The fourth quarter usually has good seasonality for markets, but this year it has started with some extra-ordinary bad behaviours. When the Japanese bond yield jumps by 20% to reach levels not seen since 2011 and the US long bond sells off by 9% in as many days to reach yields not seen since 2007, something is clearly up in the bond markets. When the $ rallies and Oil spikes but Gold falls and the Copper market is in the largest contango since 1994 we see it as being more about supply than demand and more about positioning and (di)stress than about fundamentals.
The seeming trigger for all this was the FOMC and the notion of ‘higher for longer’. We are skeptical that investors seriously ever believed in a pivot (and regard the futures markets as deeply unreliable as predictors), but the behaviours suggests that, more than ever, the cost of US cash is dominating everything. Deliberately or otherwise, the Fed is diverting the world’s liquidity into the short end of the US Treasury curve and things are starting to break.
Is Japan having an SVB moment?
We suspect that we are getting a re-run of the problems that hit UK Pension funds last September and Silicon Valley Bank back in March. Mark to market is a serious issue, especially when, like the US, you have spent the last decade regulating your financial sector into buying bonds. Now those same regulations threaten to create forced sellers. As we noted in a recent post (Japan has woken and more things will get broken), both US Treasuries and Gold remain in positive territory over ten years in Yen terms, so it may well be that having to make up for Japanese bond losses in portfolios is triggering distressed selling of ‘what you can sell’ rather than ‘what you would like to sell’.
Short Term Uncertainties - 1994 redux?
The September options expiry was not a significant event such that we would normally have expected the positive seasonality for Q4 in equities to kick in during the second half of the month. In fact, the reverse happened, as the US Long Bond was hammered, with TLT US, the ETF proxy we look at, dropping 9% in as many days, seemingly in the aftermath of the Fed ‘pausing’ but remaining hawkish. Welcome to ‘risk free’. We doubt that this is the true reason, but the impact was nevertheless powerful. We note that the systematic traders - the CTAs that had such a great 2022 and, until now a shocking 2023 - had their best ever month in September according to Goldmans, as equities had their worst month year to date. There was thus undoubtedly some momentum trading going on, but even if this slows down, we are still concerned about some underlying things that feel ‘broken’.
We are old enough to remember the Bond Market Massacre of 1994 (financial journalists love a bit of hype), a story that was repeatedly told every time the Fed started to raise rates, but had largely slipped from the collective memory, not least because it never seemed to play out as badly. The difference this time may be however that Japan is now back in the picture for the first time since then. For years, being short the JBG was a trade known as ‘the widow maker’, but we suspect now, for mark to market reasons, being long JGBs may assume that name.
When markets move like this, someone is getting badly hurt.
Meanwhile, the US$ as measured by the DXY, has broken higher, looking to regain the levels of last November and is currently challenging ‘round number’ targets on all the big currency pairs (Yen, Euro and Sterling). As usual, the explanations are all created at the economic level, but for us the obvious culprit is the return available on US cash. Put simply, if you can get 5% return on US cash, with a following wind from an appreciating $, why would you own anything else right now? In keeping rates high, the Fed is basically creating a liquidity crisis across all markets.
Is the US basically asking for its ball back?
The fact that the markets appeared to fall over on the announcement that the Fed were going to stay higher for longer suggests to us capitulation rather than a shift in asset allocation. Our Fixed Income Model Portfolios have been exclusively in cash for a considerable period, but now, looking at our Equity Factor models, they have all now switched to sell signals. This is extremely unusual and signals an unquantifiable risk out there. As the expression goes, it is less about trying to catch a falling knife and more about catching a falling piano.
With no prospect of a lower cost of funding, many leveraged positions are clearly being wound down. Profits are being taken - in equities and probably gold - and as we noted, it is likely that the Japanese are a key ‘new’ player in the selling, given they are still in the black in Yen terms. Meanwhile no one is there to take the other side. As positions are deleveraged, we are seeing all sorts of apparently contradictory signals, not only from a ‘fundamental’ viewpoint (oil up but copper down for example) but bond/equity correlations and other relationships are appearing to break down which is causing a lot of models to break. As an aside, we can’t help wondering if the last six months has seen Chat GPT build a whole lot of ‘bespoke’ but ultimately identical day trading models. Models that are all positioned the same way.
Meanwhile, the sharp move up in Oil prices contrasts heavily with the weakness in other commodities, but here again, we suspect this has little to do with fundamentals and looks largely to be around Commodity Market positioning and the ability to deliver on the underlying product. Physical oil stocks, particularly at places like Cushing, are dangerously low, so the need to buy back contracts is high and while underlying demand remains robust the excess supply in markets like Copper is driving the markets lower, such that the Contango in the Copper markets is the widest since 1994. Meanwhile, Uranium has broken to the upside and the Baltic Dry cost of shipping is back to levels consistent with strong activity (ie excluding the distortion produced by Covid shutdowns).
