“…granting boundless power to government agencies to solve the world’s problems does not square with my disposition…some may believe the biggest threat to our economy comes from outsiders who seek to change the status quo—I don’t agree…I believe the predominant risk come from choices made inside the four walls of our most important economic institutions.” Kevin Warsh, April 2025.
Commanding Heights April 25 2025 DC.pdf
Are the challenges of our times the results of policies enacted in the last 30, 60, 90 days or, more likely, accumulated through decades of efforts undertaken with minimal consideration to longer term consequences? We side with Mr. Warsh.
This is really a great speech that Kevin gave at the recent G30 hosted IMF Lecture. We highly recommend clicking in and giving it a read.
“To be trusted, economic institutions must be trustworthy. To be trustworthy, they must prove themselves competent. Economic institutions must also:
- Maintain epistemic humility – that is, accepting that knowledge, even great knowledge, has its limits;
- Abide by other limits – limits imposed by the Constitutional and laws – and by the good judgment of leaders – to constrain the inherent tendency to expand their footprint;
- Be permitted to act within well-defined ex ante frameworks; and
- Be accountable – the greater the power of the public institution, the greater its responsibility to explain and answer for its decision.” Kevin Warsh, April 2025.
If we had to make one complaint, on an otherwise exceptional speech, we would query why he felt that he had insufficient space or time for an explicit criticism of Flexible Average Inflation Targeting.
Overall, however, this jibes ever so nicely with much of our own past writings. We discussed similar considerations at some length in our April 2023 Update – “Credibility” Convex Strategies | Risk Update: April 2023 – Credibility.
“Credibility matters. With nothing backing the fiat currency, we need to trust that they won’t print away its value. With nothing backing deposits, we need to trust that our funds won’t be gambled recklessly…Neither of these have been turning out particularly well as of late.”
The “be accountable” bit, as we so often discuss, is really the key to all things risk related. To steal a recent quote from our great friend Niels Kasstrup-Larsen, of Top Trader Unplugged podcast fame https://www.toptradersunplugged.com/, in a discussion about the failings of central bank policies – “a vacuum of consequences”. Love that!
In a wonderful presentation for the Global Risk Institute our friend, William White, echoed much the same sentiment as Mr. Warsh.
“Above all, make those responsible pay a price.” William White, March 2025.
“Focus on systemic risks rather than triggers. In a systemically stressed system, anything can be the trigger…Forecasting in CAS [complex, adaptive, systems] is essentially impossible…What we are facing in a CAS is not risk, that you can measure and quantify, it is uncertainty.” William White, March 2025.
“In order to hold the whole system together, it’s important that steps are taken to try to deal with the problems of fiscal dominance and financial instability.” William White, March 2025.
Figure 1: Fiscal Dominance – US 5yr Treasury Issuance Size
Source: Bloomberg, Convex Strategies
This is a wonderful presentation on Bill’s long-established views of economies as complex, adaptive systems (CAS). He closes out the presentation referencing the note from his BIS successor, Claudio Borio, that we highlighted back in our November 2024 Update – “Rationality Wars” Convex Strategies | Risk Update: November 2024 – “Rationality Wars”.
Whither inflation targeting as a global monetary standard?
We would certainly add Bill’s presentation to our comments about Claudio’s being considered by those undertaking framework reviews in the coming months!
“It is very unlikely that we find ourselves with an invitation to the May 2025 powwow (the Fed’s framework review gathering) but, if we could be of any assistance, we would simply forward them this recent speech from Claudio Borio (we might argue, given Claudio had laid it all out, there is little need for the Fed to go much further).” Convex Strategies, November 2024.
Meanwhile, the other side of the fiscal dominance issues just keeps chugging along. We had our latest Quarterly Refunding update from the US Treasury and the accompanying Treasury Borrowing and Advisory Committee (TBAC) reports.
TreasuryPresentationToTBACQ22025.pdf
A couple of charts that give us little hope that there is likely to be near term improvement. So far, for Fiscal Year 2025, the budget deficit is accumulating at an historic rate.
Figure 2: US Cumulative Budget Deficits for Fiscal Years 2023, 2024, 2025
Source: TreasuryPresentationToTBACQ22025.pdf
Meanwhile, official assumptions about term funding costs seem out of synch with market pricing.
