Research and Writing

It’s interesting to compare this dynamic with other asset classes. Do high equity prices lead to less demand or more demand for equities? I’ll leave that question as an exercise for the reader.

For the adage to work, though, the physical world needs to cooperate. And one of the important things happening in markets right now is that impediments to the “cure” are preventing some high commodity prices from reverting.

Diesel is the shining example of this. Diesel prices are at all time highs. So where is the cure? On the supply side, inventories are already down to low levels. That leaves it to refiners to produce more diesel. But that’s hard to do when your refinery is getting hit by drone strikes, or cut off from the world by a war in your major egress pathway. Other global refineries are trying to pick up the slack by foregoing maintenance and running as hot as they can. Foregoing refinery maintenance is like forgoing necessary medical care…it might be ok for a while, but if it persists you get a disaster. Putting it all together, we doubt the supply side will ride to the rescue.

That leaves the demand side. Diesel demand is hard to dent. Imagine running a grocery store and telling your suppliers “don’t bother bringing us more groceries to sell, diesel prices are too high.” That’s not a thing. Academic research suggests that diesel elasticity in much of the developed world is close to 0 - meaning demand doesn’t really change with price. Instead, the burden of demand destruction gets shouldered by poorer countries, who in many cases use subsidies to shield their consumers from the very high prices that would cause the demand destruction. We are seeing some demand destruction across the globe, but not nearly enough to bring us back into a comfortable balance. Prices have more work to do.

In talking about markets, we use heuristics - things like “the cure for high prices is high prices” - as a way to help our simple human brains understand a complex world. When it comes to trading markets, though, it’s important to understand the linkages that are underpinning those heuristics, and to spot when they are breaking down.

These managers are aiming for a portfolio of longs and shorts that are neutral to a benchmark like the S&P, with returns coming in two flavors: (1) performance above zero, and (2) realized losses used to offset gains. Like any other hedge fund, they can perform well or terribly based on the manager or market conditions, and in any given year or series of years these strategies can lose a lot more than they provide in tax benefit.

As an example, below are the drawdowns of AQR’s equity market neutral fund – what they sell as a stand-alone long-short. Its done particularly well in the last few years (not coincidentally when they have had massive success selling their tax-aware strategy). And because of that, the cumulative performance since inception is solid. But investors in the first few years experienced a 38% drawdown over the course of five years.

These losses are not wildly outside the norm, even for funds with a good long-term record that haven’t lost their edge. One of the hardest things about allocating to managers is knowing, on year three after they’ve lost 40%, whether they have the capability to earn it back. The history of financial markets tells us that many clients probably threw in the towel at the trough and got the bad without the good.

These strategies are also susceptible to broad market events that impact all similar managers simultaneously. Below are three notable cases of this in equity long-short. In 2007, over two days a typical manager with an annual target risk of 6% lost about 25%. It’s a classic example of the limitation of standard deviation as a measure of risk – if the managers were right that they held 6% risk and financial markets were well behaved, 2007 was a 45 standard deviation event. A 45 standard deviation move is less likely than you winning the Powerball jackpot, every single week, for 52 consecutive weeks.

Given how much money has flooded into implementations of this strategy that are likely similar to each other, there are probably crowded positions lurking. Crowded positions carry asymmetric risk. If you have large managers that have to unwind their book - because leverage has made losses too large, or client redemptions, or any other of a host of reasons - then their trading can push the same positions further apart, causing cascading losses for everyone else. That was a big part of the story in the 2007 incident. It’s impossible to know how big of a risk that is today, but with so much money flying into the space so quickly, it is a little hard to believe it isn’t at least a modest concern.

We won’t say much of the benefits of these strategies, since that case is well made all over the Internet. And much of the benefits are real. For folks staring down the barrel of big realized gains elsewhere in their portfolio, these things can work great. Just size accordingly and be aware that things might not be as rosy as you hope.

Early in my career, a mentor taught me something that has stuck with me since. We often talk about the “government” or a “company,” but in reality these entities are not monolithic. They are collections of people. And those people have their own set of motivations. Understanding those motivations is key to navigating them and getting what you want from them. The best salespeople have a nuanced feel for this. Who is trying to get promoted? Who has an ego that needs to be fed? Who is the ultimate decision maker and what do they care about?

Senior members of the US government generally fall into two camps. One camp has, as their overwhelming source of motivation, extending their employment for as long as possible. For members of Congress, this means getting re-elected. Term limit bills are DOA, donations are welcome and “appreciated,” and any rings or babies that need kissing will get smooched. For members of the cabinet, it means keeping the President happy. For senior members of various regulatory agencies, it means following the marching orders that come down from the White House, even if they are in direct opposition to their personal beliefs.

But there is also a sliver of the government that cannot be fired at will. This puts them in a second camp. For those folks, you see a more nuanced set of motivations. Jerome Powell seemed to me to be concerned about his legacy, afraid that future historians would subject him to the same bashing many of his predecessors regularly suffer. Paul Volcker cared deeply about the long-term health of the American economy and did the hard things to foster it.

Which brings us to the question of the day - what will the “government” do about the bond market? Bond yields have been rising steadily, with 10 year yields up about 50 bps this year. If by “government” you mean Warsh, then the rise in bond yields is, in his words, a welcome sight. It is the market setting prices without intervention, and in doing so tightening conditions in a strong economy that needs tightening. If by “government” you mean Bessent, then his boss hates interest rates with a crooked number as the first digit, and if you want to stay employed you need to do whatever it takes to get them down. Including, but not limited to, directly intervening in the bond market and bailing out the Yen.

