Everyone is saying it’s confidence. It’s an overheating economy! Yet real retail sales have been stalling for months now.

It’s not even the magnitude of the rally I have an issue with. 13% happens quite frequently especially after a large drawdown. It’s the unbroken spell that took us well beyond prior all-time highs without a second thought. All without a resolution to what could be one of the biggest energy crunches in history. Apparently, all that’s needed is the concept of a resolution.

There are two explanations for how this happened.

1. The “war is obviously over” argument and negotiations will just work themselves out;

2. The downside case is so obviously catastrophic that any reasonable trader was positioned defensively and a massive short-cover ensued, coupled with a US obsessed global market in which the US is least affected by the closure.

I favour #2, in line with my “binary markets” theory. I firmly believe this ridiculous reaction is purely because participants can’t really process what is just ahead of us down the road, so they are desperate to seek safety in the herd. And the herd was buying. This isn’t driven by confidence, it’s driven by fear.

We need to look cross-market to confirm. The post “ceasefire day” gap breakout rally has been limited to the US and Japan. Few markets have participated, and the closer a market is to the fuel crisis, the worse that markets performance has been.

Australia is the closest to rationing, with diesel and jet fuel reserves hovering between 20 and 30 days, with lack of any visibility of deliveries in May. Australia has very little (~20%) domestic refining capacity, and also nearly all of its crude oil production is sent for export.

The performance here has been stark versus the US, underperforming heavily since “ceasefire day”. I expect this to continue.

The prospect of fuel rationing hasn’t been the only thing causing this underperformance. Fuel prices have already made their way into some pretty serious inflation in construction materials and at the supermarket. Delivery costs are up 30-50% which flows through to nearly everything. Home-brand milk has been marked up by 12% at one of the large national supermarket chains.

This is coming for you no matter where you are.

Australian equities were the first to fill the ceasefire gap.

The fact remains that Australia (and Europe which has seen a similar level of underperformance in the chart above) is already experiencing the effects of a closed Hormuz. Every day that passes will see this ratio head north, until one day when the US starts feeling the effects. This will happen within equity reporting (remember the S&P500 has about a 40% revenue exposure to foreign markets) rather than fuel effects directly, which will take longer.

We aren’t there at all when it comes to recognition by US markets. And this allows it to get carried away with the “Mythos” trade which is one of the frothiest things I’ve ever heard. Can Anthropic even deliver on compute which it’s already been struggling with? Didn’t we all hate AI because of the huge capex spend in the 4 months before the war? We all like it again now? OK, sure.

Has anybody even seen and used Mythos or is it the equivalent of “Gabbo is coming” from the classic episode of The Simpsons?

The fact remains that everywhere apart from the US is not convinced “war is over”. Even if it was, there would still be some probability priced in that it wasn’t. All-time highs are one indication that downside isn’t priced, as is the vol crunch.

Subscribe now

Vol doesn’t make sense

Front-month VIX futures didn’t trade over 30 and we got the bounce we did. It seems that markets front ran itself here - many look at this level as a key point to start buying.

The VIX itself is at 19 against realised volatility of about 13%. This is a lower premium than what persisted for most of February and March.

Implied volatility prints well above realised when fear of the future encourages downside hedge buying at a greater rate than current volatility would suggest.

This lines up with the persistently high put buying that I have spoken about for the last 3 months, which has now sharply turned to call buying.

Market structure has changed because of the use of options, especially in the US. Highly protected markets find it difficult to go down as dealer hedge buying overwhelms. This leads to the “stairs down, elevator up” pattern that is upside down from what has persisted in the past.

Subscribe now

Rates need a discussion

Large downward moves in US equities are difficult to conceive after what happened in April. Rates markets haven’t bought the recovery in the same way that equities have. This point casts further doubt on the validity of the rally as well.

Inflation at this point is a certainty. How central banks deal with it is going to be the next question.

For the ECB, repeating Trichet’s mistake of 2007 might well be on their minds. The ECB however has a more explicit mandate that is tied to inflation.

6-7% headline inflation is baked in at this point. It can be worse of course. But if the supply side shock hurts growth more, will central banks change tact? It is a possibility.

Being short rates seems to be the obvious trade here, but I’ll have to leave a deeper dive on that until next week.

In the meantime, keep an eye on Dec-2026 /CL future. It seems to have attracted liquidity away from the broken front-month contract. The chart above shows little evidence that the “war is over”, and in fact highlights how prolonged this crisis will be.

That has now cleared in probably the most unsatisfactory was possible for the global economy.

But why? There was a deal, right? At time of writing the Strait isn’t open, oil infrastructure is blowing up and on fire and war in Lebanon rages on. The ceasefire was unilateral, using the Pakistanis to give it some legitimacy. Whether Trump couldn’t stomach continuing the war because of the falling markets or just felt the voter dislike of deploying ground troops is irrelevant.

One thing is clear, however. There wasn’t the possibility of a deal before the war started, and there barely is one now given the leverage Iran has.

This is not based in a view that the US/Israel military operations were a failure. They caused an incredible amount of destruction. Or that any ground invasion would be unsuccessful. But it just isn’t enough against a regime that is prepared and just don’t care about death enough to derail their aims.

This is what eternally makes Middle Eastern wars almost impossible to win.

Subscribe now

Equities as the warmonger

The fact that the US has walked away from the war (for now) doesn’t change anything in regard to the left-tail risks for the global economy. With the Strait still closed and further damage to oil infrastructure there is no way for physical barrels to either go around or to get to where they need to.

If it was the S&P500 that was shouting at President Trump to withdraw, it will also be the S&P500 that will beg him to send ground troops in to restore the Strait and start feeding the globe with oil once again.

Equities markets will want whatever makes them go up. This means they want the energy they need, and cheaply. That is what they will demand. It has always been the case - horrible political decisions have been forced by the market in pursuit and low volatility and profit. That is all that matters.

For the last 2 weeks the market believed that an end to the war was the best way forward to achieve this.

The collective wisdom of all market participants thought that de-escalation would result in the preservation of oil infrastructure and would offer the best way back to good times.

Collective wisdom and the power of the herd can swiftly change, however.

Think of how narrative changes in individual stocks affect how they trade. A restaurant or fast-food chain rolling out stores aggressively can be bullish, where the same company in a different circumstance could only improve its stock price by closing down stores.

The same can apply to the Iran war.

The market pushed for and will now test the strategy of withdrawal. It is obvious why this was the first choice - a withdrawal would clear up the Strait far quicker than any other option if it worked.

It will take some time for the market to find out that it is not working.

Once that happens the question won’t be “how far do stocks need to fall for Trump to force a ceasefire” it will be “how far do stocks need to fall for ground troops to be sent into Iran to open the Strait?”.

This isn’t inconsistent when the goal is so clear (get me oil) and so broad in its demand. In most jurisdictions energy isn’t a large part of the index and it is pretty much everyone outside of these guys that want to see lower energy prices.

