become more skewed to the upside. It is therefore appropriate for the Bank to adjust the degree of monetary accommodation in a timely and gradual manner.”
If risks to prices are skewed to the upside, why are they still running highly accommodative policies and only adjusting such in a gradual manner?
And, finally, one right on the bullseye.
“Prices could deviate upward from the baseline scenario due to further progress in the pass-through of cost increases to consumer prices toward fiscal 2025 and to the depreciation of the yen. In addition, investors’ expectations have increased, following a rise in asset prices including real estate. It will be necessary for the Bank to adjust the degree of monetary accommodation from the viewpoint of avoiding the yen’s depreciation and the overheating of financial activities, both of which appear to be due to excessively high expectations of continued monetary easing.”
To us, this sounds like truth. Is anybody listening? Could the weak yen, above target price stability measures, rising inflation expectations, surging asset prices, have anything to do with “excessively high expectations of continued monetary easing”?
Fortunately, we can get a wonderfully thorough answer to all things Bank of Japan policy related from their recent 25-year review, “Review of Monetary Policy from a Broad Perspective”. Governor Ueda announced the undertaking of the “Review” in April 2023, and it has taken a little over a year and a half to generate this.
Review of Monetary Policy from a Broad Perspective
This behemoth comes it at circa 200 pages, but it is a beauty. We would recommend keeping it close to hand and using it as a go-to reference for all things Japan. For anybody new-ish to the wonders of the Japan markets and economy, and the BOJ’s undue influence in such, for the last 25 years, this is truly a graduate level course guide.
The Review leads off with a history of monetary policy over the last 25 years (we wish they would have gone back even further). They provide this nice view of the various iterations of policies over the period and then overlaid with a timeline of interest rates going back to 1985.
Figure 6: Bank of Japan Monetary Policy over 25 years
Source: Bank of Japan
Figure 7: Bank of Japan Overnight Call Rate and JGB 10yr Yield. 1985-2024
Source: Bank of Japan
Figure 8: Japan CPI and real GDP
Source: Bank of Japan
You can’t say that they didn’t put in the effort. Also, you could make some supposition that, given the CPI behaviour in recent years, it might be working. Nevertheless, as they keep stressing, they are sticking with significantly negative real interest rates.
Figure 9: Japan 1yr Nominal and Real Interest Rates. 1995-2024
Source: Bank of Japan
Figure 10: Japan 10yr Nominal and Real Interest Rates. 1995-2024
Source: Bank of Japan
In the above two charts, the real interest rates are calculated relative to the composite index of inflation expectations, an index that continues to track well below that of recent years’ actual realized inflation, an issue that we might argue has been one key factor in the BOJ’s lagging removal of policy accommodation. We always like to ask the question as to who is actually behind the so-called “deflationary mindset”. Maybe it is the guys that keep low-balling their forecasts? Nevertheless, the direction of movement and the absolute level would, again, give credence to the inkling that it might be working.
Figure 11: Japan Inflation Expectations Indices. 2007-2024
Source: Bank of Japan
This chart of wages and Core CPI is maybe the most visually obvious that, at the very least, something has changed. The current levels of year-on-year changes have not been seen since the Japan bubble burst in the early ‘90s, and have now sustained through three years, with even BOJ forecasts now predicting them to do so through 2026. Yet, they stick with highly accommodative, negative real interest rate, policy settings.
Figure 12: Japan Wage Measures and Core CPI. 1991-2024
Source: Bank of Japan
Something that is, slowly, getting increasing consideration are the challenges around the declining population. Is it possible that the declining working-age population is impacting the tightness in the labor force and, as such, the rising wage dynamic? Again, is aggressively accommodative monetary policy the right medicine for this circumstance?
Figure 13: Japan Population Demographic Outlook
Source: Bank of Japan
Maybe our favourite pair of charts come from Appendix 1, relating to the engagement with the public on their views around the period of monetary easing. The below charts speak for themselves, households clearly feel the side effects outweigh the benefits. This may have something to do with the recent electoral challenges for the long-dominant LDP ruling party.
Figure 14: Japan Household Perceptions on Monetary Easing
Source: Bank of Japan
Finally, Appendix 2 takes on a discussion around the “Development in the Natural Rate of Interest”. This, along with other mythical numbers like underlying inflation and inflation expectations, continues to be at the heart of the argument for sustaining the highly accommodative policy setting. Per most likely Himino’s comments above, we would keep an eye on this issue battling out between the academic economist set and the technocrat staff crowd.
Figure 15: Japan Estimates of the Natural Rate of Interest. 1990-2024
Source: Bank of Japan
We will reiterate, this is a fantastically useful overall reference source. It will provide any reader with an immediate, up to date, understanding of the history and circumstance of BOJ policy. If said readers are anything like us, it will leave you scratching your head as to how they continue to justify their current policy setting.
As an aside, it is worth noting that a new member has been nominated to join BOJ Policy Board. Junko Koeda would seem to be adding to the ranks of what we class the “academic economist” faction and, as noted in the linked Reuters story, has in the past been critical of the prolonged monetary easing.
