Capital Flows and Asset Markets

Red pill/blue pill is an analogy I have used before. I like it, because it goes to heart the angst markets put me through occasionally. Red pill is for the hard truth, and blue pill is for the comfortable lie. But in financial market terms - you want to be taking the red pill, when everyone else is taking the blue pill. My red pill is that governments are now “pro-labour”, so we will see a prolong period of rising inflation, rising interest rates and a rising cost of capital - but no real rise in unemployment.

Blue pill is a return to the deflationary environment that existed from 1980 to 2020. US markets are starting to say deflation again. My preferred trading idea, GLD/TLT, it taking a beating - and is now down for the year. Technically, this looks dire, and the first time since 2021 it has breached its 200 MDA. As a rule, if the 200MDA starts to turn down, I tend to just walk away - but as descent have been so quick - the 200MDA is still rising.

I know that gold got caught up in a speculative frenzy with precious metals at the beginning of the year. Silver has now fallen 50% from its peak. As I told people at the time, I don’t like silver as I don’t think central banks buy it. My biggest concern is that precious metals just got caught up in a speculative bubble - like a meme stock - and the price action is actually meaningless. This is more likely with silver than gold, but it is my biggest fear.

What made me like gold, and still like it today, was its break out versus the S&P 500 from 2025.

Previous breakouts have rewarded perseverance with the trade. But moves this year are signalling a false break out. This adds to the fear of precious metals just being an investing meme.

Even more disturbing, the 30 year US treasury briefly topped 5%, and has promptly rallied back to 4.86%. You could argue that yields have topped out.

The problem for me is that the market is starting to say deflation but I read the politics as inflationary, and remaining so. In the UK, Andy Burnham will be likely next PM - who will likely move left to try and out manoeuvre the Greens and Reform. In the US, the Democrats are now talking of more tax cuts, again abandoning any fiscal restraint as it has become a political trap. But more than that - my lodestar market, Japan continues to point to inflation. 10 year yields continue to surge.

Even more impressive have been Japanese banks that are outperforming on a relative basis. This is even more impressive when you think how well tech stocks have performed, of which Japan has many. What I also like is how Japanese banks picked up deflationary turns in the market well before it was apparent, in the early 1990s, again in 2007 and then again in 2011. But as of today - everything looks great.

Here is where push comes to shove. Has the nationalistic/populist political winds changed? I don’t think so. Have governments moved away from industrial policy? Nope. Do governments have any mandate for austerity? Not that I can see. But markets have to price what they see - and they see short term rates going up, and that has been deflationary since 1980. But the politics of 2026 is not the politics of the 1980s. Or to put another way, Japan signalled deflation all through 1990s and was correct - and today its signalling inflation, and I am thinking it is correct. Perhaps I should be asking “赤い錠剤 or Blue Pill?”. That is do I believe the Japanese markets or the US. I think I pick Japan.

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Since a peak earlier this year, GLD/TLT has entered a bear market, down nearly 23% from the peak.

At the time I expressed my surprise at this move, as it coincided with a steep rise in the oil price - which I would see as gold bullish and bond bearish. We have also seen a period of pronounced dollar strength.

What seems to be driving movements in GLD, TLT and DXY is short term interest rate expectations in the US. The spike in the oil price has coincided with a rise in 2 year US treasury yields, as tighter Federal Reserve policy has been priced in.

The question now then, is do I expect the Federal Reserve to get even more hawkish? Probably not. PPI, which tends to be more volatile than CPI, has tended to be better at predicting Federal Reserve dovishness or hawkishness. Almost all bear markets are preceded by a spike in PPI, and falls in PPI mark dovish turns. Currently, we are at 9.1% YoY - one of the higher numbers seen.

You do not have to be a genius to understand that PPI tends to move with the oil price - which after spiking earlier this year, is now turning lower.

As a sense check, I also look at CRB Food Stuff Index, and this remains with in the recent range.

What I think is likely is that softer inflation numbers will start coming in, and President Trump, who has seen his popularity fall with War In Iran, will get impatient with either a strong dollar or high interest rates or both, and this should reignite the weak dollar trade. I particularly like this because of three other reasons. Firstly, the Renminbi remains at strong levels. If it was weakening, I would worry about gold and short TLT.