There is another option to sending in ground troops which is a total capitulation to Iran’s demands in return for an open Strait. This seems less likely than ground troops, but you have to be aware that politics globally is swinging hard towards non-interventionalist policy so it may be a viable path and cannot be discounted.

A capitulation to Iran’s demands would change the world in far more ways than that local to the Middle East. It would also involve the withdrawal of troops from Europe and maybe even Asia. The entire world would change.

This applies to China’s role as well. There have been reports that China stepped in to ensure Iran “accepted” the ceasefire. This is something I’ve flagged many times, but words won’t be enough to say something. If Iran persists, China will have to change its stance on not being interventionalist to force a reopening. China has plenty incentive to see the global economy steam along given their exposure to global exports.

These factors are the only things stopping this resolution from being favoured by Mr. Market. The US pulling out from its “world police” role would only serve to decrease stability and increase volatility while also resulting in a higher average oil price over time even if it did make oil flow.

It is for these reasons the market will eventually choose the US finish the job that they started with a ground invasion if talks fail.

The trigger for a switch towards this role for the market is unknowable. We’ve already had a few - I wouldn’t blame you if you thought that drone attacks on the vital Saudi’s east-west pipeline would be the trigger - but it might be a failure of deal talks or something incredibly small that just tips the market over the edge. Perhaps the market is pricing success (or hope) of negotiations succeeding. At the moment Iran controls the global economy and has received the benefit of no more US strikes. It is in a strong position.

Perhaps we need to see a physical barrel of oil somewhere in the world trade hands for more than $200 (and I’m not talking about futures markets here).

Subscribe now

The real price of oil

I’m not going to engage in the ongoing crying about manipulation in markets. Nobody is owed trending prices and low volatility one-way moves.

The plunge in oil prices since the ceasefire is just an adjustment of the probability weighted distribution of future returns. The distribution shifted on the news of the ceasefire whether or not there is a physical shortage or not.

Why? Not everyone who buys or sells the CL future is planning to deliver anything, so the price of physical doesn’t matter. But it can’t matter forever as eventually someone has to supply/take delivery of the barrel of oil. This makes each roll date for the futures extremely important. We saw the same thing earlier this year when gold was having its wild swings. When delivery became reality, prices surged and then tanked after.

The CL first notice date this month (rolling to the June contract) happens on the 23rd of April.

Always keep in mind what makes oil so hard to trade even in normal times. It is that last barrel that sets the price for everything. If there is 1 more barrel than needed, all of oil reprices lower to balance. The same happens in the opposite direction when there is 1 less barrel than needed.

A final word on “real” oil prices.

I’ve seen this around a lot. Technically this isn’t incorrect, we adjust most nominal prices by inflation for accurate comparison.

It is interesting to think about though. In this case, is it the right thing to do? For that we have to ask why we do it.

In the case of input costs, the right thing to do is adjust by inflation because your revenue is (hopefully) increasing by a similar amount. “Real” profit should be broadly static if volume or productivity hasn’t changed.

The problem lies in two places:

1. Has “real” profit increased because nominal oil prices have stayed flat?

2. Are you adjusting the inflation multiplier to take out the weighting to oil?

The answer to both of these is no and no. It only makes sense to inflation adjust oil if you have benefitted from it not inflating in price in the past. I don’t think that’s true.

Secondly oil as an input is so deeply embedded in everything within the CPI that it is the prime determinant of inflation. You can’t adjust a price of something so important with an input driven by itself!

It’s also saying a 30-50% price increase on transport or delivery isn’t bad because we should have had that cumulatively over the last 10 years anyway. Clearly that isn’t going to make anyone feel better.

The aim of central bank inflation policy is to keep low, predictable inflation. There is a reason for that, and it’s because having large jumps is worse for confidence than slow predictable bumps higher.

I would go as far as to say that even the nominal level doesn’t matter. All that matters is how far it has increased in a short period of time. A doubling contributed as a trigger to the GFC. A quadrupling caused the 70s crisis.

We’re yet to find out where this one lands.

The size wasn’t huge, so I countered for 35c and got filled. The seller must’ve been very motivated.

Come Monday, my boss raked me over the coals for that trade, even though Morgan Stanley survived that weekend and the bonds were immediately revalued at double the price we paid for them.

Did I get lucky? Definitely. There was nothing about Morgan Stanley that made it any more important and worthy of being saved than Lehman Brothers.

So, was the purchase of those bonds poor risk management (as my boss attested) or was I actually buying them cheap for the amount of binary risk present? We’ll never know the ex-ante probability of that default because we only know one outcome - where Morgan Stanley survives. The probability function collapses and there is no way to observe the “true” probability of default.

This is the main reason people hate binary outcomes so much. They are hard to diversify and after the fact an honest trader won’t be able to determine how much was luck and how much was skill.

They also spike volatility and then crush it. You’ve got one chance to make or lose a whole lot of money and then that’s it.

After Monday’s Truth Social post and one of the biggest single candles I’ve ever seen we have settled into the hated binary outcome market. Does the war end (even temporarily) or not?

Subscribe now

Governments and the binary market

The story above about the Morgan Stanley bonds challenges the idea that we are in a unique period of binary outcomes with Trump’s random tweeting.

The truth is that these binary outcomes have been present in every crisis because we expect our governments to manage volatility during these times.

Whether banks lived or died during the GFC fell to the arbitrary decision of regulators. Whether TARP (the Troubled Asset Relief Program, designed to remove toxic assets from bank balance sheets) would pass congress or not (to make things even worse it didn’t pass and then did, but only when markets fell too much!). Sure, it didn’t get expressed by tweet, but the same arbitrary decision making remained.

The traders who said “there is no way they are going to shut the global economy down” before the pandemic are using the same rationale as those that believe that there is no way the war will continue because the effect of blocking the Strait will be too much for the global economy to bare. This isn’t a judgement of these traders at all…it’s a valid expectation. The first just didn’t happen to be right because politicians chose otherwise.

These binary outcomes generally happen when there is one decision maker in control. Whether it’s King Trump or Congress (who move in a herd anyway) the binary effect on markets is no different. It’s just as difficult and just as tiring.

This ties into a previous piece I wrote about how intrinsically the government is tied into these outcomes because the amount of outstanding debt in the economy (both public and private) forces volatility management and makes them much more important than they otherwise would be.

Subscribe now

The binary outcome we are faced with

We know the market hates this type of uncertainty with the trading range bounded strongly and small in size despite elevated implied vol.

Participants prefer not to play by initiating new positions and just keeping their old. You can minimise regret that way. Many will just move enough to try to get to flat so that they have no exposure either way.

Getting back to flat without liquidating is tough as well since different assets will have behave differently depending on the outcome. You might be perfectly hedged in a “war continues” outcome but drag heavily if there is an end to it, or vice versa.