The result of this tussle is one of the most consequential things investors face today. We have spent umpteen hours in the last few days studying the history of Fed/Treasury conflict, with no clear roadmap or synthesis to show for it. We don’t know where policy will settle. We also don’t really know what will motivate Warsh now that he has the job he has so long sought after. Does he believe in his light-touch approach enough to fight for it? What we do know is that the optimal Warsh portfolio and the optimal Bessent portfolio are basically opposites of each other. We also know that having a big bet on who will “win” and being wrong will be ruinous. So, we are monitoring events closely, stress-testing our client portfolios for both scenarios, and adding hedges accordingly.

So we did the work. And let me start by saying that the work was difficult. Step one was getting everything on an apples-to-apples basis. But some bonds are callable, some are not. Some bonds are general obligations of the borrower, and some will default if the town pool doesn’t sell enough lemonade on Tuesday. Etc etc. These things are snowflakes, which probably meaningfully contributes to misconceptions about them. But we grinded through, bond by bond, and came up with a normalized universe of 337 bonds, with a total market value of about $17 billion. For each we calculated a tax-equivalent yield to treasuries with the most generous assumptions - no transaction costs to buy them (and they tend to be expensive to buy), you own bonds from your own home state and you never leave, you never sell them so no requirement of a liquidity premium, and you are in the top tax bracket. Under those generous conditions, you make a little bit of money if you are willing to lend for longer time periods and take some idiosyncratic risk, but not much. And shorter-duration munis are basically a wash. There is no free lunch.

It’s worth noting that the picture is worst in California. This is such a classic dynamic - California has high tax rates, so everyone wants tax-advantaged bonds, which means the prices get bid up past fair value, which means the returns stink.

When considering whether to include something in your portfolio, it’s also important to consider when it will make and lose money. That’s diversification, and it gives you a smoother ride through bumpy times. Munis are downright horrible along this dimension. They usually behave like treasuries, except when you need them most, at which point they behave like credit instruments. The chart below shows the Covid period. If you owned treasuries you made money that could be rebalanced into cheap equities. If you owned munis, they just exacerbated your problem.

Like any other asset class, there will be better and worse ways to hold munis. And some of you may genuinely have access to brilliant muni magicians that are able to pick and choose the right issuances for outsized returns. I don’t. So for me, in my portfolio, I am much happier holding treasuries.

For those that think the US antagonizing our allies is a new phenomenon, Nixon did this without warning any foreign states. They went to bed thinking they could swap dollars for gold any time they wanted, and woke to learn “nah.” This prompted Treasury Secretary John Connally to blurt out at the next G-10 meeting the famous quote “the dollar is our currency, but it is your problem.” Zing! I have no notes, I give him 10/10. He gets 0/10 for his later foray into taking bribes and lying about it.

In the 55 years since, the global economy and global financial markets have gotten more and more entangled. Now, every country faces problems from stuff they don’t control. The dollar is still high on the list - ask anyone who had dollar liabilities during the Global Financial Crisis how fun that was. But the dynamic extends much more broadly, to rare earths, chips, etc etc. There is no country on earth that is even remotely self-sufficient at this point.

Which brings me to a piece of news that struck many as odd, which is that the US Treasury intervened to help support the Japanese Yen. Why would they do such a thing? Well, the Yen is their currency but became our problem.

It’s no secret that our government spends more than it brings in. Waaaaaay more. That means that the government has to borrow the difference, and much of that borrowing comes from foreigners. Put another way, if a key foreign lender to the US government became impaired, that would mean someone else has to step up, and that would require the cost of borrowing to go up. No bueno. Japan certainly qualifies as a “key lender” - they own more Treasuries than any other foreign country. If the Yen aggressively weakens, and they want to support it, they need to sell treasuries to get dollars and use those dollars to buy Yen. But we want them to be buying treasuries, not selling them. Hence the problem and the intervention.

There is no doubt that nationalism is rising up around the globe, raising the spectre of everything from stickier inflation to increased kinetic conflict. Doom and gloom. But it is good to take a deep breath, and remember that countries still need each other, that will likely be true for our lifetimes, and as long as it is true there will be room for mutually-beneficial cooperation.

Luckily for this author, there was a Fed meeting this week. And it was a doozy.

To understand why it was a doozy, it’s first necessary to establish some context:

1. There is no such thing as a “free” market. Every government intervenes in their domestic markets, it’s only a question of degree and frequency. Having a good mental model of how much the government is likely to meddle is critical.

2. Pre-GFC, the Fed was much better about staying in their lane and letting markets set their own prices.

3. Post-GFC, the meddling got dialed up to 11. This was particularly true in the bond market, where they systematically and deliberately held yields down. This juiced asset returns and ultimately fueled inflation.

4. It was understood by market participants for the last 20 years that the scope of interventions included a “Fed Put.” If the stock market fell too much or the bond yield rose too much, they would whip out their printing presses and rain money on the system until the “market price” was what they wanted it to be.

In his presser this week, Warsh implied multiple times that he wanted to go back in time. To a simpler time, where the market set prices and the Fed managed short-term interest rates. Now, one press conference is not enough to immediately forget two decades of policy behavior. But our eyebrows are raised. If you flip to that mental model of meddling, it completely changes the risk/reward of all global assets, and in many cases would have you do the opposite of what you would do under Powell and the like!

The aftermath of the meeting was a lot of criticism of Warsh for not tightening. Thought experiment: in a world where interest rate sensitive borrowing is weak and strong spending is being funded by the performance of long-duration assets (read: equities), how do you tighten? The short-term rate is pretty irrelevant, what matters is the bond yield…which did in fact rise. We needed a tightening and Warsh did it - he tightened by not tightening! And now we wait and watch. We watch to see if he did it on purpose, if he’s serious about freeing our markets from the grip of the Fed, and if it is in fact time to dust off the old pre-GFC playbook.