Capital Flows and Asset Markets

The thing about the US/Japan Yen intervention is that it is less about currencies and more about bond yields. Japanese bond yields have led US bond yields lower for more than half a century. And since 2020, they have been leading US bond yields higher.

The sell off in the long end is basically saying that Japanese short rates remain too low, and should be higher if the BOJ is serious about curtailing inflation. You can see this most clearly in food inflation in Japan. Japan had no food inflation form 1990 to 2013 or so. I think in that period, low interest rates make total sense. But in a period of rising food inflation, loose monetary policy is a political and economic mistake.

The BOJ has not been TOTALLY negligent. Interest rates have risen from lows. But still remain at below 1%.

But plainly this is not enough to stop food inflation or Yen weakness. The obvious answer it to raise interest rates to slow down growth, or strengthen the Yen or both. The Japanese yield curve is a bit odd - it only really inverted in the late 80s, early 90s. Even then, getting back to 50bp spread seems a reasonable target. This would imply raising BOJ rates another 70bps.

Plainly the US treasury and BOJ want to avoid that - hence the FX intervention. Yen appreciation would help deal with inflation - and particularly food inflation. Its not hard to understand why the US doesn’t want Japan to raise interest rates. The US treasury is already at the upper limits of Bill issuance. Having more competition for issuance at the short end would be a problem.

It is easy to see this is a a borrowing problem. US and Japanese governments are borrowing too much, and trying to keep interest rates down. I see it differently. The growth outlook for Japan is now so good, deposit flows are starting to slow.

While loan growth is accelerating.

In essence, the pool of available money to invest in to JGBs is declining. And if there is less money for JGBs, then there must be less money for Japanese to buy Treasuries as well.

The Yen intervention could help with Japanese inflation, and maybe the BOJ would not need to raise rates. But the real problem is growth is so strong now, the pool of capital for governments to borrow from is shrinking. And Yen intervention will not help with that - only a recession. But that is not on the cards either. I think the greater risk is that Japanese start bringing money home to invest domestically. Then the Americans will really be in trouble. Then the Yen will surge and Treasuries will collapse - but that is a problem for another time.

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Technology changes, and the world changes. Back in the original dot com boom, a tightening of the energy markets in 2000 heralded the end of the tech boom, and a rising China then drove an old school “commodity super cycle”. For investors of a certain age (lets say 50 or so), this confirmed an old rule, oil is the dominant driver of markets and economics. Spiking natural gas prices in the US tended to be a catalyst for recession and bear markets.

A similar dynamic was at play in Japan. Rising energy prices tended to coincide with weak equity markets, and poor growth. Here we can look at Japanese Energy CPI has a proxy. The period from 2007 to 2011 was particularly dire for Japan. But despite high energy prices from 2020 onwards, Japanese economy and equity markets has been fine.

Being an oil exporter was (usually) the only way to record a very high current account surplus. Norway for instance has had a current account surplus over 10% for most of the 21st century.

Taiwan now runs a 22% of GDP current account balance, with Korea not far behind.

Korea has always been a diversified export powerhouse - but now semiconductors dominate.

The big change is that semiconductor pricing no longer falls.

This is the log scale of semiconductor pricing. But oil was very similar. For decades the crude price of oil was fixed, but when supply became restricted, oil pricing surged, and the modern macro world was born. In real terms, oil fell through most of the 1900s. I expect when oil spiked, it was as great a surprise as I feel looking at DRAM prices up 500%

And as we have seen rising semi prices is NOW good for the equity market, even more than the negative of rising oil prices. The surge in oil prices this year, historically associated with weak equities. Not this time. The big question is whether surging semi prices are come to be seen as inflationary or not? It seems like they should be.

The other very interesting comparison to oil, is that the US great economic rival has a very different approach to semiconductor industry. The USSR kept energy prices low, even during the 1970s, which undoubtedly was seen as a political and economic advantage at the time. China seems to be pursing a similar economic model where AI is cheap, but so is its semiconductor pricing. SMIC prices much cheaper than TSMC (not totally apple for apple comparison - but indicative).