There is also the notion of carry (or negative and positive theta) to consider here as well. In this crisis it works in both directions.

Every day that the Strait is shut, there is an accruing amount of damage to the global economy. This is negative “theta”. Absent a resolution of the binary outcome, the risk neutral level for whatever asset should be shifting every day. For bonds it means a drag higher in yields as the market wants to price more hikes the worse the crisis gets (for the time being as this could flip). For equities, the level should be further down as the crisis drags on.

The same applied to the GFC. The longer it dragged on without resolution, the worse the effect on the economy. The pandemic worked in the other direction, but the market kept falling as the probability of the shutdown increased.

There is a positive carry element too. US equities still have earnings that are growing at 20%+ and the market has been flat for more than 6 months now. The negative carry of the oil problem probably outweighs this.

The gap between good and bad outcomes also increases by the day, increasing the volatility on resolution of the binary outcome.

Subscribe now

Investors like outcomes to fit into historical probability distributions

The title of this section is a very fancy way of saying that investors just want their assets to behave like they have in average over the past.

Nearly every professional investment process is based on the idea that assets will perform in the future like they have in the past, whether quantitative or qualitative.

This is the main reason for why market participants find it so hard to stomach binary outcomes. A “normal” market has such cool, predictable features as:

• Momentum

• Mean reversion

• Sort of log-normally distributed returns

These are not present in a market with some sort of binary-shaped distribution.

Markets exhibit these features because the underlying economies/companies act like wave functions. Recessions and recoveries happen slowly. Company earnings exhibit momentum. Stock prices and bond prices reflect the fact that the underlying drivers are also continuous functions.

There is also the problem of trying to predict when and to what that distribution changes to.

If an asset isn’t going to perform like it has in the future, then how will they possibly act? And if you manage to guess it right, you’ve lost every other time you’ve tried to predict that change.

It’s too hard and too uneasy. Real-life just doesn’t work that way. Gains and losses are incremental and build over time. They also average over millions of people. There is no reason we should be left with perpetually shifting return distributions when the normal one reflects real life in modern ecnomies.

Subscribe now

What happens in Iran

Enough about how uncomfortable the current situation is. What will happen?

Short answer is that nobody knows, least of all me. Everyone is lying, as each party has the incentive to lie. Trump will lie because it keeps the oil price down. Iran will lie because it wants the oil price higher.

The post above summarises it well and I would generally agree but gives no answers.

The conceptual chart above from BCA reflects the same idea. Whether Iran cares at all if the entire globe is against them is yet to be determined.

Agreeing to ceasefire also means that Iran can’t force shipping to pay tolls since they can’t fire on commercial vessels (which would obviously break the ceasefire) and would result in an open Strait. Such a deeply binary outcome for Iran as well.

It remains to be seen how much Iran will push for its pound of flesh. Allowing it to keep the tollbooth would undermine free and unfettered transit and would be a serious blow to US hegemony due to that being the entire point of the US having such a dominant navy.

With the move of oil to below $90/bbl this puts basically every single macro asset in drawdown since it peaked. Equities in some places might be flat (Europe), but bonds are definitely down along with gold and most other commodities. This is after the Trump “we’re negotiating!” post.

Correlations eviscerated. Portfolio theory blown up. I’m short equities and it is very uncomfortable.

It will be demand destruction that is the real tail risk here, and it will bring a test for risk assets and bonds.

I don’t want to recite the bear case for our current situation in any detail because it’s everywhere. Suffice it to say that the cake has probably already been baked in regard to production shut-ins and increases in costs for refined product. The bearish argument is an easy one to have, and my argument last week was that any real disruption would result in a withdrawal and a re-flow of oil and gas. This can still happen of course.

The degree of damage done by the US and Israeli strikes have the inverse effect of making exit more difficult, if it isn’t impossible already. Since it is now a matter of survival for what remains of the Iranian regime, a pull out may not get the desired effect. They are playing for keeps.

Where little discussion has been and where I think the direction of the war will go is where China and her sensitivities to the risk of a closed Strait comes in.

China, like the rest of Asia, is highly dependent on energy imports. If it wasn’t, we would probably be in WW3 already. The fact remains that China can’t decouple for two reasons:

• Energy dependence

• Export dependence

China can’t afford the same attitude that Trump has with the effect of prices surges and shortages of refined product. Yes, China reports a huge reserve of crude. At 1.2bn barrels, it is good for 120 days of supply at about a 10mbbd import rate, tempered by about 1mbbd from Iran and continuing flow from Russia.

We know China is worried about this because not only have they understandably shut down export of refined product (which many neighbours in Asia rely on) but they are slowing down refining as well which seems odd given the spike in refining margins.

This gives us some idea of the sensitivity here.

On the analysis of the war itself I can’t offer any view. All I can do is try to do is understand the incentives and leverage each player has to see what a solution looks like.

We know we are in an unstable equilibrium with energy flows effectively being stopped. We know that shortages will hurt economic growth. If it was just a matter of price, I wouldn’t be worried. Those can be absorbed. However, there is already evidence of demand destruction with airline flights being cancelled and rationing starting to take effect in smaller countries. This is only happening in transport so far.

If the oil started flowing tomorrow, it would probably be OK, and we would avoid the tail event. The effect would be on price rather than gaps on volume. This is looking less likely the more successful the US and Israel are.

This is the point that those with the most sensitivity will be pulled in to exert influence to make either side back down where there is no off-ramp.

China has that influence, but it possibly has it more with Iran than the US. Influencing Iran to reopen the Strait is more easily accomplished. In the case of a China that is unable to power itself and trading partners that are unable to buy its exports, the will certainly exists.

This leaves China in a tough situation. China also faces a poor outcome in the event that the US is to control the Strait. This might be enough to see China hang back and not exert any influence. Economic sensitivities put a timeline on them in the same way as for the rest of the world, but I would argue that it is double the effect for China when both domestic and external demand affect them greater than anyone else.

Given these dynamics, China has a clear incentive to get Persian Gulf barrels flowing again. More so than the US.

China has been an unwavering focus for Trump with nearly all of his tariff-related and military moves ultimately aimed at weakening China’s (mostly transactional) allies.

China hasn’t said nor done much up until now. The deficit on oil imports might be one that forces China’s hand in the matter. There are tactics that could escalate the situation - like forcing a devaluation of the currency (more on that below).

There is also the ongoing fight with European “allies” who would suffer the most in the case that the US stops exports of crude oil. Playing hardball would mean stopping exports unless help with the war effort is forthcoming. This might be European belligerence, or Europe finally playing mimicking Trump’s by not giving any concession until it’s paid for.

My tone has changed over the last week because of the degree of damage the US has done creating a “all-in” mentality from both sides.

This leaves us in stagnation in equities. The way this episode has played out is unique and there really isn’t any parallels in post-2000 markets with the interplay between equities, volatility and bonds.

