Capital Flows and Asset Markets

Much as been made of the US 10 year bond yield pushing through 5% for the first time since 2007.

And much has been made of the fact that net interest payments are much larger than defence payments, and closing in on social security payments.

But a weird thing is happening. The US tends to devalue when it is bust. Back in the 1970s, the value of the US dollar collapsed against the Swiss Franc, and again in the 2010s. But as of today the Swiss Franc is around the level it reached back in 2011, and is actually losing value to the US dollar this year.

Even the one currency that Scott Bessent explicitly told us should rally, the Japanese Yen has been selling off again.

My preferred measure, GLD/TLT, we are not seeing rampant default risks being priced in by markets (yet).

What I think the market is pricing in, is that growth in the US is going to be even stronger next year. Despite higher yields, debt issuance does not look like it is slowing down.

A good live indicator of AI trends is pricing of DRAM - which has become a bottleneck. There is no sign of weakness here.

What I see is growth surprising to the upside, and hence yields getting smashed. For industries and companies already suffering from high interest rates, tough luck. AI is crowding out the capital markets, and looks likely to continue to do so.

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How you feel about central bank policy making since the appearance of Ben Bernanke around 2000, will pretty much determined by your positioning in asset markets. Private equity love him. Renters not so much. But one think that Ben Bernanke certainly introduced to markets was asymmetrical policy making. Helicopter Ben was all about big dramatic cuts and interventions to the downside, and then only inching up rates when growth returned. 2022 was a return to central bank surprising hawkishly, but since then, its been a return to cutting interest rates whenever possible.

This asymmetry of central bank policy making is even clearer when you look at balance sheets, quick to expand, slow to shrink.

One upshot of central bank policy is that they have effectively tied corporate credit to sovereign credit (I did mention private equity love Ben Bernanke?) The spread of corporate credit to treasuries has remained at very low levels since Cvoid. In essence, the corporate debt market either believes there will never be a recession again, or if there is, central banks will be buyers as they were in 2020.

So far, all hunky dory - central banker high fives all round. But, I see a problem now. As mentioned, markets just don’t believe either the government or central banks will act to create a recession, so loan growth is accelerating - even in Japan.

The problem for central banks, is because of this asymmetrical policy action, bullish players are now almost willing to pay any yield to access capital. I note that Softbank, is looking to borrow short term at 9% in the US and 8% in the Europe.

Even a recently issued 7 year Japanese bonds is trading at 4.8%

Traditional analysis would suggest that this higher yield is “credit risk”, and hence the “AI Bubble” is about to burst. You can find such analysis everywhere on Substack - and is probably wrong in my opinion. What I think is happening is that the hyperscalers and AI companies are competing via capital spend. The big players like Microsoft and Google have cashflow (although they also tap credit markets now), but more capital constrained players are going to credit markets. And why wouldn’t you? The calculation is pretty simple. Traditionally corporates would be cautious on using credit markets to raise capital, because in a recession and default, the bond holders could end up controlling the company via a debt to equity swap. But over the last few years we have seen central banks intervene in the credit markets BEFORE any material bankruptcies. In fact a recession could be helpful, as central bank may well end up cutting rates and buying corporate debt, so a company like Softbank could refinance these bonds at a lower rate in the future. In essence, Softbank and its ilk is beginning to price central bank policy making into corporate credit. It is already beginning to change the way markets work. If you told me that the KDP High Yield daily yield would rise form 5.5% in January to 7% today, I would have assumed markets would be flat to lower.

But what I am seeing is corporate not caring what the cost of debt is - because they are aware of the asymmetrical policy making of central banks. This is a problem for central banks and governments. If corporate bond yields are higher because of demand, and investors come to the same conclusion that corporate defaults are not possible, then why would anyone want to buy a government bond? You could consider this a reversal of the crowding out theory that used to exist - except in this case corporates crowd out sovereigns. This makes a lot of sense to me. China has been willing to default property companies, and accept slower growth because of it. Chinese government gets to borrow at rock bottom interest rates.

In the West, policy making has in essence suffered regulatory capture by corporate interests. And hence borrowing costs go up. The conclusion is pretty obvious. Central banks (and governments) would have to prove they have the stomach to bankrupt some large corporates to gain control of yields again. Possible, but with the current personnel, unlikely.