Chinese AI pricing is also much cheaper than the US. The “great” thing about capitalism is the boom/bust cycle does mean that capacity gets built, as pricing encourages it. In China, given pricing and the lacklustre equity performance, it must be driven in some parts by diktat.

What are the implications of semi as the new oil? Well one would be that central banks should be raising interest rates more. Korea has started to raise rates.

Given the enforced supply restraint on semiconductor supply (ASML monopoly, and restrictions in China), the only way pricing can fall is if a monetary policy is used to create a recession. This was what happened in the 1970s, until supply side reform saw an increase in oil production. From a practical point of view, the implication is that inflation and interest rates are likely to go higher.

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The pro-labour theory of markets has played out in all ways but one in my view. First growth would be good, and unemployment would be low. Correct. Second, cost of capital would rise. Correct. Third, equity markets would suffer from higher cost of capital. Not so true. I am going to focus on this third part.

Ever since Covid, when the Federal Reserve stepped in as a buyer of corporate credit, credit spreads have become tighter and tighter. This is bullish for equities, and as of today, these spreads are at very tight levels.

Binding corporate and sovereign credit together is pretty common in emerging markets. While it is great for corporates, it tends to not be so good for sovereign yields. So the question is when do rising sovereign yields begin to affect equity markets?

Is there one market that western macro investors just can’t seem to get right - its Japan. The only thing that is constant is that once they think they get it, they really don’t. For someone who used to live in Japan, I can say with 100% confidence, foreigners are always the last ones to get the memo. The closest I have ever come to being an insider was near the end of my high school exchange, and I have been playing with the basketball team for an two hours a day, during school term, and six hours a day during the summer. We had shed blood, sweat and tears together, when at the beginning of training one of my teammates mates came over to me and said “we are not talking to Tanaka today - he skipped training yesterday. Ok?” I said ok, and did not talk to Tanaka as instructed. I had mixed emotions - I felt sorry for Tanaka, but I was also pleased I have finally made it to the inside. If you have never heard of Japanese high school club training, “bukatsu”, perhaps watch some Japanese high school baseball videos on Youtube. Intense is the key word here. And team spirit is everything. Anyway, the key issue is never trust a foreigners view on Japan - they know nothing.

I remember in 1997, Steve Roach, a very famous economist for Morgan Stanley, was very bearish on JGBs. If memory serves, he called the 10 year JGB at 3%, the short of the century. They or course went to zero, or where the greatest long of the century. In fact short JGB trades destroyed so many hedge funds, it came to be known as the widowmaker trade.

Associated to this was Yen strengthening during times of US recession. Early 1990s and again after the GFC gave rise to Yen being seen at a “safe haven” currency.

I always felt this trade was easier to understand in terms of Korean Won. Macro traders often preferred Korean won to Japanese Yen as it had higher interest rates, and similar industrial structure. The Won/Yen carry trade was always popular with macro traders. Periods of Yen weakness against the Won tended to be followed by periods of Yen strength. The “macro community” has learnt from this, and have been pushing long Yen trades for a while now.

In recent days the US and Japanese government have intervened to strengthen Yen.

The macro community has started melting down again. Here is a couple of choice selections from Twitter.

Lee Roach seems to be pushing for a huge carry trade unwind (what is with people called Roach and Japan?!?) and Michael A. Gayed thoughts are not totally clear to me, but I do know he is “VERY EXCITED” about Yen moves.

What do I think? Well in the political world we live in I have a really simple view on Yen. I think it goes exactly where the government thinks it should go. Which basically means, they like it weak, but not too weak. Do I think we are going to be a catastrophic Yen carry trade unwind? Well the Japanese (who would know if this was going to happen) would be buying JGBS in that case. They did that in 2007. Today, not so much.