The closest parallel that I can draw is that from December 2015, even if oil did the exact opposite of what we’re seeing now.

Subscribe now

December 2015 parallel

Markets had just recovered from the surprise August devaluation in the Yuan.

This prompted serious concerns about the health of the Chinese economy which had pursued an attempted rebalancing away from investment-led growth to consumption-led growth. Commodities plunged and global equities had a sharp 12-15% drawdown (equities were way more volatile/VIX more supressed in that day and age).

While equities recovered quickly back to their highs by early November, the CNY continued to depreciate, and the broader effect of a severe China slowdown took hold on EM especially.

However, this didn’t fully materialise until equities fell again in January 2016 by 10% again. November and December was volatile, trading in a ~4% range with VIX futures trending up.

What makes this episode unique is that implied volatility (represented through VIX futures) has been trending higher without a major shank lower in equities. This hasn’t really happened in the past as vol markets have tended to operate in a binary high/low fashion with quick and sharp drawdowns and subsequent recoveries.

Some interesting parallels lie in the timing (quarter end) and path that equities took. They eventually couldn’t hold off the pressure and the crack came.

Given the way things are going, it seems like equities will barely hold out until early April.

The main (if opposite) parallel was that it was oil that really drove the risk off in January 2016. After declining in an orderly fashion in the months preceding, they took another 30% leg down in January.

Oil big down and oil big up speaks the same level of economic health. The direction doesn’t matter.

The last week of March is important for developments in the war. Equities have been trading up with news that the US are making moves to open the Strait.

The above will likely arrive on March 25. That, combined with month end, will keep risk orderly. After that the dam breaks.

Subscribe now

Correlation trap

Gold has performed very poorly, down over 10% this month.

Most expect gold to do well in environments as these. Speculation is that it is ME/Asian selling, however this isn’t clear.

What it does show is that single macro asset return distributions are relatively static and don’t change often. This isn’t an unusually weak month for gold.

What it does show is that it is leaning on cross-asset correlations in a portfolio is what can get you undone. If you were holding gold as a hedge, you were probably too long equities at the same time.

The chart above shows the oil-equities correlation in different oil environments. If anything, it shows that the damaging negative correlation can increase more if past episodes are a guide.

Iran’s actions are making less sense, making them seem more desperate than being in a position of control. But the fog of war is thick.

This isn’t to say that the headless chicken can’t inflict huge damage and disruption. They currently are by firing indiscriminately on commercial ships and infrastructure and attempting to mine the Strait for no other reason than to create chaos as it is their only bargaining chip left.

There may have been a chance that they had a friend in China by allowing Iranian tankers to traverse the Strait (those in the chart above purported to be heading to China). Goldman (perhaps as an attempt to validate last week’s heavily panned view) were the only ones to capture the movement of these vessels.

These situations have shown China to be extremely transactional in its approach to alliances, and this one is no different. In this case it would still be problematic for China in that it was used to receiving 4-5mbpd through the Strait before the war. It is unlikely to be held at that level.

Then there are other questions related to non-US aligned oil getting through the Strait. Iran has fired on Chinese flagged ships and has also declared it was going to lay mines in the Strait.

Lay mines and nobody gets through, not even Chinese oil on Iranian tankers. Smart mines, guided navigation? Probably not, although who knows. If it does close the Strait entirely then this crushes Iran’s own financial capability.

Shooting oneself in one’s foot is not always evidence of stupidity, but rather desperation. The question is whether desperation is weakness, or their power.

Either way the truth remains that a full closure of the Strait will be economic devastation for the world, and very few will be immune, even if energy self-sufficient.

And it’s not the crude oil I’m worried about. It’s the urea, LNG and helium supply that are impossible to divert and are even more important than oil in maintaining a functioning global economy as we know it. Disrupting urea means disrupting fertilizer production and means stunted food production. Expensive/non-available food production equals civil unrest.

The possible outcomes are so dire that if the US Navy can’t find a way to ensure relatively safe passage, then the US will just have to give up and pull out. The other outcome is just not feasible when it is avoidable. If they don’t open the Strait after that…well we’re in for trouble.

When you are getting too negative about the conflict it is worth keeping this in the back of your mind. The stakes are high and responses will have to adjust to this reality.

Nobody, even Iran, is interested in a Strait that’s closed. But a headless chicken is only interested in running about aimlessly, and they can do this for longer than you would think when it comes to defenceless shipping and infrastructure.

In the end it’s not that much of a different feeling to trading through the GFC or the pandemic. Be realistic about the bad outcomes but also realise there are actions that can be taken that may result in them not happening.

Subscribe now

Equities

Divergences are closing in the relative performance of markets.

The underperformance by “short energy” countries occurred mostly in the first few days of the conflict.

After that point, the divergence is minimal at less than 2%. The US outperformed during Monday’s big drawdown but also recovered less. The short-term trend is fairly clear here.

Many are surprised by this sort of slow burn sell-off in equity indexes. To me it makes perfect sense. The extreme cases (US wins and gains control of the Strait or nobody gets urea/LNG/helium and dies) is so vast that we can only price in the middle. Individual headlines (another tanker gets attacked/a desalination plant explodes) are negative, but these events singularly aren’t important in themselves, so no single event can cause a large drawdown. Many more tankers will get hit. Eventually the market will become immune to it (as sad as that sounds).

The US was the clear outperformer as everyone that needed to be hedged was hedged already and it was one of the few countries with energy independence.

Keep in mind that hedges expire and must be replaced. Important if you believe the downside is capped. Having said that, a slow burn downwards will still likely make these hedges losing bets.

The skew isn’t lightening up for the those rolling hedges though. The move in equity markets for breakeven returns on these hedges is only increasing.

For another measure on how implied volatility pricing has outpaced realised see the chart above. VIX futures have underperformed by far more than delta has to been in the league of other vol market blowups.

Subscribe now

Japan

Japan sold off heavily this week; however, this has tempered.

Increased confidence around the size and accessibility of Japanese oil reserves and source of their LNG has revived some confidence here.

Japan has huge sensitivity to the pricing of these commodities however, and it may bring back worries around another current account deficit situation with implied effects on the Yen. That cross is back in rate-check territory which freaked out markets in January.

I’ve avoided commenting too much on inflation forecasts from the effect of skyrocketing oil prices because it’s slow and not the dominant effect moving markets right now. The above gives an idea to the hit on core CPI in Japan given different scenarios. A declining Yen will only exacerbate this.

In the midst of all of this, US February core CPI printed weak! Does anyone care? No.

Just ask the front end of European rates who have not only sold off ~70bp but have had to endure 30bp intra-day ranges. Brutal.

While analysis of the war itself is left to others, let’s look at which markets are genuinely under pressure because of the knock-on effects of the war, and which have been hit by unwinding of crowded trades and stop-outs.

First-order effects are surprising. The Strait of Hormuz, Iran’s greatest gambling chip, is effectively closed and WTI is still below $80/bbl.