Secondly, strong dollar trades, as seen with weak Yen positioning is back at near peak levels.

Open interest in gold has collapsed to lowest levels in at least 10 years.

But to be clear, this is a political bet first. And that bet is that President Trump starts putting pressure on the Fed and his trade partners for a weaker dollar and lower interest rates. The economics and positioning are supportive - but it is a bet that with lower oil prices, weaker inflation prints will encourage President Trump to return to this theme.

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The use of levered ETFs has grown substantially over the years. This year has seen record notional volumes.

200 stocks have their own levered or inverse stock ETF now.

It should be unsurprising that long leveraged ETFs dominate.

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There are an increasing number of divergences in markets, which typically signal caution. Furthermore, there are signs of increasing amount of leverage in the both bond and equity markets.

Generally speaking, I have gotten most of the big calls right. Unlike the vast majority of the "macro community”, I did not think closing the Straits of Hormuz was going to be a massive problem (see my Gays of Hormuz note). In essence, I argued that closing the Straits only really hurt China as an oil importer, and would just accelerate the development of alternative energy sources. That is chasing the oil trade in March looked like a good way to lose money - which has proven correct.

I have expected yields to keep rising - and 10 year JGBs are now at the 2.6% - a level that would have been unthinkable not that long ago.

And this has played out well in my preferred expression of JGB bearishness, bullishness on Japanese banks. Topix Bank Index continues to trade well.

I also thought that rising rates would make like difficult for private equity/private credit. This has been correct. Invesco Global Private Equity ETF is a good proxy for their travails.

I did start to get bearish parts of the AI market, as it seemed like credit markets were not willing to fund the AI spend anymore. But with SpaceX IPO, it looks like retail investors will take over the capital baton. But there ARE mixed signals from this space. Meta, Microsoft and Oracle both have traded relatively poorly this year. But just when it looked like it might unwind, SpaceX, OpenAI and Anthropic are all rushing for the IPO door. This makes things more difficult, and I think it is right to have a more nuance outlook.

Generally speaking, I have a bias towards weak dollar, but not aggressively so. If we look at the dollar index - its has gone nowhere this year.

Coinciding with dollar strength, my key recommendation, GLD/TLT, has taken a long breather, and corrected back to the 200MDA.

While I have been tempted to buy China shares from time to time, the politics has been ugly for China, and I would consider it more a “trading market”. This has been borne out this year. Bullish calls on China from the macro space has proved premature again.

While I was bullish on European defence stocks for a while, there were signs of the capacity build out being more than sufficient. Leading defence stock Rheinmetall has fallen some 41% this year.

One of the big positives I take from this year has been the primacy of politics over economics. And in general, inverting my investing process to take account of politics first has, I think, put me closer in tune with market moves. My current feeling on markets is that we are getting closer to a bearish washout - if purely to clean out the leverage that has built up in the system. I will discuss further in part II.

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The Economist happened to be hosting a conference on “Commercialising Quantum Global” at a venue that was about seven stops down the tube line for me - so I decided to pop along. When I started in markets from 2000 onwards, I learnt that tech and pharma stocks were the most unpredictable of investments, so generally avoided them if I could. The last ten years has shown that is not a viable option anymore, although there are plenty of tech and pharma stocks that have disappointed, the AI trade has made almost everything (utilities, power generation equipment, interest rate outlook?) a tech trade, so you are basically now forced to have a view on tech. With this knowledge, I thought I should see what was going on in quantum computing.

If you have followed quantum computing, then you should know that there is no mass commercialisation as of yet. Most listed companies can almost be called “pre-revenue”. Rigetti Computing which has been listed since 2021 has USD 10m or revenue in last twelve months, but has a market cap of USD 7bn (the Rigetti CEO was at this conference).

The conference was very hyped. There was a speech from the UK Minister for Science, Innovation, Research and Nuclear, Patrick Vallance, as well as former leader of the opposition, William Hague. Many of the presenters were very excited about the progress that quantum computing had made, and talked at length about the developments. But what was probably the biggest driver of excitement, or at least to me, was that both the UK government and the US government were becoming heavy investors into the quantum area. Most notable was that the UK government was very keen to not only develop the technology, but keep the technology in the UK. Plainly, they did not want to see a repeat of DeepMind being sold to Google, or ARM being sold to Softbank. The quid pro quo here was that the UK government funds you know at a high valuation, and you keep the technology in the UK. Plainly this is in response to the UK and Europe feeling left behind in the AI race, and making sure this does not happen again. In theory this is great news for the UK. In practice, when they laid out the seven areas of quantum computing they are supporting and the companies they are funding, the majority are already American owned. See below.