Figure 3: US CBO and OMB 10yr Treasury Rate Assumptions vs Implied Market Rates
Source: TreasuryPresentationToTBACQ22025.pdf
As they say, hope is not a strategy.
Over in Japan, the Bank of Japan (BOJ) made their Statement on Monetary Policy from their recent meeting as simple as possible.
“At the Monetary Policy Meeting held today, the Policy Board of the Bank of Japan decided, by a unanimous vote, to set the following guideline for money market operations for the intermeeting period:
- The Bank will encourage the uncollateralized overnight call rate to remain at around 0.5 percent.”
That’s it. All of it.
They did come out with their quarterly Outlook for Economic Activity and Prices.
Outlook for Economic Activity and Prices (April 2025)
We can update our view of BOJ versus their global peers on the metric of real policy rates versus inflation measures.
Figure 4: Real Rate vs Inflation Rate. Japan (red) vs Other Developed Countries
Source: Bloomberg, Convex Strategies
In their ongoing commitment that their aggressively stimulative policy setting “WILL NOT WORK!”, they lowered forecasts for fiscal year 2026 Core and Core-Core CPI from where they had projected them back in January of this year. These are now back below 2% for the FY2026 forecast. They, of course, will use this to claim that they have not yet achieved their 2% inflation target, despite having been above it, in realized terms, since Q1 2022.
Figure 5: Japan YOY% CPI (papaya), Core CPI (white), Core-Core CPI (blue)
Source: Bloomberg
Figure 6: Bank of Japan Inflation Forecasts
Source: Bank of Japan
For those unfamiliar with the recent forecasting prowess of the BOJ, we refer you to our tracking of their forecasts against realizations of their Core-Core Index (CPI ex Fresh Food and Energy). By our count, their forecast for this one has been lower than subsequent outcome (and lower than each subsequent projection) for 18 consecutive quarters. As Bill White often says, maybe they have the wrong model.
Figure 7: Japan Core Core CPI and Past BOJ Forecasts
Source: BOJ, Convex Strategies
While the BOJ remains staunch in their belief that their accommodative policy stance will fail to generate more of the inflation that they seemingly want, the longer dated JGB market seems somewhat more confident in the policy’s efficacy.
Figure 8: JGB 30yr Yield
Source: Bloomberg
As we discussed in the February 2025 Update – “Rational Accounting Man” Convex Strategies | Risk Update: February 2025 – “Rational Accounting Man”, they truly need Rational Accounting Man to step up and buy those long duration bonds.
All of this is just to say that the risk is endogenous. It is still the same old, same old: Who is going to buy the bonds? We had a nice little spark thrown into the fragile forest this month, in the form of Trump’s infamous Liberation Day tariffs. That created a bit of volatility, arguably cleaning out some risk from the system, right up until it got too close to the big one – that being the uncapitalized tail of bond holdings.
In yet another bit of déjà vu, we got to see this take place during Asian market hours of the morning of April 9th. For those who were around, this might have brought back memories of a similar Asian hours bond meltdown back on October 14, 1998. Back in those heady days, the panic was quickly reversed when the Fed threw in an emergency, non-meeting, rate cut later that day in US hours. This time, the bond panic, seemingly, led to a Trump Administration ‘pause’ of the global tariff impositions. As we heard from the administration many times, equity market volatility and losses are acceptable, but clearly the bond market must be protected.
Figure 9: US Treasury 2yr vs 10yr Yield Curve. Oct 14, 1998 (purple) and April 9, 2025 (blue)
Source: Bloomberg, Convex Strategies
How bad was it? Bad enough that the Bank of England had to cancel one of its scheduled bond auctions, part of its QT programme.
Bank of England Postpones Long-Dated Bond Auction After Market Rout
“The Bank of England dropped plans to sell around $780 million in long-term debt after this week’s market freak-out…The central bank said it will reschedule the sale until later this year.” Wall Street Journal, April 10, 2025.
As we have discussed many times before, one of the most open solutions for who is going to buy the bonds, at least in the case of the US, is to remove the Supplementary Leverage Ratio (SLR). This was written up in the below linked story in The Banker, referencing amongst other things the linked speech from US Treasury Secretary Scott Bessent to the American Bankers Association.
The new face of the Fed – The Banker
“There is a silver lining to the current market turmoil: the Federal Reserve is close to cutting banks some major slack when it comes to capital…Plans to review the supplementary leverage ratio, which forces banks to hold capital against total assets regardless of risk, are all the more pressing now.” The Banker, April 24, 2025.