Maintaining prices at these levels relies on a resumption of shipping as pointed out in the GS chart above. They see Brent moving to $100 if the Strait remains closed to traffic for much longer than a week.

To make it clear I have no idea how they can forecast this outcome, and many online seem to have the same impression this piece of “research”. Perhaps they expect the US’ novel offer of insurance and escort for vessels to unclog the artery, but there are a lot of questions around this plan.

In the defence of Goldman, closing the Strait for an extended period of time is not without cost to Iran, either. And it doesn’t directly hurt the US; in fact it hurts the rest of the world a lot more.

The data in the chart reveals the largest drop in traffic in the Strait, ever. No denying this. Pre-conflict, roughly 6 LNG cargoes transited Hormuz daily and reports now suggest flows have collapsed to zero.

The interruption to shipping is also showing in delivered prices (affected by extreme backwardation) as well which are added above the prices you see on your screens.

Crude delivered to China is already close to $100/bbl.

This is the story in oil. Gas is the more immediate worry.

Subscribe now

Europe

Europe has some real exposure here but hasn’t moved as much as you would have expected it to, given their reliance on Qatari gas.

Europe-traded LNG doubled on the start of operations but have subsided since. Still, pricing is below highs set during a cold snap in Europe over Christmas. Qatar initiated a force majeure on 20% of world supply of LNG, affecting its customers in Europe and Asia.

Comparing it to prices over the Russia-Ukraine war, well…

Inventories are lower than normal which has heightened the sensitivity to supply disruptions. Luckily this war didn’t start in December last year.

Most banks are cutting Euro GDP forecasts and bumping up inflation forecasts by about 0.2% down and up respectively. This puts a brake on the growth upside that has recently been priced.

Equities took it personally.

The DAX is back in the range set since last April’s drawdown, rejecting the breakout set in January this year and falling more than 6% at its worst. Rotation out of the US has been a popular theme again, but economic reality of Europe’s place in the world and vulnerability to trade (through its large current account surplus) and energy disruptions (it has no energy).

The DAX awaits deliverance of the promised fiscal spend which at this point seems like it was priced to perfection all the way back in May of last year.

The more tech-heavy Eurostoxx was hit a little harder and resulted in a breakout in of vol indicators, something we are yet to see in the US.

This hit to both Europe (and Asia covered next) caused a violent run back to the USD.

The EUR fell nearly 2%, but this only puts the cross back to where it was before the Greenland story came to light in January. The USD is still weak relative to fundamentals.

Subscribe now

Asia

60%-70% of Asia’s LNGs needs are served by the Qataris, so the effect there could be worse than for Europe.

Asia LNG benchmarks have doubled in a comparably worse move to what happened in Europe.

Japan is the most exposed to the disruption in LNG flows. The Nikkei fell >9% from last Friday and is experiencing intraday of more than 3%. In the context of how it has traded more recently these sorts of moves aren’t uncommon, and the index is still up well over the year.

The KOSPI captured the imagination of the market for the first few days of the week. Falling 20% and recovering half, it is worth remembering that the index is also still up a lazy 35% this year. I think we can chalk this up under “market clearing” rather than anything related to energy.

The bigger issue might be if Goldman’s are wrong as the Strait doesn’t open up anytime soon what the replacement will be for crude oil imported into Asia. Nearly everyone is exposed here, with most countries having 4 to 6 months of reserves (China being the outlier here with much more in strategic reserves, but more exposed through effectively being Iran’s only real customer).

Asia tops the list for biggest importers in the world.

If these reserves decline, there is little to cushion the blow, and this sensitivity will surely affect US decision making on which way the war goes. But this also means Iran’s supposed friends won’t be there anymore (if they ever really were).

Subscribe now

Bonds

Bond yields are back to mid-range. Some like to attribute this to rising inflation forecasts because of oil disruptions, but I would like to think of this more as a market clearing event as well. Bonds got far too ahead of themselves.

The short end felt this as well as the curve experienced a parallel shift higher. ECB pricing went back to pricing hikes in 2026 (above) after spending 3 months grinding out a new cutting path for the ECB. Once again this was greatly affected by one-way positioning.

The ECB did deliver hikes into the Russia-Ukraine war (being a very inflation sensitive central bank) but the global environment was very different at the time. In the worst case here the effect on growth would likely be larger than that to inflation.

The comparison between rising USD and falling bonds is out of line with history. The flight to safety big would usually be across both assets but moves like this as the first reaction (bonds did have a very short-lived rally on Sunday night) highlights how bonds have abandoned their role of the 2010s.

Japanese yields didn’t rise, but they hardly fell either. It’s a different world.

Subscribe now

Equities

Amidst all of this, software actually managed to rally!

More closing of shorts (market clearing) probably is responsible, along with Block’s decision to fire a whole firm’s worth of people.

The spread between S&P500 constituent and index volatility fell as well, despite the index being immune from the falls seen in Europe and Japan. It was the start to the Iran war that fixed this imbalance.

Taking positioning data for what it is, it doesn’t seem like anyone is going to be caught without hedges on. The skew is so extreme for a reason, and while I don’t love positioning data, it does explain the pricing we’ve seen in traded volatility markets.

The US has outperformed nearly all other DM. This might be related to heavy downside positioning, but also to the fact that the US is largely energy independent.

Hopefully I don’t regret posting a BCA chart but here I go. Their analysis above indicates that the US has been the price setter for world oil for a while through effectively being the marginal producer. This is a powerful position in itself.

Subscribe now

The uncertainty of war

I’ve outlined some of the bearish outcomes above. Obviously, this is the focus of the market, and the market will trade lockstep with WTI crude futures.

There is also a bullish case. The regime is overthrown and Iran’s production floods the world market once again. This seems impossible given how Middle East wars have gone over the last few decades but is always a possibility. Iran is also a different country though.

If there’s one interesting thing to come from this conflict, it’s that Qatar seems to have finally picked a side. Iran’s strategy to fire on their Gulf neighbours to put pressure on the US to end the conflict has clearly failed.

On an annualised basis it competes with some of the biggest investment programmes of all time. This time around a lot of that spend will end up reflected in the drag from net imports in GDP, as a lot of the metal isn’t produced in the US. The infrastructure and meaningful expansion in the supply of electricity will, however.

From my point of view the uncertainty of whether AI will work on a cost-to-benefit perspective (and thus offer a return on capital) is the bigger question than what it will do to employment or the regular person’s welfare in 5 years’ time.

The economy is an infinitely complex system, and respect must be given that nobody knows how individual actors will respond given such an incredible change to how we work if AI is successful in delivering intelligence at a cost that is far less than labour. And that’s a big if.