Rigetti we have already talked about and is US listed. Cold Quanta is owned by Infleqtion, and is a relatively new listing in the US, Oxford Ionics is owned by US listed IONQ, and QuEra also a US company with no listing. This leave Orca Computing, Quantum Motion and Aegiq as the three UK owned company as UK’s best hope. The problem for the UK is that the US has a similar strategy, but invests far more. Infleqtion and Rigetti managing to get money from both the UK and the US governments.

Government investment is the bull story. The bear story, was that through out all the presentations, the commercialisation story remained pretty weak. As can be seen above - there remains different possible options to making quantum computing work. And most of the chat was that in the end two or three platforms will survive. The main viable end use was mapping molecules (so biopharma) and cryptology. There was some talk of cloud computing - but this was always in cooperating with existing technologies, and with the idea of helping reduce or optimise the computing load. That is the excitement comes from government investment, rather than commercial logic. I was reminded very much of the Chinese government approach to investment - choosing an area, flooding it with money, and hoping for success. If we take electric vehicles, and area that the Chinese government has favoured - in the first stage everyone wins, but after that, with excess competition, returns are much more muted.

Obviously, we are still in the bull market era of western governments intervening in markets. When that ends, I am not sure. Maybe today, maybe tomorrow, maybe in 10 years. I will write another post on that. If you are looking to “speculate” in quantum, then Infleqtion could be interesting. As noted about, they have capital from both the UK and US governments, and have already shipped various sensing equipment. It has produced quantum clocks can act as alternatives to GPS, which is increasingly being blocked in Russia and elsewhere. It can also be used in submarines. So government money and already shipping product is a plus. On the negative side, they listed last year via a SPAC - which is a red flag. Their CEO is a former venture capitalist, Matt Kinsella, which is either a red flag or green flag. Red flag in so far he is looking to monetise quantum hype, or green flag in that he had decided to join the most promising quantum firm he could find. On the positive side, all that fund raising means the firm is sitting on USD 500m cash balance against its current valuation of USD3bn, and sales of USD 40m.

What would be bullish development in quantum? Well it would be if the uses of quantum computing could be generalised. And as yet there is no sign of that. But just like with GPUs, which were initialised developed to play video games, it may take a while to find an end usage. Personal, I think you can sit and wait.

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With the bull market and now bear market in gold, I had lost sight (temporarily) of what I am trying to do with GLD/TLT. My thoughts for the last few weeks were all on why was gold so weak. And this is fair enough. But the real issue is why has TLT not been weaker? My thoughts on TLT were reignited when I was reading a Special Report on the treasury market in the Economist. Generally speaking a good report - but one paragraph really exercised me. The writer foolishly believes that central clearing will improve liquidity for treasuries.

I have written a letter to the Economist, explaining why this is wrong, which is below, but I doubt it gets published.

I have been intrigued by clearinghouses for years now, ever since I read about a Nordic power market central clearinghouse going bankrupt back in 2018. It took some digging to work out what went on, but to cut a long story short - clearinghouse have no ability to price risk, and no incentive to do so. So they basically assume tomorrow will look like today, which creates huge momentum trades. The better something is doing, the more leverage they will supply. And in essence, what happened in Nordic power in 2018, is getting primed to happen in treasuries.

You may well say, how can you be sure the treasury market will blow up? Well the good news is we had a dry run in the gilt market already. When Liz Truss shocked the gilt market, it caused UK gilts to diverge radically from other bond markets for a good month or so.

And we almost realised a Treasury blow up during the liberation day tariff sell off in 2025.

So how do clearinghouses cause illiquidity in gilts and treasuries? Well clearinghouse are owned by profit maximising corporates, and so have a naturally tendency to try and maximise volumes. If you look at the middle chart below, you can see that banks used to be borrowers from repo markets, but are now lenders. This chart is 7 years old, but as we have seen above, hedge fund borrowing would have only increased.

