The big story in the past week was the massive currency intervention by the Bank of Japan (BOJ). Hard to know exactly how much went through, but reports were in the range of $70bn on Friday alone. FX interventions by major central banks are less frequent than they were years ago. This was the first BOJ buy side intervention since 1998. There is a pretty simple reason we don’t see intervention much anymore – it does not work. Let’s have a quick look at what’s going on.
Against the trend of most other central banks, BOJ policy has been to maintain low interest rates and keep long term yields under 25bps (a policy called yield curve control, YCC), despite rising inflation and a global backdrop of major economy yields rising substantially. They have been the principal buyer of Japanese Bonds, leading to a crash in liquidity. In recent weeks we have seen multi day streaks when the benchmark ten-year bond (the JGB as it’s known) has not traded. Forcing long-term interest rates to below market levels (the 10y swap market has rates around 70bps) has created massive pressure on the currency, and the BOJ has tried to stem the tide.
The current trend in the managed futures world is … expand the portfolio, trade every little market in every suspect exchange around the world to get the maximum diversification. That’s fine I guess if your goal is to create a standalone investment with the best possible Sharpe ratio. But if your goal is to diversify a broader portfolio, adding many second-tier markets may be counter-productive. Let me explain.
2022 has been an awful year for most all assets. Through the end of the 3rd quarter, the S&P 500 is down 23.9%, High Yield bonds down 14.4% and Investment Grade bonds down more at 21.2% (worse than HY due to the longer duration in IG). Over the past few decades, investors have been somewhat accustomed to seeing US Treasuries do well in tough times for equity and credit markets, this year though, 7-10 year US Treasuries are down 15.7%. It’s an ugly scene…not a lot of places to hide.
One bright spot – Managed Futures strategies. We wrote about these earlier in the year here. Our long-held view is that Managed Futures are fantastic portfolio elements. We like them more than most – and execute them in a purer form than most as well – but recognize them for what they are. A Portfolio Element. Most investors, us included, hold portfolios of stocks and credits. To our eye these are also Portfolio Elements. Stocks tend to do well in times of economic stability, growing earnings and rising multiples. Managed Futures tend to do well in periods of macro-economic uncertainty and instability. Combining these two elements makes a lot of sense to us.
The idea of investing quadrants has been around a long time. Divide the potential environment into 2 planes, basically growth and inflation. Determine the current intersecting box, invest in the things that have done well historically in that box. It’s a great shorthand method of putting order to chaos, most of the time. Thought experiment … Is the economy growing? Real GDP is negative, so no, nominal GDP is on fire, so yes. Weekly unemployment claims are low, so yes, but job openings are falling, so no. You get the point – picking the box is tough. We are in a really inflationary time, so buy gold, right? Wrong, regardless of what the cable ads say.
Some big pool of money (BPM) would like something for nothing. Large financial institutions (LFI) are happy to help. Heck, they even compete to help the most. As long as X never happens – and of course it never does – we can give you exactly what you want. In the 1980s, pension funds wanted to be long stocks but not the downside tail. Buying puts was too expensive. No problem says LFI! We will give you something called portfolio insurance. Instead of paying implied volatility, you can own an option-like structure at realized volatility. As long as the market does not gap down a lot – which of course it never does – there is plenty of liquidity to execute the hedge. October 1987 put an end to that little fantasy. Then there were those good old sub-prime loans. Some BPM would like some higher yielding debt. No problem says LFI! Each mortgage may be risky, but they are much better behaved when we look at a big basket of them and we’ll spread them out all over the country. As long as house prices never go down, which of course they don’t, and certainly not all over the country, these bonds are golden. We’ve even paid someone to give them a AAA rating! That ended…not well.