If the capex does produce viable cost-effective intelligence, will there be another whole sector of employment that arises from this? Who could’ve foreseen the rise in the “bullshit email job” as a result of industrialisation that so many lament and criticise as a driver of poor productivity growth now? Who is to say the infrastructure spend doesn’t just drive a new commoditised market in inference? What if AI drives a return of the more dynamic and higher productivity small business that can compete with large corporates without breaking a sweat? This outcome alone would be incredible for the economy.

The effect on AI on much white-collar work is no different to mechanisation and then automation through robotics of much factory work on blue-collar workers, but both of these developments just resulted in more and higher quality consumption. The offshoring of what remained of manufacturing in the US after this surely had a bigger effect than the automation itself. Offshoring itself is a result of other new technologies like the commercial aircraft, better shipping and the internet - technologies that have delivered many more benefits than drawbacks.

In preparing for this piece, I struggled to identify new widely adopted technologies that didn’t ultimately lift our standard of living, even if they had other downsides. Even something horrible like asbestos provided significant benefits in the reduction of deaths by fire before the true downsides of that discovery became apparent (and then hid by many companies for many years). Social media is another. The benefits probably outweigh the drawbacks even if the drawbacks seem more corrosive.

If you can think of any widely adopted technologies that only caused downsides, please drop them in the comments.

I don’t have the answer for what will happen, but all I know is that AI is becoming a more useful tool as it develops and has found some real uses in my own daily workflow. Whether it will remain cost effective after subsidies end, I’m not sure.

The development of new technology is the only way to expand productivity and lift the standard of living. If it doesn’t do that, then it likely won’t be implemented and it will fail. We’ve been through the “there is better and cheaper labour somewhere else” cycle a number of times and it always seems to work out. There are losers, and there are winners, and the economy (and politics) reshapes around this new reality.

Being negative on a new technology that is years from viability also strikes me as negative when the default option should be optimism.

A possible failure and thus nervousness about the capex spend coupled with the real downsides to some business models if it was successful is really what is driving markets right now.

Subscribe now

Tariff decision, yet no vol respite

I was wrong on two counts last week. The SCOTUS decision on IEEPA tariffs came before the state of the union address, and its announcement didn’t really take the vol premium out of markets, even if equity markets are trading higher than we were on Friday.

With the decision out of the way (which at this point doesn’t have much effect one way or the other since they will likely be implemented in a different form), it only leaves the continuing dispersion and volatility of the constituents of the S&P500 as the culprit.

Despite Thursday’s session seeing a mild sell-off at the index level, dispersion has started to decrease.

Until dispersion lowers, index level volatility can’t decrease, and the persistent buying of put protection likely won’t slow.

The volatility skew and straddle pricing remains elevated…

…and the first VIX future has failed to break lower.

Dispersion can however moderate in a number of ways, with all stocks starting to fall a possible solution to that problem. This would likely require a rout in semis.

I’ve written about this a few times now, but these dynamics are key to why the US market continues to struggle relatively. While European markets haven’t done a huge amount better over February, Korea and Japan have shown that there is still considerable appetite for risk. It’s just not anywhere near the big tech spenders.

To look at this market you need to put your credit PM’s cap on. A credit PM (who maybe owns Microsoft or Oracle debt) will be looking at skyrocketing capex plans and reevaluating their exposure both in size and where it is bucketed in their portfolios.

CDS spreads have widened from ~20bp levels in 2024 (much safer than most of the index) to about 40-50bp now, (Oracle is in the 120’s). This is still lower than the average in the IG index, but this repricing will directly carry through to both equity volatility for each name and their P/E premium, as illustrated in the chart above. Their businesses have meaningfully changed and the market needs time to digest that. The nature of “tech” has changed.

Does 40-50bp seem tight given that a number of these firms are in a capex war? I would argue that it does, especially since a number of these companies no longer generate much (if any) free cash flow now after capex. The wider spreads go, the higher implied equity volatility will be, along with lower multiples.

Subscribe now

Rates follow-up

Dec-2026/Dec-2027 SOFR is now starting to price cuts after last week’s move extends.

The belly continues to outperform…

…but it’s likely to hit some resistance.

European bonds continue to do well which is surely dragging down yields in the US as well.

Subscribe now

China requires some attention

Missing from narratives at the moment are movements in China. The USD just can’t catch a bid, this is no less apparent in USDCNY, which is usually a low volatility managed currency.

The RMB has appreciated continually since liberation day, to the tune of about 6.2%.

Keep in mind that this is the nominal exchange rate. Anaemic inflation in China versus the rest of the world has meant that it is still as low as it has been despite the recent turnaround.

Even the IMF is recommending that China do something about it. This may have been prompted by discontent in Europe where even they are talking about tariffs. Either way their estimate of 16% undervaluation is likely way off the mark.

This article from late last year covers the dynamics well. They estimate the Yuan undervaluation is about 30%. More recently China seems to be acting against the move by directing state banks to buy USD to offset the appreciation, working entirely against the narrative that China is trying to “dump” US Treasuries.

While the economics are strong all across the western world, China’s is not looking good.

Net exports continue to prop up a continuing capitulation across the property sector.

Steel pricing isn’t showing any signs of life but isn’t necessarily breaking down either.

Leaning against the currency doesn’t seem like great messaging about the state of the Chinese economy to me. A lot wrong with the world now would correct if the RMB did appreciate, but China’s reliance on net exports as the only engine of growth will ensure that this doesn’t happen.

At the moment, the terminal rate implied by 1-month SOFR futures sits at just over 3% somewhere in the middle of 2027 but pay attention to the shape of this curve.

Employment data mid-week saw big headline payrolls growth which, rightly so, is a number that is being dismissed as being too unreliable at this point. It was the solid unemployment rate that emboldened positioning in SOFR futures that ultimately were expressing an inflation and employment picture that would see a Fed that would be forced to hike out of any politically encouraged cutting that would be priced in with the new Fed chair in charge.

The forward curve instead paid more attention to the weakness in equities, and then the inflation print put the nail in the coffin.

While the move itself wasn’t huge (12bp or about half a hike over 2027), it represents an important shift in how the market is now looking at forward inflation risks alongside an economy that is still rapidly growing in real terms and past the effect that tariffs were theorised to have on employment.

The argument that tariffs were going to have a persistent and large effect on inflation was never credible, and even the data from the first 6 months after they were applied said the same.

There was an argument that a US economy that was running hot could cause inflation to remain elevated into the future, and that argument is far from settled at this point in time. My own view is that a level of about 2.7% for core inflation that persists into the future was used in my recent piece on bond haircuts.

Core inflation printed at 2.5% YoY which wasn’t that far below expectation. Where the change in narrative came from was that this number was only held up due to volatile components such as airfares, while everything else was on the weaker side.

This now tops a run of weaker services inflation prints that brings the consensus view of inflation into real question.

The chart above from ING illustrates this quite well. I’ve been bearish on core goods inflation which also caught many by surprise (most had strong numbers in their forecasts for January CPI because of strong retail price tracking), but it really is the moderation in services inflation that is changing the markets (and my) view here.