Why does this create illiquidity? Well hedge funds buy physical treasuries and then sell futures against them. There is a small arbitrage profit - but with leverage it can be substantial. Pre GFC - you could not use clearinghouses to do this trade, as the cost of initial margin would make this prohibitively expensive. The only way to do it would be to borrow from banks - which is what LTCM did. LTCM was very secretive about how much it had borrowed to do this trade - but once the banks found out the size of the borrowing, they cut lending, positioned themselves the other way, and scalped LTCM.

Theoretically, with central clearing, this should not be possible. All trades are done with the central clearinghouse and require initial margin. However, this ignores another change in regulations - compression. Essentially, clearinghouses will look at your trades, and if they think they are similar enough, will allow you to compress the trades, and return initial margin to you. LCH (the main fixed income clearinghouse) used to boast of the amount of compression it did a year. The last number I have is USD 800 trillion in 2019. Treasury cash futures basis trade should qualify for compression.

In my view, compression trades make clearinghouses as dangerous as banks pre GFC. It removes the excess margin which kept them safe in 2008, and has a nasty side effect of making the market bifurcated - that is in this case, hedge funds on one side, and banks on the other. The banks know all about this - and have been urging reform - but on deaf ears.

Anyway, given the size of the basis trade market, and the relative unattractiveness of US 30 year treasuries, the market looked primed for a big move.

If you read this far, then I can tell you what I think will happen, and why I like short TLT so much. At some point, there will be a shock - tariff increase, big increase in fiscal deficit, something. And Treasuries will fall. The clearinghouse will raise margins, and both lenders and borrowers in the repo market will have pay more initial margin. That is BOTH sides of the market will have to put up cash, meaning that BOTH sides of the market suddenly do not have cash, and the market become illiquid, leading to further falls in treasuries. The treasury market will become very illiquid, and traders will be looking for other ways to hedge their position. TLT being and ETF - can provide liquidity - and I see it trading to a big discount to NAV, as all the hedge fund will need to reduce their physical holdings of treasuries. Of course the Fed will be motivated to act, although Kevin Warsh and Scott Bessent have indicated a tendency to want the Fed to do less - there is a chance they let this play out. That is I expect the treasury market to totally freeze up, and TLT will act as grey market for US 30 year treasuries - which will be much lower than it is today. I would also expect US assets to do poorly in this situation.

Why is weak gold good for this trade? I owned gold as a hedge against the Federal Reserve not allowing the market to clear properly. If gold is falling because the Fed is reducing liquidity - then the risk of a treasury blow up should be rising substantially. Exciting times.

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I think gold still looks interesting - mainly because Donald Trump is still President. This makes owning treasuries seem unattractive, AND makes it likely he will pressure the Fed. That being said, it is some 25% down from it peak, and squarely in bear market territory.

These days people typically talk about passive investing distorting the market - see Michael Green’s work. Personally, I have found market tends to find a way to make money from distortions. If we look at ETF flows into gold, if it was truly distorting, gold should still be at highs!

That being said, there are two style of “passive” investing that I do think distort the market - factor investing and CTAs. Both these styles are dominated by “robots”, who tend not to really think about what they are doing, but follow “rules”. The rules tend to be pretty self explanatory - and you see them in many big funds like Bridgewater was well. We will just look at gold and factor investing for the time being. Factor investors tend to love gold when the US dollar is weak. So I was bearish gold in 2012, and been bullish since 2022 - in part because this “factor” looked to be turning at both these points. Gold this year peaked at the same time time dollar hit its low.

Gold also tends to do well when US rates are falling - but for me this is much more a secondary consideration. If the US is raising rates, but the US dollar is still falling, expect gold to do very well. That being said, gold also peaked when US 2 year yields were at their lows.

There are lots of different assets and different factors, but for gold these are the key. What I can tell you is that factor based investors robots just move money in and out of assets based on these factors. I am 99% certain factor investors were buying gold in 2025 and early 2026, and now they have become sellers. And should dollar weaken, they will likely become buyers again.

Even dumber investors robots are CTAs. Who are basically momentum investors. If you ask a CTA they will tell you they are not a momentum investor, but they are. They will probably claim they have “better stops” than anyone else, but this plainly b******t. CTAs love buying assets going up, and selling assets going down. Typically they use moving averages to determine buying and selling. My guess they went very long gold in early 2024, and are now fully out of gold as of today, and possibly even short selling.

