It is an understatement to say that the price action over the past week has been impulsive, rapid, and emotional (chart 1). There is an intimate link between liquidity, volatility, and leverage. The paradox of the “Sharpe-Ratio” (or value-at-risk) approach to managing exposure is that long periods of stability encourage investors to take on too much leverage when liquidity is plentiful. As a result, participants become short convexity (or volatility).
Chart 1
What we have probably just witnessed is a forced unwind of this leverage or as Dave Dredge has termed “the great stop loss.” Prior to the correction, positioning and beliefs had become very crowded long equities (especially mega-cap technology and AI), short JPY and short volatility. While it is not straightforward to measure, most common positioning metrics were at or near the 100th percentile.
What we also know is that long phases of stability lead to large episodes of instability. If you want to know where future risk is; follow the leverage. The Bank of Japan’s yield curve control (or peg) forward guidance that this would persist encouraged the accumulation of JPY funded carry (in many forms). That clearly reversed last week from both the Japan side and from a shift in the prevailing bias on the path of US short term interest rates. The additional context, as we had warned, was the non-existent equity and credit risk premium.
Another observation we have made is that human beings are not particularly good at non-linear thinking. From our perch, a key reason why there is resistance to consider extreme (or non-linear) outcomes like monetary policy reversals, inflation persistence, acknowledgement of higher neutral rates, depletion of inventories and wars is that most investors benefit from asset prices going up. The real world is not linear and systemic risk can increase at an accelerating rate as correlation moves to one in a major episode.
The current episode is clearly correlated to the move in currencies. It is important to remember that currencies are always a relative price. Interest rates, growth, inflation, and external positions are all relative considerations in foreign exchange. It is important to consider the dollar’s reserve status and the Fed’s role in influencing Treasury yields across the curve. Fiscal dominance remains a risk now that government debt-to-GDP is above 100%. The positive news and the “good outcome” for US Treasuries is that the odds of a recession have increased again. That has clearly narrowed the US-Japan interest rate differential from the US side (chart 2).
Chart 2
Of course, for growth assets the start the rate cutting cycle signals that growth and profit margins are under pressure. The start of the rate cutting cycle in 1990/1991, 2000/2001 and 2007/2008 was not bullish for equities and credit. The context, as we noted above is that the equity and credit risk premium is still narrow. Although risk perceptions have clearly changed materially over the past week. In some markets, for example Japan, the correction has been so large (~20% from peak) that the forward-looking returns (odds) have improved. We started to scale into Japanese equities today. Our Japanese sub-portfolio is 8-9 times earnings and net cash on balance sheet. While the US-Japan rate differential has narrowed, it is likely to remain very large in favour of the dollar. We would also expect a recovery in the dollar over the coming weeks.
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