Silver lining?
Just begs us to quote one of our own renowned aphorisms – Banks don’t go out of business taking risks. Banks go out of business levering things they can account for as riskless.
We have a sneaky suspicion that the comments from Secretary Bessent are signalling some of the stealth financial repression, cum capital controls, that we have been whispering about for so long now.
Treasury Secretary Scott Bessent Remarks before the American Bankers Association | U.S. Department of the Treasury
“We need to take a different approach. We should not outsource decision making for the United States to international bodies. Instead, we should conduct our own analysis from the ground up to determine a regulatory framework that is in the interests of the United States. To the extent that the Endgame standards can provide inspiration, we could borrow selectively from them.” Scott Bessent, April 2025.
Watch this space. This seems a fairly obvious means by which regulators can prioritize holdings of domestic sovereign bonds over competing 0% RWAs. Just exempt your own local government bonds from whatever is the equivalent of the SLR in your banking sector. UK could do it for Gilts. Japan could do it for JGBs. It gets interesting, and gets very much to our past conversations from Russell Napier, should the Germans do it for Bunds, and the French do it for OATs, etc.
Hunger Games…
The one country that did not get the benefit of the ‘pause’ on tariffs was China. The trade battle between the two largest global economies persists. Just how the rebalancing gets done, of the largest surplus-deficit pairing the world has ever seen, is far from being settled. There are, however, two very simplifying principles, as we see it:
- It is easier to address the deficit, just stop paying, than it is to address the surplus.
- There are lots of countries willing, and potentially able, to step into the supplier role of China. There are not any capable of stepping into the consumer role of the US.
A couple of great articles/interviews with George Magnus, “Talk of Cosying Up to China is a Dangerous Fantasy” and “Nobody Can Win This Trade War”, making similar points.
Talk of cosying up to China is a dangerous fantasy
“There is a widespread belief, not least propagated by the UK Treasury, other governments and many commentators, that faced with a tariff-crazy, unreliable US there is solace and even relief in seeking out closer trade ties with China. This is both fantasy and dangerous…China’s economic model, which is unlikely to change, is mainly about exporting to others, not importing from them. Moreover, there is no China or other substitute for America’s 30 per cent share of global consumption.” George Magnus, The Times, April 2025.
For some perspective, Wikipedia https://en.wikipedia.org/wiki/List_of_largest_consumer_markets pegs US Household Final Consumption Expenditure at circa $19 trillion while the likes of Japan, Germany, France and the UK come in at just over $2 trillion, each.
George Magnus: Nobody Can Win This Trade War
“There is no question that the US was the founder of the rules-based international economic order, and there’s no question that they are destroying that order now. The caveat is that the reason we’re here, and the reason that the international economic order has proven so easy to destroy, is because it was already flawed. The world trading system was unsustainable…The problem is that the system couldn’t deal with the huge surplus of China. It was never equipped to discipline countries that ran large, consistent surpluses.” George Magnus, The Market, April 2025.
And one more from Michael Pettis, “The World Cannot Absorb the Overproduction of China”.
Michael Pettis: The World Cannot Absorb the Overproduction of China
“Trade relations are going to continue to get worse, and there will be lots of threats of retaliation. But the problem for China is that it is very hard for large persistent-surplus countries to retaliate because they are likely to be the ones most badly hurt by a decline in global trade. Their trade surpluses are what allow them to overcome the very weak domestic demand that they have such trouble resolving domestically…A trade war is much more painful for surplus countries than for deficit countries like the US.” Michael Pettis, The Market, July 2024.
Again, back to our friend Russell Napier, these sorts of conversations certainly lead one down the path of wondering about the evolution of a new global monetary system. Mr. Magnus seems to agree, stating “I just hope we don’t have to go through a cataclysm in order to have a new Bretton Woods.”
Regardless, it is pretty safe to opine that the Trump tariffs and, more broadly, the US attempts to address long accumulated imbalances in the global system have triggered a seeker droid into a forest with all manner of interconnected dry brush. One such item, one that we have discussed often within our circles that like to hear about the inner complexities of structured product markets, is the infamous Taiwan insurance industry’s passion for callable bond structures, aka “Formosa Bonds”. These have garnered some attention of late, not least due to a couple of detailed articles, rather surprisingly published in the FT in late January and early February, authored by Brad Setser and Josh Younger, “How Taiwan Became a Quiet Bond Market Superpower” and “What Does Taiwan have to do with US Mortgage Rates?”