What happens in markets these days - in my view anyway - is that some factor changes (interest rate cut, oil price surges etc) and the factor investors duly move money around. This causes the CTAs to start buying this new trend, and can push as asset like gold up a long way. But then factors change, and the process goes into reverse. As mentioned above, I like gold, mainly because President Trump is still President. What are the chances that he begins to complain about a strong dollar, or interest rates being too high, between now and the end of his term? 90% seems reasonable. Where is market positioning on a weak dollar? Pretty close to max short on Yen.

And also pretty bearish on the Swiss Franc.

Not so bearish on Euro, but still below recent highs.

The funniest thing about all of this, is that even though I am looking at Euro, Yen and Swiss franc - there is one currency above all that should be linked to the price of gold - and that is the Chinese Yuan. For me a strong Yuan tends to imply a strong gold price. Chinese Yuan has been conspicuously strong.

I find it really hard to be negative on passive ETFs that buy and hold indices - its an efficient way to hold an asset that is designed to go up over the long term (sorry Michael). But I do find it easy to be negative on passive “rules based” investors like factoring investing and CTAs. They are always doing dumb stuff. Basically they seems to have said, “oh dollar has rallied against Yen - sell gold”. When I see Chinese Yuan is still strengthening against the US dollar and has USD 1 trillion trade balance to deploy, and President Trump is still President, I struggle to get bearish gold. CTAs and factor investors are probably short and out of gold, and short Yen and Swiss Franc. Yep - makes no sense to me either - but this has always been the problem with investing using historical data - you are fighting the last war, not this one.

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I have like gold as part of GLD/TLT trade for a long time, and it has been a great trade - but last few months it has been very lacklustre. It has traded right back and now through its 200MDA, which might mean its time to add, or its breaking down. What follows is a stream of consciousness analysis…..

The truth of the matter is that all the price action has been in the gold part of the trade. I think the market got VERY excited about gold when it started to outperform S&P 500. This meant you could be BEARISH (owning gold), and outperform the S&P 500. Sadly, this trade, GLD/SPX, has smashed through the 200MDA to the downside, and as of today has created what “technical analysts” call a dark cross. That is the market is saying you should sell gold to buy SPX.

What’s the problem with gold? In the last few months, and contrary to market expectations earlier this year, markets have started to price in the Federal Reserve ACTUALLY doing its job.

Gold has been far more sensitive to central banks tightening than the long end of the bond market or equities.

Equities have not being bothered by rising bond yields at all. That is financial assets have been very resistant to rising yields.

I guess another way to put even when bonds have a higher yields, investors still prefer equities.

So the problem with gold, is that it has reacted EXACTLY as you would expect to higher bond yields, but equities and long dated bonds (or financial assets) have not. To be fair, some financial assets such at Bitcoin and Private Equity have been weak, but broader indices have been fine.

While I had a good fundamental reason for buying gold - mainly on central banks getting out of treasuries - I did worry about speculative excess. There was only limited signs of excess in gold. Back in 2012, we had seen ETF holdings of gold rise from 20m troy ounces to 80m, and in the 2016 run up it went from 50m ounces to 111m ounces. Both marked tops. So far we have seen a run up from 80m to 98m troy ounces. This was not screaming speculative excess to me.

On the other hand, silver did take on a speculative nature in late 2025 and early 2026.

Looking at flows into a silver mining ETF (SIL US), it definitely became excessive - but has seen some meaningful outflows recently

Unlike most people, I have been bullish and bearish on gold in different parts of my career (my experience is that people choose to be either bullish or bearish gold, and then never change their views). Back in 2012, I was bearish on gold, as I saw Indian Rupee weakness and broad based US dollar strength being bad for gold. Indian are big buyers of gold. However in this market, gold has moved independently of the Indian Rupee.

I had assumed that the most recent bull market in gold has been driven by central bank buying out of China and Eastern Europe. I have no reason to believe that this buying has ended. China still has an annual USD 1 trillion trade surplus that needs to be deployed somewhere, and it is not going to be US treasuries. And here we get to the crux of the problem. Do I believe that the US is about to undergo fiscal austerity? No. Do I think that Donald Trump won’t try and influence monetary policy again? No. These are bullish for gold.