Services and housing inflation is still running at >3% on a component basis so it won’t convince everyone (including the hawks on the Fed board) that cuts are needed yet, and the Fed minutes released this week support that.

The market, however, sees it from the point-of-view that is relative to other economic strength.

If a 4.3% unemployment rate and nominal GDP growth still punching well above 5%, then what chance does inflation ever have of surprising stubbornly to the upside?

Net outward migration could be having a significant effect on these components of CPI as well, with particular focus on housing. If that’s the case, maybe everyone is off on their forecasts.

I am currently ignoring the argument that productivity growth is so strong that US GDP growth can be as hot as it without being inflationary. Fed chair appointee Kevin Warsh has himself put this forward as a reason for why rates can be lower than where they are. With AI capturing so much of people’s thought processes these days it’s also very appealing from a narrative perspective.

While some economists will argue with you until they are blue in the face that productivity calculations are robust, it still remains that it is simply an “error” term after growth is attributed to capital and labour. If something else is driving growth (like, let’s say, record government expenditure coupled with an enormous trade deficit), then it will partially appear as productivity gains.

Subscribe now

Zooming out on rates

With this shift on how the market is seeing the forward path for rates in the US you would be forgiven for thinking that we were on some breakout path for bonds that would put an end to the bear market that started in 2022.

Nothing could be further from the truth.

The chart above tracks the price of a cumulative US 2-year future that takes out the misleading effect of the curve shape when looking at a yield chart. This shows you that absolutely nothing has changed recently or even since the Fed started cutting rates. It is still ranging and offers very little reason to think a breakout is coming.

European markets outside of the Bund are the only markets which have continued to show strength. Even French OATs have a chart that show some evidence of breakout. This is resulting in tighter spreads to Germany, a theme which has continued off the back of Spanish economic outperformance, and the ongoing plan for Germany to increase fiscal spending dramatically.

The US isn’t the only region that is benefitting from a growth upswing either, making bond strength look a little more suspect.

While I was never a fan of steepeners in the short-end purely because of the number of competing drivers, I still like them longer out the curve with my preferred expression not much changed over the week and also still ranging.

The delta in inflation expectations falling will be felt in the short-end over the long-end in my opinion, so this trade still offers a better expression in either outcome.

4% in 10-year Treasuries is well supported for now, and outside of inflation expectations isn’t as desired as the short-end for portfolio purposes.

Subscribe now

US equities

A final comment on US equities. We are approaching the fourth month of sideways trading, and many have covered the disaster in software (which has mostly been offset by gains in semis) which have put the brakes on further appreciation.

The US has broadly underperformed nearly everyone else at the index level this year, especially EM and the UK (also EM).

However, removing the effect of megacap tech changes the picture of relative performance considerably!

Vol remains elevated and probably will until the SCOTUS decision on tariffs comes through. It is meant to be soon but is unlikely to come out until after the State of the Union address next week to avoid giving Trump the stage to comment on it.

Current trading in the VIX (elevated level without a significant drawdown) bares most similarity to the end of 2014 and into 2015, where the S&P500 traded sideways for the entire year until a China FX devaluation induced drawdown in August of that year.

The difference between the VIX and the VIX for the underlying constituents continues to print with an extremely large spread. This spread has been climbing over the last few years as long/short equity strategies have grown in gross exposure.

The margin of her win gave the market all it needed to bid equities to the moon as this genuinely is a historical turning point for Japanese fiscal, economic, monetary and foreign policy.

This turning point is captured primarily by the performance of the Nikkei. The index is up 50% from the end of 2024 and has doubled from the April 2025 lows. The move has been so vicious that trading in OSE options on the Nikkei has been almost impossible in any decent size recently.

Most people don’t think of the Nikkei as a great asset over the longer term. The fact is that the price return of the Nikkei 225 from the depths of the GFC equate to 29% per annum, something that has only accelerated since the Bank of Japan decided to step away from the ZLB (zero lower bound) for interest rates.

Frankly, it’s about time. I consider ZIRP and all related policies as deeply damaging to activity as it embeds deflation rather than defeating it. It’s not a coincidence that equities have accelerated since the 2-year JGB has ripped away from zero.

Nominal GDP has consistently printed at levels not seen since the boom days of the 80s/90s.

This has enabled Japan to “repay” (in GDP ratio terms) the debt assumed during the pandemic. This is unique for the developed world where not only has debt/GDP increased, but the accumulation of debt has only accelerated. Ther ecan be cases where nominal GDP growth is “bought” via debt, but this doesn’t seem to be the case in Japan.

We can see how the forward curve has evolved as equities have rallied in the chart above.

The forward curve has steepened. The current BoJ rate is at 0.75%, while the June 2026 3-month rate is at about 1%, implying 1 hike over the next 6 months. At 1.32%, there is 1 and a bit hikes priced in for the next 6 months, with just less than another 3 over 2027.

The “terminal rate” displayed above (Dec-2028) has topped out at 1.76% and hasn’t moved higher on the election results. This, of course, is more to do with the BoJ signalling that underlying inflation has improved towards target. I still find it unlikely that the BoJ will hike to this level, and either way the progression to that level will be very slow.

Still, sufficiently large fiscal expansion and a weaker Yen could change the outlook here, although that even seems to be mean-reverting within its decently large 10% wide range.

Either way everything remains remarkably in control. This has been a hallmark of Japanese policy which stood out during the pandemic, and has been handled well ever since.

This doesn’t fully explain the level of USD/JPY though. When considering rates differentials a serious break occurred at the Liberation day turning point. This is due to 2 factors:

1. Real effective rate are still negative in Japan. This classes the Yen still as a funding currency, and the strong risk-on environment since last April indirectly causes a weaker Yen.

2. Capital outflows are still large because hedging costs have been high. This is now changing and JGBs are looking more attractive on a hedged basis.

As I’ve covered before…

…BoJ selling and a lack of domestic interest for JGBs. The 2-year/30-year JGB curve hasn’t moved since the large steepening that occurred in April last year.

We are very much in uncharted territory on a lot of measures, or at least uncharted since about 1992.

AUD/JPY is one of the classic Yen crosses that was known for its correlation to RoRo (risk-on, risk-off) and was very volatile itself being the opposing sides of the funding currency equation as their interest rate levels were so disparate.

This pair has now broken a near 40-year top. While we are unlikely going back to the position on the Yen in the pre-Plaza Accord days, the current level could be ushering in a new regime, or alternatively the harbinger of a huge drawdown in equity markets!

The story here in general is good, and Japan will offer a good diversifier to other developed markets both in rates and equities. The economics here is so much different to other current account surplus countries. It isn’t experiencing the same issues as Europe…

…and Japan seems to be successfully competiting on her terms against its neighbour, China.

It isn’t a secret that China is a driver of a planned re-writing of the Japanese constitution to enable a military expansion either.