How Taiwan became a quiet bond market superpower
What does Taiwan have to do with US mortgage rates?
These two articles do an excellent job of talking through the enormous expansion of foreign bond ownership by Taiwanese insurance companies over the last decade. As usual, the accumulated imbalance is the unintended consequence of intentional manipulations of Rational Accounting Man.
“…after changes to the rules governing insurance portfolios, Taiwan’s life insurance companies quickly found they could profitably issue local currency policies and invest the proceeds overseas in dollars. As a result, they exploded in size, and now hold assets equivalent to about 140 per cent of Taiwan’s annual economic output.”
“The local regulators have certainly helped the Taiwanese insurers out. For example, they were allowed to shuffle a lot of the foreign bonds into hold-to-maturity portfolios, where their accounting value didn’t have to reflect their market value at the time.”
The articles lay out in pretty good details the scale of the FX and interest rate/duration exposures the Taiwan insurers are exposed to. They even scratch the surface a little on the short volatility component of the callable bonds.
“The complexities of modelling and managing the risks embedded in callable bonds means they rarely trade and are difficult to value. But for life insurance companies trying to fund expensive liabilities, it’s easier to focus on the higher yield than the relative illiquidity.”
The implications of these FX exposures, arguably triggered by the tariff-shock and globally weaker dollar, generated quite the extreme drop of USD/TWD just over month end.
Figure 10: USD/TWD Spot FX Rate
Source: Bloomberg
As scary as the implications are of a sustained bout of FX hedging from the Taiwanese insurers, we still think the bigger concerns rest with the unrealized losses on the mass of callable notes they are sitting on. Some may remember us discussing this Mexico “Formosa Bond” back on January 4th, 2021
Mexico raises $3 billion with first Formosa 50-year bond | Reuters
The Bloomberg headline announced this $3 billion 50-year bond as the longest and largest Mexico USD denominated bond in history. You had to dig a bit deeper to see that all of the arrangers on said bond were household global investment banking names, and a bit deeper still to see that in every case it was the Taipei Branch of said global investment banking name. And, yes, it was a callable structure. This bond is currently valued on Bloomberg at 53.80%. Good luck selling it there.
Figure 11: Mexico 3.75% 2071 Formosa Bond
Source: Bloomberg
We joked about this bond, and the subsequent supply of USD interest rate volatility, at the time as likely marking the low in long-term USD bond yields and the low in long-term USD interest rate volatility. It did.
Quoting a Mexican Finance Ministry official, the linked Reuters article proclaimed:
“The issuance was more than three times oversubscribed…the Taiwan deal attracted 10 new investors, mostly Taiwanese insurers with long-term investment profiles…The transaction covered 35% of the foreign currency funding requirements for Mexico’s 2021 budget.”
Just one of many pockets of combustible material out there, waiting for a spark.
Will the Trump administration’s attempts at conducting controlled burns eventually clear out some of the accumulated risk in domestic and global systems, paving the way for a new golden era? Or will they set off a conflagration that can’t be controlled? Or will the fear of the fragility lead to still more of the Pavlovian response that we are all familiar with, more borrowing, printing, can-kicking?
We don’t know!
But, from an investment/risk management perspective, the answer remains the same – be convex!
We saw it so clearly again in April. Folks that protected their portfolios with explicit, negatively correlating, convexity were a lot less anxious during the shaky markets earlier in the month, than were the folks that were relying on assumptions around stable correlations as their core risk mitigation strategy.
We talk about these dilemmas all the time. What is going to happen? Will Trump’s policies work? Will Trump’s polices fail? Will central banks buy the bonds? On and on.
We put it this way in one of our favourite Updates back in December 2023 – “It’s Just Math”.
Convex Strategies | Risk Update: December 2023 – “It’s Just Math”
“While this is a wonderful discussion at cocktail parties and on podcasts, the more relevant issue is what it means from an investment and risk management standpoint. The answer to that is that it both doesn’t matter and that it is absolutely critical. It doesn’t matter because the solution to the investment and risk management challenge is the same either way – be convex. Yet it is critical because if you get it wrong, in either direction, not being convex could be a disaster”. Convex Strategies, December 2023.