The real problem is whether I think AI trades makes a better hedge than gold on monetary craziness? Now we get to the crux of the problem. In the 1970s, oil and gold was the best hedge on monetary craziness. Are semiconductors a better hedge these days? Is this was SPX/GLD already saying? If the 1970s was about cars and oil, maybe the 2020s are about compute and semiconductors? If we do Philadelphia Semiconductor Index (SOX) v gold chart, then we get a very interesting chart indeed.

What I love about this chart is that it did pick up the when you should have flipped from gold to semis in 2012, and it does give exactly the mixed vibes on gold versus equities that existed for the last few years. And it does pick up the very toppy vibe in semis that exists today. But also suggests that the craziness might not yet be done. But the story seems clear - hyper competition is driving a capex frenzy, that will end in a bust. At that time, a US fiscal deficit of over 10% will likely drive a weaker dollar, higher gold and probably a weaker long end of the treasury market. Just not yet, or that is, the gold trade is still early.

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When I first starting to think about the idea of a pro-labour theory of markets, I assumed the cost of capital would rise for political reasons. The long period of "pro-capital” policy had lead to the creation of large pools of capital. The first, and most exceptional in my view were foreign reserves. The idea of buying another countries fixed income was a completely foreign idea before 1980. All foreign reserves were gold, but from 1980, led by the Japanese, buying US treasuries became accepted as a “better” form of foreign reserves.

It also happened that from 1980 to 2000 or 2015, owning treasuries was much better than owning gold, which reinforced the idea of owning bonds over gold. This has since reversed.

I saw buying treasuries as foreign reserves as pro-capital policy, as much of the Japanese buying of foreign reserves was meant to keep the Yen weak - that is to keep labour costs low. Competitive devaluations is most clearly a “pro-capital” policy (devaluations reduce labour costs, and boost competitiveness - which favours the owners of capital). In the new pro-labour world, I envisaged governments endeavouring to keep their currencies strong, and hence foreign reserve growth should slow or reverse. Japan shows this trend, but official holdings of treasuries have been falling for a while now. Total official foreign holdings of treasuries has been weak.

I also saw that rising interest rates should begin to kill interest in “alternative asset managers”. These businesses held huge amounts of “dry powder” - but it is hard to square this dry powder with redemptions that most of these businesses are now seeing. The performance of the Invesco Private Equity ETF confirms these problems. That is two big pools of capital - foreign reserves and private equity are already displaying signs of problems.

I also assumed rising wage demands would start to effect the cash piles that had grown in American corporates, the third biggest pool of capital. Microsoft for example had seen cash and equivalents go from USD 25bn in 2007 to USD 140bn in 2021. This cash pile has now fallen to USD95bn or so.

Google claims to have USD120bn of cash and equivalents, but are choosing to raise USD80bn in an equity raise.

Obviously, around USD 100bn of cash equivalents seems to be the line in the sand for Google, and they are already spending everything they make on AI. But they want to spend another USD80bn, so raising equity is the obvious answer.

So to my surprise, rather than wages rising, it has been the price of semiconductors that have been the driver of inflation, or perhaps more correctly, the biggest beneficiary of governments working to halt recessions. For many other firms I look at rising labour costs have drawn on capital reserves, but with big tech, is is spending on semiconductors that has reduced their pool of capital.

And the AI boom has ended one of the enduring features of capitalism. Technology should make things cheaper. But technology itself is no longer becoming cheaper.

From what I can see, the rising cost of capital continues to work its way through the system. It has already stunted the use of debt markets and private equity. It has reduced the size of foreign reserves, and also seen central banks try and reduce the size of their balance sheets. Some how corporates have managed to keep their cost of capital relative to government costs very low, but for how much longer?

Hence corporates are now turning to one final source of capital, equity markets. And here we can see that 2026 is big year for IPOs.

The question then is when or if does a rising cost of capital begin to impact equity markets? Or has it already done so? Gold vs S&P500 has been indicating issues for over a year now.

For big US corporates, they have engaged in “capital wars” with each other to dominate the AI trade. But how much capital is left? And it is making capital expensive for everyone. I can see the political winds shifting to try and get costs lower, but I can not see how that will come via wages or unemployment. At some point, governments will want to see price wars among corporates. I just don’t know when.

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