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Markets are about greed and fear. Greed is easy to understand, but fear is more difficult concept. One way fear shows up is in a rejection of something new, and this in particular appears in older investors. I have a lot of sympathy for this fear. In the markets I grew up in, crises and crashes were the norm - not rare events. Japanese bubble burst 1991, the Tequila crisis in 1994, Asian Financial Crisis in 1998, Dot Com Bust in 2000, Latam Devaluations of 2001/2, GFC in 2007/8, Eurocrisis of 2011, EM problems of 2015/6. To survive in markets, being paranoid and cynical was a prerequisite.

If you have been a long time reader of this website, you will know that I looked at a number of macro indicators, which basically signalled a market top in 2016. The first, and one that is still quoted today by people looking to be bearish is Net International Investment Position (NIIP). The deterioration in US NIIP is so vast, its easy to make a bearish case on all US assets.

I tried to be more sophisticated with NIIP analysis, by stripping out central bank holdings of treasuries and using GDP as a denominator. Still looks scary. Adjusted NIIP topped out at 10% of GDP in 2000. Today we are 4 or 5 times that level.

The other similar chart that gets the macro community worked up is Fed Flow of Funds Net worth to GDP. 300 to 400% was the norm. Now we live at 600%.

Basically the combination of macro extremes, and a history of crises through the 1990s and 2000s makes many people naturally bearish, and I sympathise with this view. But as mentioned, this macro view broke down 10 years ago. I think there are now much better things to look at. So “old macro” was all about getting prices, and the cost of credit down. One thing about all the crises listed above, is that drove US treasury yields lower. I would argue that the “point” of these crises was to get lower prices and lower bond yields.

Growth during this loan period of falling yields was driven by credit growth. When banks were lending, all good. When they pulled back, problems. But the problem was that debt levels had gotten too high, and so a new growth model, was needed. In essence, wages needed to rise to get debt levels down. And we are seeing this in the data. The Conference Board in the US produces an index of Commercial and Industrial loans, deflated by 1996 prices. Loan growth matched up with booms and busts, until 2020, when loans have fallen in real terms. Or in other words, credit growth is not as important as it was.

Changing politics has changed macro. In Japan, rising inflation has helped make government debt levels look better.

We see similar dynamics at play in Europe, where inflation and some growth has restored fiscal health to some southern European nations.

Inflation (particularly wage inflation) is the growth engine when credit markets need to be tamed. And politically credit markets needed to be tamed as assets, particularly housing had become too expensive. You can see London house prices have levelled off.

Or in the US, a refinancing boom has been ended by rising yields. Flat house prices, or the end of a refinancing boom, would be “macro-bearish” - no longer.

But the macro change that has really destroyed macro thinkers is that the 10 year treasury yield no longer act as a ceiling to Fed Fund Rates, but as a floor. From 1980 onwards, when the Fed Fund Rate rose to 10 year Treasury yield, growth would slow and yields would fall. But back in the 1960s and 70s, the 10 year was more of a floor. It was the level that markets thought was appropriate, and when the Fed Fund Rate fell below that level, inflation took off again. We are now back in the 60s and 70s, which makes macro based on bond market signals look bad.

The big political and macro question is when do yields get so high, they cause a political change again? Some day, but not today. Take care when listening to “old school” macro thinkers.

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Getting old has pluses and minuses. One recent plus is I can finally play some decent tennis, its only taken 15 years of work! One recent negative is I can only maintain a high standard for one set before getting tired. C’est la vie.

I mention this as we move closer and closer to the 20 year anniversary of the GFC. 20 years is a long time. When I started working people were still talking about Black Monday, 19 October 1987. I remember in the early 2000s thinking, why they still talking about that - old news! But because everyone remembered it, we have never really seen something similar, at least not for the S&P 500. Yes the S&P 500 has fallen - but in this case it gapped down.

As the GFC recedes into the distant past for most of us, I was struck by a strange strange symmetry when looking at markets. As hard as it is to believe now, through 2006, 2007 and early 2008, everyone KNEW subprime mortgages were a problem, but were not in the least bit worried about prime mortgages or big banks. The key word at the time was “contained”. The KDP High Yield only really sold off in late 2008.

This was despite mortgage delinquency rates beginning to move higher in 2006.

The GFC was about subprime credit working its way up to prime. If you have seen the movies from the time (The Big Short), the big money trade was working out that prime was the problem, not subprime. So why do I mention this?

I was lucky enough to start working at GAM in 2002. GAM was a leader in the fund of hedge fund business just as it was booming. The source of this success was not hard to find, and being at GAM was a great place to see it. The dot com bubble was coming to a head in 1999 - and as one investor told me - funds had to sell value stocks to buy growth stocks or risk underperforming. This Morgan Stanley Growth v Value index gives an idea of how extreme it was.