Do I think Yen is about to be catastrophically weak? Like an Argentinian Peso or Turkish Lira? I think you need to see Japanese interest rates ABOVE US rates and still weakening to really believe that. That may happen - and then we would have to consider that risk. But for the time being Japanese yield remain below US yields.

I think the simple story is Japan has inflation now, and is much more a “normal” country now. Why was it so special for so long? Japan challenged the US in the 1980s, so agreed to economic policies that hamstrung it for three decades. But now that China is the challenger, Japan is free to do as it pleases. And it chooses inflation. And we know, inflation is good equities and bad for bonds.

Personally I look at the above, and I am neither bullish or bearish on Yen. I am bearish on JGBs, but also bullish on Japanese equities. As a for “macro investors”, they are so much like the generals of old, always fighting the last war.

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It was a wild month in equities, where momentum investing got destroyed. The GS US High Beta Momentum Index shows it well. You have to go back to 2008 to see a similar size move.

Semiconductors were the area to get nailed in July. Philadelphia Semiconductor Index fell nearly 30%.

What really stood out to me was the rally in heavily shorted names. The GS Short Momentum Index rallied through the month. Certainly what I saw during the month.

We now know that the hedge fund Situational Awareness became aware it was in a situation, and was forced to sell longs and buy back shorts. This was very reminiscent of LTCM, back in the day. And it was noticeable that markets stabilised once it had deleveraged. The VIX finished the month at 16 which feels VERY at odds with individual stock volatility.

Amidst all the drama, the Federal Reserve decided not to raise interest rates, despite the largest investment boom in modern history, and the largest fiscal deficit in modern history. The market decided to sell off Treasury yields, and the 30 year finally pierced 5%.

The other, and in my view, highly related move was in Japanese Yen.

But for me, the move in Yen was not the big news. It was the amount of Treasury selling that was needed to make Yen move was the big news for me. Estimates range from USD 50bn to USD 100bn. If we look at Japanese official holdings of Treasuries, at USD 1,143bn - it is pretty clear that they spent a big chunk, just to get Yen back to where it was a month ago. That is, if they just intervene, and do not change fiscal or monetary policy they will run down the foreign reserves very quickly.

The market clearly wants higher interest rates in Japan, but the BOJ is afraid of what has happened previously. Raising rates in mid 1990s started the Asian Financial Crisis, in 1999 the Dot Com bust, and 2006 the GFC.

The thing is that the JGB market sniffed out trouble pretty early in those situations. This time, it keeps selling off. Or in other words, the JGB market sees inflation. I agree.

I think people are starting to wake up to what I have been saying for a few years. We are in a rising cost of capital world, driven by rising investment needs, and the realisation that neither our governments (which are populist, or populist threatened) or our central banks are acting to keep inflation at bay. This incentivises people out of cash, and makes inflation even worse. Warsh could have ended this vicious cycle early - I think a 50bp even a 100bp increase was called for. Now the Fed is in catch up mode. What I mean by that, is both the BOJ and Fed will come under pressure to raise rates by a lot more. They could have avoided this outcome - but they chose not to. GLD/TLT has had a long rest, but looks interesting to me.

But I think the short TLT looks more interesting than the GLD side here. What I think is more likely is that bond yields rise, and at some point President Trump or American business will ask the Fed to “fix” the bond market. If they attempt YCC, or QE or something like that - THEN gold goes to the moon. That is Fed inaction - causes yields to rise. Fed intervention - causes gold to rise. The only way to get bond yields down now it to jack short rates way about the 30 year yield - which would be 6 or 7%. I don’t see them doing that - especially after blinking in this meeting. The real mystery here is at what level do higher bond yields hurt the S&P 500?

Exciting times.

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At the heart of the AI discussion is one issue and issue alone. Are the hyperscalers spending too much? The Economist provides a nice guide, basically showing that we are twice the dot com boom in half the time!