Japan government nominates female academic to join BOJ board | Reuters
“Japan’s government on Tuesday nominated Junko Koeda, an academic who had warned of the cost of prolonged monetary easing, to join the Bank of Japan board in March, a choice analysts say will keep the central bank on course to raise interest rates.”
Japan is in a league of their own when it comes to the extent and longevity of their monetary extremism. How they unwind it and the impacts that may have around the globe, particularly given their role as the world’s largest net foreign creditor, is an exercise in the management of imbalances and fragility that is certainly worthy of attention.
The guru of fragility vs antifragility, Nassim Taleb, just drafted this succinct little note on the topic. (99+) What Is Antifragility?
“(A)n accelerating (super-linear) response to negative stressors (as well as the passage of time) and a decelerating (sub-linear) response to positive outcomes portend fragility; the reverse situations represent antifragility, limited of course to a specific range of variations and a certain time window.” Nassim Taleb, January 2025.
In our race car analogy terms, fragile is accelerating/driving too fast in the dangerous parts of the track and decelerating/driving too slowly in the safest of straightaways. Antifragile is the inverse.
In a world full of imbalances and fragilities, it is the investment manager’s job to build portfolios that are antifragile to divergences from expectations. It is not their job to try to guess what the future will, probably, look like and then leave a portfolio that is susceptible to the volatility drag of performance as outcomes deviate from the mean of expectations.
We like to measure the antifragility in a portfolio with what we call the Convexity Ratio. As usual with us, this is just a simple heuristic calculated as (1+UpsideBeta/1+DownsideBeta). The below charts, similar to what we showed last month, base around a core of a traditional US-based 60/40 balanced portfolio, 60% in SPX Total Return (SPXT Index) and 40% in US Treasury Total Return (LUATTRUU Index). This 60/40 balanced portfolio, over the 10yr period, has a Convexity Ratio just barely above 1.00 at 1.01. The bonds added just ever so slightly some positive convexity. We rebalance the weightings annually.
Strategies that are below a Convexity Ratio of 1.00, in other words whose UpsideBeta is lower than their DownsideBeta, include the Sharpe World stalwarts of Risk Parity (SPRP10T Index), Endowment Index (ENDOW Index) and the EurekaHedge Hedge Fund Index (EHFI251 Index). These are all examples of strategies that are optimizing to the Wittgenstein’s ruler performance metric of a Sharpe Ratio, ie they are treating upside volatility the same as downside volatility, driving slowly to mitigate risk. This is reflected in their inferior accumulation of capital over the period.
The two hypothetical strategies with the higher Convexity Ratios, and consequently higher returns and larger terminal capital, are two of our regular examples of strategies incorporating explicit loss mitigation, in the form of the CBOE EurekaHedge Long Volatility Index (EHFI451 Index). One is our Always Good Weather Portfolio (AGW) which is comprised of 40% SPX Total Return, 40% Nasdaq Total Return (XNDX Index) and 40% of the Long Volatility Index. The other is what we call the Dream Portfolio made up of 70% SPX Total Return, 10% Gold (XAU Currency) and 40% the Long Volatility Index. Both of these have Convexity Ratios of 1.23, ie greater UpsideBeta than DownsideBeta. They are more antifragile, accelerating in good markets and decelerating in bad markets. Again, these are rebalanced annually.
Figure 16: CAGR vs Convexity Ratio. Jan 2010 – Dec 2024
Source: Bloomberg, Eurekahedge, Convex Strategies
We can look at those strategies over that same 10yr period in our Opportunity Cost view of things, using the past 10yr return of the 60/40 portfolio as our target return rate at 8.3%.
Figure 17: Opportunity Cost: Hypothetical Relative Performance of AGW (dark blue), Dream (light blue), Endowment (fuchsia), 60/40 (red), Hedge Fund (orange), Risk Parity (brown) vs 8.30% Targeted CAGR. 2015-2024 realized. Target path 2025-2039.
Source: Bloomberg, EurekaHedge, Convex Strategies
The superior Convexity Ratio strategies have the superior compounding paths. It is just math. The supposed diversifying strategies embedded in the inferior Convexity Ratio strategies (Risk Parity, Endowment, Hedge Fund), most of which will be adhering to an emphasis on stable correlation and positive carry, are impeding compounding paths. The explicit loss mitigation, true diversifying strategies, in the hypothetical AGW and Dream portfolios will be focused on the non-linearity of correlation and incurring negative carry. They are investing in the benefit of greater convexity. Positive carry does not equate to positive returns, nor does negative carry equate to negative returns. Risk management needs to be more thoughtful than that.
One last comment on correlation. In calendar year 2024, our sample 60/40 portfolio had returns of 15.24%. The S&P Risk Parity 10% Vol Index that we used above had 2024 calendar year returns of 5.36%. This is a stunning level of underperformance by the Risk Parity strategy. Risk Parity relies on taking advantage of historical correlations and volatilities to “risk weight”, often utilizing leverage, multiple asset classes across the portfolio. One could surmise, given the scale of underperformance in 2024, that correlations were not particularly stable and favourable. Continued such underperformance does risk ongoing pressure on said correlations.
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