Many of the hedge funds started in 2000 had a value versus growth bias, and did extremely well. The S&P 500 also fell 50% from 2000 to its low in 2002, and had three down years in a row. Hedge funds did well just at large cap US stocks were doing poorly, and this drove huge inflows into the industry.

The GFC was good for me, and for SOME hedge funds. But in 2008, you could see the problems were starting. The average hedge fund lost money. Part of the problem with the hedge fund space then and now, is that it is often just a fee strategy looking for an investment strategy. If you don’t know what that means, basically fees are higher in hedge fund space, so everyone wants a hedge fund, even if they don’t know what they are doing. What I remember so clearly about 2008/9 was that it destroyed momentum strategies. In 2008, everyone went short banks and long commodities, which worked great until half way through 2008, when the market suddenly remembered financial crises are bad for commodity demand, and then just as everyone got short in 2009, the market rebounded hard. Looking at the GS Momentum Long/GS Momentum Short index shows the carnage.

I remember in the period after 2009, hedge fund investors changed dramatically. No longer did they trust big names to know what they were doing. Questions became more pointed, and no one paid hedge fund fees for beta any more. They were happy to allocate to low cost passive funds if they replicated hedge fund strategies. This lead eventually the decline in hedge fund launches, although not in the total number of funds.

Over the years, the hedge fund space has become increasingly detached from the market. What do I mean by that? Well the industry has become increasingly prone to drawdowns from “rotation”. As the 40% drawdown in momentum strategies above shows. It is probably easier to see with GS VIP Long vs Most Short Index. Since 2016, any spike in VIP Longs v Most Short has been met by brutal reversals. That is the core long/short strategies no longer work.

Why is this? In the hedge fund space, I have noticed the rise of various different styles of fund - pod shops, or what I would call volatility management style of funds. I would add first loss capital in to this bucket. What all these management styles have in common is an incentive structure that rewards upside, but hugely punishes downside. In pod shops, it is common to hear that 2% drawdown will be met with huge capital reductions to the managers. With first loss capital, a typical structure is that a fund manager can charge a high monthly fee on profits, they need to take 100% of a loss. Another way to interpret this is that while headline fees are high, the manager is forced to sell a zero cost put option to the first loss capital investor. This is great for first loss investors, not great for managers.

This creates a huge incentive to cap downside risk. In theory, the best way to create an investment strategy with asymmetrical risk is to use options. I don’t like options - but I can see the appeal. Option volumes have exploded. I am not sure this is the right index, but it fits in with what I have heard.

Why do I say “in theory” that option strategies are the best way to create asymmetrical risk? Two reasons. First of all the cost of buying options tends to destroy returns - called time decay. The second reason, is that selling puts tends to be a great strategy until it is not. In my experience, the only winner from option trading are investment banks, which is why they are so keen on selling them.

What has all this got to do with long short funds being so bad? Well, option trading has also become the drive of asset prices, no the derivative. Ladder attacks, where investors buy a series of call options with progressively higher strikes to force investment banks to buy have become increasingly common. One problem I have always had with options is that hedging is almost impossible, and so when option strategies work, they sow the seeds for their own destruction. And if you are downside risk averse, you need to be constantly hedging successful options.

This is why momentum strategies tend to break to new highs and then suddenly fail, with both long book and short book moving in opposite directions. This probably explains why long short hedge funds have a similar return profile to CTAs. Option strategies create mindless momentum trades, and CTAs being mindless momentum traders follow. Since 2008, CTAs have also been a waste of time.

What changes this? I do think higher bond yields will at some point destroy the attraction of pod shops. You can now get a guaranteed 5.3% return by leading to the US government. Why are you bothering with a black box fee machine?

A good bear market would also help the long short community. Again, this would probably need investors to allocate away from equities back to bonds.

I have my views on the “political” changes that would be needed for long/short to thrive again. Time to be patient I think.

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One of Prime Minister Abe’s aim was to get Japanese investors to stop being conservative. He was particularly keen on getting Japanese investors out of JGBs. The main was was to get the Bank of Japan buying basically the entire JGB market. In USD terms, the BOJ balance sheet went from USD 1.7tn to about USD 7tn

And this has led to Japanese investments in domestic bonds falling dramatically. In other words the BOJ bought bonds of JGB investors at a very high price.