Goldman Sachs also provides a comparison, which puts total amount of capex on a par with the dot com boom.

So basically we have huge amount of capex - more than any other boom on some measures. Adding to this bearish set up - the Capex is now debt financed

And you are seeing the CDS respond to debt issuance.

And then to cap it all off, the US AI models are getting undercut by Chinese models. If you are bearishly minded, then this is a slam dunk short case.

For me, I understood all this, but I saw the capex spending as defensive. With Elon Musk joining the AI party - Google, Microsoft and even Meta could feel threatened, and so would all need to spend aggressively to defend their turf. Or to put it another way, Volkswagon should have massively raised R&D on EVs when Tesla was launched, and now its too late. The big tech was not going to make the same mistake. From this line of thinking, the bear signal would be someone giving up. But I was reading the Microsoft results, which was excellent, and could not stunned by the future contractual obligations they reported. Well over USD 700bn.

The most recent quarter also saw their cloud business become their largest single business line - with over 30% year on year growth. If I saw this type of “contractual obligation” growth in my own businesses, I would also be spending big.

So the question is can Anthropic and OpenAI actually meet the the US 1 trillion backlog they have built up with the hyperscalers? These two companies alone make up the commitment to the hyperscalers.

And here is where it gets hard. Microsoft, Oracle, Google and Amazon must all know that they are extremely reliant on OpenAI and Anthropic. But they also must have their own visibility of the demand for AI related areas. And they should also have good visibility on the capability of Chinese AI, and yet they still spend. So to be bearish you need to take a view that the tech giants have missed something, or have gotten something wrong. And this does happen. The GFC was basically caused by a belief that AIG could not go bust (the investment banks bought CDS from AIG to hedge their MBS business risk. When AIG failed, they were no longer hedged.).

What could I see that the big tech companies not see? I don’t know. I think the biggest risk could potentially Chinese AI completely upends the AI system. But Chinese cloud pricing has been cheaper that the West for years without slowing cloud growth. I would also think this was more likely if Nvidia GPUs did not still trade at a premium in China. That China still wants and needs GPUs means that their AI is still built along similar lines, and not a completely different infrastructure.

Having lived through big busts in the 1990s and 2000s, I understand the fear that investors have. But I think to really commit to a bearish trade you need to find something that the market has wrong. My personal view is that markets have interest rates expectations wrong - and I have good reasons to think that. But on AI, what I see is that OpenAI and Anthropic have huge obligations to the hyperscalers, which they seem willing to invest on the back off. Given their greater transparency, I find that hard to call that bearish. However, if they are basing their investments on the idea that US 10 year treasury yield is going to stay below 5% - then they have a problem. But that is really not tech specific.

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I have done a LOT of short selling in my life. In my previous career I ran a hedge fund of one sort or another from 2006 to 2021, so a 15 year continuous stretch. I was long from 2006 to 2007, then short 2008 to 2010, when briefly long, and then went short again, where I stayed short until 2020. I probably should have gone long in 2016 - but that’s another story. In 2013 and 2014, we were probably the only fund in London to still be net short - so much so that the GS stock loan desk took us out for Christmas drinks. Apparently we were there best customer by far.

I was short Volkswagon all through its squeeze, and eventually made (a small amount of) money on it. That was unpleasant.

I also tried and failed to short oil in 2008, putting on shorts in Petrobras in early 2008, but getting squeezed out before it collapsed.

Actually my ideal short is a cyclical stock you run long all the way up, and then switch to short when the fundamentals breakdown. The reason I am thinking about this is the ongoing momentum bloodbath in markets. The GS High Beta Momentum Index has lost 43% in just over over a month.

The only comparable move that I can remember was 2008. There was a mini one I was on the right side off in 2016, but 2008 was the really big one.