Medium Term Risks - Mexican standoffs and Financial de-globalisation
Now that US Treasury yields have hit their highest level since the GFC, but the yield curve is still inverted the question remains as to who is going to buy the long bond? Especially when you can get a higher yield from cash. The Japanese flows are drying up, as a combination of higher rates in Japan, a weak Yen and high short rates in the US making it almost impossible to hedge for Life Companies a key marginal buyer. Meanwhile, the flow from China and other BRICS+ countries is stalling/reversing for geo-political risk reasons.
The answer of course is that the $trillions held in short term $ cash will need to move out along the curve at some point, but that is the central near term uncertainty. On the one hand there is a capital gain to be made on a 12 month view, on the other there is potentially (another) capital loss to be recorded by year-end. And that is a job challenging event. Without a signal from the fed, liquidity is going to stay at the short end.
Investors happy to trade duration risk for re-investment risk. For now.
The reality is that, during QE, the US has increasingly ‘regulated’ domestic savings into the US bond market, culminating in the Central Banks being a buyer in size during Covid (essentially triggering the inflation that finally reversed QE). Now they face the prospect of a Mexican stand-off between the Fed and the Politicians. The Fed is not going to monetise the debt again and are keeping short rates higher for longer. It is not the high frequency data that the Fed is watching, it is the politicians. Again in a reference back to the mid 1990s, we are going to be talking about ‘the twin deficits’ in the US. In the meantime, this stance by the Fed is causing money to stay at the short end of the curve and triggering mark to market losses at the long end as the same people who queued up to buy the Austrian 100 year bond at 237 in 2020 are nowhere to be seen now it is trading at 61.
We couldn’t resist putting in this image, courtesy of our friends at Redburn as it brilliantly sums up the way in which ‘rules based systems’ actually make the decisions based on ‘risk management’.
But as we said, it’s rarely ever about the economics.
US$ Cash is in this sense the biggest short term challenge to markets at the moment. It is now providing a positive real return that is more risk free than the so-called risk free rate, since there is no duration risk - i.e no risk of a capital loss between now and year end. Sure, there remains re-investment risk as short dated bonds roll off, but we strongly suspect that job preservation is playing a key role in asset allocation right now.
Meanwhile, the cash that ‘should’ be in equities, but isn’t, is caught in a similar dilemma. If the long end stabilises and rallies, equities will go with them and being underweight a rising market always triggers an asset allocation scramble, especially if, as right now, as noted, there are significant hedge fund short positions in equities. But for now, Jerome’s comfort blanket looks good.
Elsewhere, we can’t help thinking that the period when Japan was last influencing bond markets on the downside - 1994/5 - was also the period when we saw Nick Leeson blow up Barings Bank and Yasuo Hamanaka blow up the copper markets at Sumitomo Bank. It’s that Warren Buffet moment when the liquidity tide goes out.
Long Term Themes - market de-globalisation
The fact that inflation in the US has come down sharply is good, but the fact that it came down as the Fed raised interest rates is not - for it reinforces the logical fallacy of correlation = causality. High inflation was caused by the central bank monetising the profligate fiscal spending during Covid. The collapse of supply chains due to Covid restrictions and the further disruptions to commodity prices due to sanctions on Russia were contributory factors to the spike, but they are dropping out of the system. The dis-inflationary impulse from China has gone however, which is a key reason why we see structural inflation now in the 2-4% range, rather than the 0-2% range.
Raising interest rates has not cured inflation. Nor, unfortunately, will recent events have cured Central Bank’s apparent belief in their power to do so.
More broadly, the fact that bonds are heading for a third consecutive year of losses and that a buy and hold strategy has failed to deliver any positive return for over 15 years is going to finally challenge some of the conventional wisdom - just as inflation finally broke the spell of QE and ZIRP. If, as seems logical, longer term investors (as opposed to traders) shift to a barbell of cash/short dated bonds and Global Equities it is going to present a serious challenge to the US government to fund its spending. At the same time, a real return on cash is now giving a distortedly high return to savers in the same way that it had previously given a distortedly low cost to borrowers. Central banks have not learned anything, they have simply flipped from one bad market distorting policy to a different one. Meanwhile, as we discussed in a previous post (weak hands to strong hands) the decades long model of eastern savings being recycled via western capital markets - principally fixed income - and then back out to equities and real assets appears to be well and truly broken. Right now, western investors are selling Chinese equities - not least for political risk reasons -and while they will ultimately recycle them into western equities, they are currently sitting on $ cash. Meanwhile, eastern savers are either selling western fixed income - also for political risk reasons as well as seeing no return in which case they are certainly not buying it, while they too buy US$ cash. All a bit of a mess really.