The good news for Japanese investors is that they sold most of their JGB holdings before yields rose. Or if you are more cynically minded, Japanese banks saw what was coming and dumped their holdings on the BOJ. Long dated yields in Japan have surged in recent years (bond values have fallen).

But as the graph earlier pointed out, Japanese investors have not sold their foreign debt holdings. As GS point out, the largest holdings are now held by investors that do not hedge (there are good technical reasons for this). But basically, Japanese have large UNHEDGED fixed income positions.

Even life insurers, who usually hedge their portfolios - they have let hedging ratios fall a long way.

Over half of their foreign holdings are in the US.

Anyway you cut it, Japanese investors (pension funds, retail and insurers) have a large unhedged position in US Treasuries. This might seem odd - TLT US - which gives a good guide to the capital value of US treasuries has been very poor.

But in Yen terms, it has been fine (ish).

This is particularly true when compared to a 10yr JGB return index.

In the old “free market” days of 2016, this combination of very unhedged positioning in the USD assets would make me EXTREMELY bullish on the Yen. Covering the unhedged position would drive Yen higher, which would cause more covering and so on and so forth. Of course the problem with that outcome is that it would drive investors back into JGBs - the very thing they have been trying to stop. But maybe Japanese investors just stop allocating money to US treasuries? US 30 Year Yields are at new highs.

But the Japanese would probably feel a bit miffed that the US is suddenly forcing the Yen higher, after they have loyally helped the US finance its budget deficit. What would I do to try and mollify miffed Japanese investors? I would probably announce a buy back (bit like the BOJ and its QE to help them out of JGBs), to support the market as Japanese try and sell. The treasury has already upped the buyback once. The next step will be to make the buyback big enough for Japanese investors to sell into. What sort of numbers would that be? Lets say US 4 trillion total investment by the Japanese. The total treasury buy back is currently USD 65bn a quarter. To help out the Japanese, it probably needs to be USD 200bn a quarter. I expect the buy back to be increased.

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Like almost everything in my life, if something works, then I keep using it, but when it stops working, I move on. Currencies used to be so reliable in finance, I build my whole investing process around it. I am provoked to write this note, because the Korean Won has just had a straight line 15% move.

What is noteworthy for me, is that for the life of me, I could not understand why Korean Won was at all time lows to start with. Korea has a cyclical currency, which tends to follow equity markets. It also tended to move with semiconductor cycle. Given semiconductor prices, it should be much stronger than it is. The lack of currency adjustment has fed into by far the largest trade surplus ever booked by Korea.

Taiwan has a 24% of GDP trade surplus, and while not weak like Korean Won, the currency has done nothing. One reason for this was the weakness of Japanese Yen. Until recently it was trading at 30 year lows.

The trigger for this has been, seemingly, the US treasury deciding that the Yen was too weak. So one side of the currency market has been currencies that should be strong, have been weak. On the other side of the market is that currencies that should be weak, have been strong. One such currency is the Mexican Peso. On of my best trades was shorting Mexican Peso in 2011 until 2016. I remember someone tried to convince me it was a long, not a short. All about cheapness relative to the US, and higher interest rates than the US, manufacturing was moving there etc etc. I just remember saying, “yeah…. but its still Mexico”.

“Why so mean on Mexico?”, you may ask? Am I MAGA man in disguise? No, numbers drive me - and the numbers associated with state owned Pemex are so poor, its diabolical. This Economist article explains.

Mexico also has an inflation problem. Since 2000, prices have risen 200%.

One trade I used to love putting on was long Yen, short Mexico Peso (you could call this the “reverse carry” trade - or the “work in practice but not in theory trade”). This was a super successful trade in 2008 and 2015/6, but since then the Peso has been much better than the Yen.

Over the same period, Japanese prices have only risen 20%.

Currency markets use to reward success (Korean semi exports for example), or ability to keep price low (Japan), and punish poorly run state owned businesses (Mexico). But these days not so much. But the quid pro quo of currencies not adjusting has been much higher inflation, and bond yields.

In practice, weird currency moves seem to be driving higher bond yields. There is no good theory for it - other than maybe pointing out that weird currency moves indicate a move away from free markets, which is itself inflationary.