What happened in 2008, was that as the GFC started to unfold, the Fed starting cutting interest rates, which weakened the dollar. The China boom was still going, so commodities, and specifically oil and iron ore were going to the moon. But as recession took hold, this cyclical stock that has attracted momentum money got destroyed. Looking at SK Hynix and other memory stocks, its easy to see this type of market again - down 50% this month.

The thing is that back in 2008, the commodity stocks moved one for one with commodity prices. Petrobras peaked around the same time as oil. Vale peaked around the same time as iron ore.

This time the memory stocks have pre-empted a fall in the underlying. Memory prices are still at or very near all time highs.

Or to put it another way, Micron stock is falling even as earning expectations are being revised up.

The obvious short case is that hypercalers CDS is beginning to sell off and this will cause Capex to fall. I would be a bigger believer of that if I was seeing long dated bond yields falling - the market would be agreeing that recession is coming.

But if you do want to short memory stocks, I can offer one interesting argument. Before memory stocks became THE AI play, power equipment stocks were THE AI play. In the US, GE Vernova was the go to play. It is weak in July - but not broken - not yet anyway.

Koreans being Koreans, pushed their own electricity generation equipment stock up 700% in a year, but has halved in the last 2 months.

Chinese electricity equipment maker, Harbin Electric, peaked in February, and then halved before bouncing a bit this month.

There is a reasonable argument to say Asian stock markets are a lead on the US. As they make physical goods, they tend to have a longer lead time, and can see when things slow earlier. Sometime the Kospi does seem to turn well before the S&P 500, and sometimes it seem to be simultaneous.

One of the big problems with this analysis is that other reliable “tells” on the market do not really work. Normally the time to buy Korea was when its currency began to appreciate, and sell when it weakened. In this cycle, Kospi has soared as the currency has weakened, and fallen as the currency strengthened.

What I am trying to say is that short selling is hard. I used to only take on shorts when I could see three different catalysts to make money. Right now in memory stocks, you need to memory prices fall. And to make that work, you are basically saying that the hyperscalers will see their rising CDS and decided to cut capex aggressively. I would bet on that if I saw their core businesses going into decline - but I don’t see that (yet). Or if I saw recession - but I don’t see that yet either.

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Bloomberg notes that CDS on hyperscalers are all beginning to sell off. Oracle has by far the highest CDS - because it has so much debt. USD 167Bn of debt, with a big increase in 2026.

I am a bit surprised by the increase in Nvdia CDS, as it has USD 80bn of cash on the balance sheet -with relatively little debt. Google now has 118bn USD of debt from USD 25bn two years ago. Microsoft has USD 125bn of debt - up from USD 100bn a year ago. And Meta has risen from USD 40bn to 87bn this year.

In the GFC - rising CDS was definitely “BAD”. But its usefulness since then has been diminished somewhat. Tesla had Oracle level CDS or higher for most of 2018 to 2022.

The high CDS sent a message about financial issues with Tesla, which led to high short interest, which eventually got obliterated, when Tesla generated cash. Short interest is the middle graph below. Being bearish on Tesla was very popular and very wrong.

My point is that CDS does represent increasing debt levels, but is largely agnostic on the future profitability or lack thereof of that investment. But the movement in CDS is interesting. It matches up with a move lower in HYG US. Which I would consider bearish.

Which is wildly at odds with the behaviour of equal weighted SPX - which is at all time highs.

If I look at the KDP High Yield daily - this is generally correlated to equities. You would think US equities would be broadly weaker.

Following on from my autocallable note, US equities are not following dividend futures.

Something funky is definitely happening. GS Momentum Index getting obliterated again, with longs down and shorts up. Now down 5% for the year, from up 70% in June. Yowser.

