As We See It: The UK Bond Debacle

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Same tune, different words. Every. Single. Time.

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.

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As We See It: Everything Selloff, But…

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When you woke up yesterday morning, this was the headline of the lead story on Bloomberg News:

Source: https://www.bloomberg.com/news/articles/2022-09-26/everything-selloff-on-wall-street-deepens-on-98-recession-odds?sref=3w8JJB7Z

The past week had been really tough, with bonds and stocks both crushed, regardless of locale. There were panic moves everywhere, but particularly in sterling. Third world type emergency action being considered to control the slide. If the Fed’s mission was to break something, well, mission accomplished. Negative skew everywhere. There was, almost, no place to hide.

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As We See It: CPI

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The reaction to last week’s CPI print was pretty dramatic. We see a couple of related factors:

  • Given the fall in gas prices, the S&P had bumped off the bottom in anticipation of a soft print. Positioning went from negative to perhaps modestly positive. CPI caught the market on the wrong foot.
  • Gas prices as reported in the CPI did fall as expected, but just about everything else went up (see graph below). Everyone knows gas fell because of releases from the Strategic Petroleum reserve. That policy is the definition of “transitory” (they will need to buy it back, no less). With everything else going up, inflation fears pulled a Lazarus.

Watch rents. Lagging but steady inflation indicator, closely tied to wages.

Source: Bloomberg

Managed Futures In The Portfolio

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The last few months have been a fantastic case for the role of managed futures in a portfolio. Managed futures do well in periods of macro volatility, and this time is no different. What investment, that can be measured passively, has done well this year? Short term treasuries? Nope. The Bloomberg US Treasury 1-3 Year Index is down 1.5% YTD (through Feb 14, 2022). Stocks? Nope, the S&P 500 TR Index is down 7.5% and the Nasdaq-100 TR Index is down 12.5%. Real Estate? The Real Estate Select Sector TR Index is down 13.2% YTD. Some of the tail risk and long vol strategies were also down. How about managed futures? The MLM Index EV (15V) is up 10.3% YTD. So why is it that managed futures have not gained wider acceptance as a portfolio element? There is a lot of blame to go around. Let’s have a look.

All the issues around managed futures arise from the character of the returns. Managed futures have positive skew, the profile of an option buyer. Lots of small losses (like premium paid), with occasional big gains. This is the reverse of the stock market, where the market goes up in small steps and down in a whoosh (negative skew). The attraction to managed futures is that the big gains are often at the same time as the stock market whoosh, like this year, and that they can capture that convexity whether it’s being driven by market moves up or down. Risk parity models try a similar approach – using bonds to diversify stocks, but that only holds when bonds go up. Sometimes its bonds falling that cause the equity whooshes. Sound familiar? Being able to generate convexity on both sides is a big improvement. The character of managed futures returns breeds a lot of behavioral biases on the part of investors. But first, let’s look at the managers.

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The Inflation Supertanker

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I recently had a conversation with a colleague about the idea that portfolios over the last 40 years have been conditioned for falling interest rates. If that supertanker makes a turn, a lot of money will be on a collision course. He said in 1984 there was an equal and opposite issue … buying bonds for the prior 20 years had been a fool’s errand. The cycle climaxed in June 1984 with a hot GDP, a low inflation print and a collapse in bonds. Even though inflation was low, no one wanted to own them.

I was intrigued and pressed the conversation with our resident bond historian and partner, Paul DeRosa. His response below:

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Pricing Escape Velocity – The Rubber Hits Abbey Road

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The chart below is fascinating to us, particularly in light of the fairly modest in magnitude, but quite speedy rise in UK yields. The chart shows the difference between futures prices for sterling 3 month LIBOR expiring in September 2022 and 3 years later, in September 2025. They price at 100 minus the interest rate, so a price of 99.5 equates to a 0.5% prevailing rate at expiry. Roughly speaking, individually the contracts can be interpreted as the markets best pricing for interest rates at those points in time, the spread between them gives a look at how the path is priced to get there.

A year ago, rates were priced to be at about zero in September 2022, and not much higher – maybe 1 hike – by September 2025. At a starting point of functionally zero rates – that’s a pretty poor prognosis for 5 years time. Earlier this year, the spread between contracts increased as the nearer maturity contract dropped a little in price – implying higher yields – while the longer maturity contract fell more in price. The spread widened to a high of 78bps in early summer. That’s the market roughly saying things are a bit better economically – over the next few years we will see about a hike per year.

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You Can Eat Or You Can Sleep

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“You can eat or you can sleep”. The biggest change I have witnessed over the course of the past 3+ decades is the change in investor preference, particularly hedge fund investors, away from positive skew to negative skew… from sleeping to eating. I sleep well. The quote came from a discussion my partner had with another manager who runs a fund that is often aggressively short volatility. He, like all of Wall Street and beyond, have monetized this preference for negative skew – regular returns most of the time, with the occasional blowup. They are eating well.

The preference for negative skew flies in the face of conventional finance theory and behavioral economics. After all, why would people buy lottery tickets? Smarter people than me have worked these ideas over, and it’s a bit of a mess. Let’s just think about 3 possible drivers (I am not bashful about stealing others good ideas). Some of these thoughts are motivated by a great blog post that can be found here: https://www.macroresilience.com/2010/01/13/do-investors-prefer-negative-skewness/

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What Did Skew Do for You?

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Sharpe or Skew?

Managed Futures offers this promise- uncorrelated returns with the potential for crisis protection. How an allocator chooses to allocate to this asset class is important. Do they judge managers by best risk-adjusted performance? Or do they judge managers by how they improve the risk-adjusted performance of the total portfolio? Do they view the asset as an absolute return element, prioritizing Sharpe Ratio, or as a portfolio element prioritizing diversification? Assuming the latter, prioritizing the addition of positive skew is critical to crisis diversification, offsetting the historically negative skew of the equity market and creating a better total portfolio.

Typical Managed Futures managers employ a risk controlled approach called vol targeting (we have written previously on this topic here and here). In essence, vol targeting involves increasing exposure when volatility is low and reducing it when volatility is high. Historically this has improved manager Sharpe ratio at the expense of skew. Our MLM Index EV and MLM Global Index EV are constructed a bit differently. While following similar trend following algorithms, positions are sized on exposure, not vol. The net effect is our indices are long changes in volatility, providing higher skew when needed most; in highly volatile markets. This makes intuitive sense; trend following tends to crash up while equity markets tend to crash down. The last thing you want to do is put the brakes on your diversifier while it is crashing up.

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Stresses In The Bond and Funding Markets: Post Mortem

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We wrote a few times during the depths of March and April on stresses we were seeing in bond, credit and funding markets. It was clear things were not functioning correctly. It was equally clear that both monetary and fiscal policymakers were trying as hard as they could to counteract. Now that some time has passed much more detailed examinations are coming out that are well worth reading to get a better idea of how the plumbing works, and sometimes gets blocked.

The first is from the NY Fed Liberty Street Economics blog and details the Feds Large-Scale Repo program.

The second is in the Financial Times (paywall) and details the moves we witnessed in the US Treasury markets:

The third is from Josh Younger of J.P. Morgan writing for the Council on Foreign Relations:

All succinct and detailed pieces that will explain a lot of what went on.