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I decided to get in to finance in 1998, when living in HK. I was fascinated at how currencies, interest rates and equities were so tightly bound, and this fascination led me to a hedge fund career. You can read about it my book. In my experience, politicians often intervene in the value of their own currencies. Either to weaken it or strengthen it. Plaza Accord was a multinational accord to weaken the USD for example. And then you have currencies pegs, which governments promise to defend, but often find the cost prohibitive. Getting a break in a peg right can be incredibly lucrative. The move in the Korean Won in 1998 was huge.

In HK, they were only able to defend the peg by offering much higher interest rates than in the US. At one point, HIBOR was 20% higher than Libor.

But to devalue or not to devalue was a domestic decision. What seems to have happened in Trump 2.0 is that other nations exchange rates have become a US policy choice. We first saw this in Argentina, where the Trump administration came into set an exchange rate of around 1400 to 1475 for the Argentinian peso. This was to help the administration of Milei in elections. Currently the exchange rate is beyond that level, but depreciation has slowed since the intervention.

But borrowing costs have fallen in Argentina - so in many ways the intervention could be considered a success.

After the “success” in Argentina, the Trump administration now wants to strengthen the Yen.

I find this gives me very mixed feelings.

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The BUY case for Yen is straightforward. As millions of tourists will happily tell you Japan is cheap. Using the BIS real effective exchange rate measure, the Yen has collapse in value. This measure takes in relative inflation AND exchange rate - so makes the Yen even cheaper than just looking at straight exchange rates.

I have in previous post called “long Yen” the Widowmaker trade. It used to be short JGBs were the widowmaker trade, as various “macro thinkers” used to always think JGB yield should rise, and instead they always went lower. Even with recent moves, long Yen has been a widowmaker trade still. Anyone hyperventilating over a 6% move in the Yen needs to get out more.

The most recent Yen strength has probably been driven by the realisation that the BOJ will likely raise rates more than the US. This can be seen in the relative movement of 2 year bond yields. The question you do have to ask yourself, is why didn’t Yen rally more in 2024 and 2025, as these two yields began converging?

If you look at the Yen versus other “safe haven” currencies like the Swiss Franc, then it looks mega cheap, and this makes it a buy.

The US wants Yen to go up, interest rates differentials are converging, and it looks like its turning against the Swiss Franc - for most people this would be a buy signal. And yet… I have a problem.

First a bit of housekeeping - I will be in Zurich and Geneva on the 29th and 30th of September. If you would like to catch up - drop me a line.

Also I am trying Substack video for the first time - feedback appreciated.

When I first came up with the idea of GLD/TLT, it was so simple and so obvious, I was almost ashamed to publish it. But as old boss once told me, simplicity breeds elegance. And I do like to be elegant. GLD/TLT has been good, and its bounced back nicely from a sell off earlier this year.

Generally speaking, I thought GLD/TLT will end as a trade when politics turns again, back to culturally liberal, and fiscally conservative. Who knows when that will happen. I thought you would need a crisis era like the 1970s for that to happen. The long term graph of gold versus treasuries shows you the 1970s clearly.

But Hartnettt out of BOA produced this chart. Long dated treasuries have even worse returns now that in the 1970s. This is partly due to the very low coupons they have, which pushes out their duration (the lower the coupon, the move of your value is exposed to rising long term interest rates). But still, the best time to short an asset it when it goes from being good to bad. I wonder - should I still be bearish TLT?

Then there was this chart - where the 10 year returns of commodities have been pretty good.

What I am saying, is that GLD/TLT made total sense politically, but also from a return perspective. When I first suggested it, we were coming to an end in a bond bull market, and the beginning of a commodity bull market. The most tricky thing with fund management is that there are two things you need to get right. The first is holding onto a good trade - especially if you got a good entry point. What the crypto guys call HODLing. But the other thing is knowing when the trade is done, and time to get out. The guys at Situational Awareness were good at the first part, but not good at the second part. While I feel my own track record is mixed on this - compared to other so called “perma bears” - I am way out in front.

So if GLD/TLT done? Probably not. With populist parties still on the march globally, policies that help GLD/TLT are still more likely. As soon as I see a head of the Fed say, “I don’t care what the unemployment rate might be - we need to crush inflation”, is the day I reverse this trade. That day is not today. The other good thing about GLD/TLT is that US retail still don’t get it. Share count of TLT has bounced back, even as ETF flow into GLD remains restrained.

Net/net - not the end of the road. But I can’t help but feel its time for TLT to perhaps do a bit more work in this trade. The gap in US and Japanese 30 year government bonds feels too low to me.

What does this mean? I got into GLD/TLT at a good time, and I probably just need to sit tight for awhile longer.

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