If I had to take a view, and I guess I do, the market got over long AI trade, and we have seen some negative pricing in CDS from big bond issuance. This led to some selling, which because of the presence of leveraged ETFs, caused more selling. This hurt long books, so hedge funds degrossed, and so bought back shorts and underweights. You end up with equal weight S&P 500 going up -see Apple at new highs. But actually, credit is not looking great - so short covering is happening at the wrong time. It does make me wonder if another momentum trade that suddenly reversed early this year is about to make another reversal? Gold has underperformed S&P 500 hugely since a February peak? Time for a turn?

This would fit more closely in with my pro-labour view of the world. That is one of volatility, as rising cost of capital fights with growing revenue. And the S&P 500 was very volatile in the 1970s.

In some ways I love this market - because I have a theory about how it should work, and we are going to see if its right or not. That theory is pro-labour politics is great for growth but raises the cost of capital - which should be more problematic for the US. Cost of capital is rising now - lets see if the theory holds.

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For a long time Goldman Sachs have published a pair trade of momentum longs versus momentum shorts. It tells you what everyone who works in asset management knows - momentum is great until its not. We have once again entered the bloodbath stage of momentum investing.

It may look like this falls apart when the long book crumples. But back in 2002, everyone was short tech names, and these rallied, the short book caused problems back then. You can see that more clearly when you look at the momentum long part of this trade in isolation. Big falls in the long book are highlighted. Hedge fund long investing has generally been good.

But what really hurts is when the shorts move against you. These are highlighted below. And that is what we are seeing today - momentum longs falling and momentum shorts rallying. Keen eyed observers will probably recognise that the only time you really want a short selling fund is AFTER short selling has not worked - that is 2000, 2005, 2011, 2021 and maybe, 2026.

The GS momentum pair has dropped 40% from its June peak, and is back to flat for the year. I don’t know exactly what goes into GS Momentum Long Index, but we can use the data from a iShare Momentum ETF to get a good idea. Broadly speaking - AI trades are about 50%.

Typically in my experience this market action tends to cause weird behaviour all over the market - mainly as sudden arrival of risk in one part of a hedge fund manager book then requires risk to be cut everywhere. One area I am surprised not to see action is in currencies. Carry trade has had its best run since the 2000s.

And Yen shorts are at Max short levels. I would have suspected a Yen rally of some sort.

As are Swiss Franc shorts. I would also have expected a Swiss Franc rally of some sort.

Despite this, the dollar remains near one year highs. Given the centrality of AI to US growth in recent years - if stock prices are to believed, then short dollar trade should make a comeback.

I guess what I am trying to say, is that while all the action is centred on AI, the outlook for short selling and potentially short dollar trades look to be improving.

Alternatively, the AI sell off is purely positional - and this is not causing any problems in the rest of the market, because the weakness in AI stocks is not reflecting any real underlying weakness in the AI trade. If I would have to find a similarity to this market, it was the blow-up in the XIV ETF back in 2018.

This fund gave you twice the negative return of VIX, or essential selling VIX. It did well, but when a small shock came along, VIX doubled over night, and it went to zero. But the reason it doubled overnight was because it was so short VIX. There was no information content in the price action, other than the XIV ETF was a bad product.

The S&P 500 fell 10%, and then carried on up -the VIX spike was the death of a bad product rather than anything genuinely market related.

It does seem to me, that leveraged long memory ETFs are the new XIV. I think you need to see far more confirmation from markets to really believe something has changed, like a weak dollar, or change in bond markets..

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Calling a top in semiconductors has been a tough gig for nearly ten years now. I thought 2018 was a top and was wrong. 2022 was a head fake too, and was 2025 Deepseek sell off. But here we are again, with the SOX down 20% from a peak in June.

The bull market in semis is very easy to understand. Pricing power has been phenomenal. TSMC, which I have been covering for 20 years, has been able to push prices up massively over the last few years. The only other time this happened was the dot com bubble.

As of today, we are seeing a very big fall in leading memory stocks. SK Hynix, which recently listed ADRs, is now down 50% from its peak. Amazingly, it is still above its 200MDA.

So was that the top? I see two different explanations for current price action.