As a quick update, we can run some of our favourite hypothetical convex portfolios and compare them to some of the Sharpe World standards.
- Hypothetical Convex Portfolios
- Always Good Weather (AGW): 40% SPX Index Total Return (SPXT Index)/40% Nasdaq 100 Total Return (XNDX Index)/40% EurekaHedge Long Volatility Index (EHFI451 Index).
- Dream Portfolio: 70% SPX Index Total Return/10% Gold (XAU Curncy)/40% EurekaHedge Long Volatility Index.
- MegaBell: 70% SPX Index Total Return/10% Bitcon (XBT Curncy)/40% EurekaHedge Long Volatility Index.
- Sharpe World Standard Portfolio
- 60/40 Balanced: 60% SPX Index Total Return/40% US Treasuries Total Return (LUATTRUU Index).
- Risk Parity: 100% S&P Risk Parity Index 10% Target Vol Total Return (SPRP10T Index).
- Endowment: 100% Endowment Index (ENDOW Index).
Figure 12: AGW (light blue), MegaBell (dark blue), Dream Portfolio (fuchsia) vs 60/40 (yellow), Risk Parity (red), Endowment (brown). Compounding Path vs 8.5% Target Return (black dashed). 2018-April 2025
Source: Bloomberg, Convex Strategies
It is clear, in this representation, that the hypothetical convex portfolios are building a nice cushion versus the return target (set at 8.5% to align with the 60/40 return over this period). Meanwhile, the two correlation-reliant portfolios, veritable posterchildren of volatility drag, the Risk Parity and Endowment portfolios, continue to lag relative to the return target.
Figure 13: AGW, MegaBell, Dream Portfolio vs 60/40, Risk Parity, Endowment. Bubble Scatter CAGR vs Annualized Volatility. 2018-April 2025
Source: Bloomberg, Convex Strategies
Forgive us for using a chart with Annualized Volatility as a variable. You can see that, with the Sharpe World portfolios, it truly tells you nothing. More volatility doesn’t really equate to any more return. All it is really showing is the volatility drag that we mentioned above. On the other hand, with the convex portfolios, there is something about more volatility aligning with more return. This can be much better seen with the below chart where we replace Annual Volatility on the X-axis with our Convexity Ratio.
Figure 14: AGW, MegaBell, Dream Portfolio vs 60/40, Risk Parity, Endowment. Bubble Scatter CAGR vs Convexity Ratio. 2018-April 2025
Source: Bloomberg, Convex Strategies
The Convexity Ratio is just our measure of Upside Beta versus Downside Beta (1+Upside Beta/1+Downside Beta). Is your participation accelerating in good markets and decelerating in bad markets. Very simple. Not surprisingly, for those familiar with another of our aphorisms – “the only true alpha is convexity”, the Convexity Ratio chart lines up pretty well if we slot Alpha in on the X-axis.
Figure 15: GW, MegaBell, Dream Portfolio vs 60/40, Risk Parity, Endowment. Bubble Scatter CAGR vs Alpha. 2018-April 2025
Source: Bloomberg, Convex Strategies
In all cases, the three hypothetical convex portfolios have lower Max Drawdowns, lower Downside Volatility, lower Downside Beta than the three Sharpe World portfolios. The benefit is in the denominator. Effective risk mitigation allows you to take more participating risk. We suppose that is sort of the premise behind Risk Parity but along the lines that effective diversification, enhanced through leverage, allows more risk premia capture. Sadly, that diversification relies on unreliable correlation assumptions. As we said, it is a recipe for volatility drag, it is precisely wrong we conclude.
When we think about traditional Sharpe World investment strategies that have levered into their reliance on correlation assumptions as their key risk mitigation tool, we can’t help but think of the Michael Lewis classic story about the Oakland Athletics, “Moneyball”.
“This is threatening not just a way of doing business but, in their minds, it’s threatening the game. Really what it is threatening is their livelihood, threatening their jobs. It’s threatening the way that they do things.
Every time that happens, whether it’s a government or a way of doing business, whatever it is, the people who are holding the reins, that have their hand on the switch, they go batshit crazy.
Anybody who is not tearing their team down right now and rebuilding it, using your model, they’re dinosaurs.” Boston Red Sox owner to Billy Beane. Moneyball.
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