Subscribe now

The first week of Feb was really that bad

Nomura reports that while the headline index was unchanged, the average S&P500 stock had an average absolute move of 10.8%!

Nomura also agree with the reasoning I’ve put forward in Charts & Notes on a number of occasions - vol of this form is due to crowding both at the strategy level and at the position level.

The market has a thirst for vol and goes where it can find it. Trends in funds management are driven by narratives and past performance. To generate outsized performance, you need to be in a market that’s moving. This could be from just strong upward momentum (this has driven inflows to tech, gold, crypto over the last few years), or via strong dispersion within or between markets which then offer opportunities to deliver significant alpha or correlation benefits.

These conditions need to be present to drive fund-raising, which is generally cyclical.

Cycles of fund-raising end when too much capital finds its way into a sector and either cause too much vol, or outright losses. Nomura alludes to this in the paragraph above, with not only total funds under management increasing, but the gross notional exposure of individual managers has also increased!

When too much capital finds itself into the sector we start to see what happened at the start of this month occur much more often. At the moment we see a “de-grossing” event like this about once a year, but if the usual stocks and factors bounce over the next few weeks then we should start expecting it more often.

A “de-grossing” event is the market telling managers that it can’t support the current amount of capital crowding into the same positions and strategies, similar to how credit markets will see default events after large capital inflows or as leverage increases in volatility products.

>3 Sharpe ratios cannot be safe forever!

The most tracked macro assets - the S&P500 and US bonds - didn’t really participate in any of this. The S&P500 hasn’t drawn down much greater than 3% even though poor sentiment (which is reflected in elevated implied volatility) was clearly coming from US politics, and despite the move on Thursday’s session.

US 2y bonds have traded in a 16bp range for 4 months now, and yesterday’s 2% fall in equities has taken it to the lower end of this range. This is exceptionally low volatility, again despite the fact that there is rare uncertainty about who will be leading the institution and much ink spilt about whether the person that Trump ended up picking would be forced to readopt ZIRP.

None of this adds up. Is it time to spend on puts?

Firstly, I want to advertise my latest mainline Macro Is Dead piece:

This piece talks about how a hard default for a country like the US is only possible if she so chooses - but this doesn’t mean that bondholders are immune from default-like capital losses.

The interaction between forward inflation and the Fed’s monetary policy has caused real capital losses for bondholders. I quantify this and show that despite pandemic-era inflation being far more subdued than in the 70s, losses for bondholders were far higher.

Stop he’s already dead

Volatility on the 2-year T-note contract is now in the mid-range of what persisted during ZIRP, while 2-year rates are at 3.5% and all the aforementioned worries persist in the market.

In 10s the story is even worse. Realised volatility is as lower than during ZIRP and as low as just before the pandemic and during the “eye of the storm” moment before the Fed realised it had an inflation problem on its hands. This also includes the “Liberation Day” drawdown in equities!

When measuring the true range (capturing highs and lows and not just close) and expressed as a percentage of outright rates, the picture is even worse. It’s tough work being a bond trader now.

What’s going on? Why do we read of panicking about Fed independence in deciding terminal rates, yet markets continue to print lower and lower vol?

Add to this the break between the US Dollar and rate differentials (illustrated last week) and the breakout in gold prices, the puzzle deepens.

There are a few possible explanations for this:

1. The market is already priced for perfection against two highly divergent paths for rates

2. The market has no idea how to price two highly divergent paths for rates and is just sitting on its hands (i.e. it is asking questions first and trading later which is not usually how things work)

3. The market has given up expecting any negative correlation to equities out of rates given the strong growth/inflation backdrop so no rush to safety ever happens.

The third explanation is likely the most accurate given that bonds really didn’t participate is the persistent jump of implied volatility in equities from ~14v to ~20v.

Subscribe now

No bond vol, no equity vol (but insurance is expensive)

So, US equity and bond realised volatility is low. However, the VIX has stayed stubbornly high since the market was triggered by Greenland.

This persistent elevation in the cost of downside protection just doesn’t match with low realised volatility, which is at historical lows. This is saying that volatility risk premium is high, and the market is expecting a sharp rise in realised volatility in the future.

There is some memory present here. It seemed like traders couldn’t get a weekend without worry in January. From Greenland to Japanese FX intervention to Iran - the standard trade is to bid up vol into the weekend because the market at least has an idea of Trump’s preferences for timing of announcements now.

Each of these events ended up being largely irrelevant, hence why realised volatility has stayed so low.

Another underappreciated effect is how falling slowing upward momentum in stocks triggers put buying in quant programmes. Adding to this is the positive historical relationship between the success of put buying and the level of implied volatility.

Odd as it sounds, buying puts works far less when implied volatility is low and puts are cheap. Most success occurs when volatility is moderate and high. Cross-validate this with high realised volatility and rate of success increases. It is still rare to have puts pay off because of a persistent volatility risk premium in equities, but it does happen.

In a similar story to the start of 2022, what might be driving index level vol buying is the amount of volatility under the hood, especially in tech.

Being a pure macro enjoyer, I don’t pay too much attention to stock reporting as these outcomes are generally wrapped up in the risk premium a certain market offers. If results are too volatile, it will manifest itself in a change in return distribution at the index level. From a 1000ft view, things don’t seem to be going too well for the markets favourite sector momentum trades.

There is a narrative attached to this, as there always is. Once again worry has set in about the volume of capex attached to infrastructure and (more importantly) the morphing of cash-flow generation to consumption. This has an obvious flow on effect on semiconductor companies which have been the strong momentum trade. Amazon reported an expected $200bn capex bill versus expectations of $141bn! Truly a turning point when it comes to the view of the future.

Another factor to consider is the rotation that is happening within US equities at the moment as well. Software, which was only a few years ago one of the largest sectors within the S&P500, has drawn down more than 30%, while small caps and the rest of the S&P have outperformed!

The narrative for this rotation seems to be at odds with that of infrastructure - how can AI supplant software if the market is saying no to more spending in the sector? The answer is that the rotation is driven by hedge funds running for the doors at once. This seems to an annual occurrence and is expected when gross long/short exposures are so large.

Volatile rotation has the ability to also make managers nervous and cause persistently higher implied vol. On top of this is the exposure of the jumbo private credit funds to software, of which some have exposure of 20%.

Private credit is still the left-tail risk. The post above details the corner they’ve painted themselves in.

Subscribe now

They’ll work out one way or the other

These divergences in volatility between US assets is also replicated in FX markets as I posted last week.

The sharp move in the Dollar seemed to replicate fear rather than fundamentals. A lower Dollar should see relatively lower US rates, but this hasn’t materialised.

This isn’t true across the board, however. The RBA hiked interest rates at their meeting this week, ending one of the shortest easing cycles in western central banking history.

In this case the rise in the AUD had a delayed reaction to interest rate differentials, and likely won’t need the sort of adjustment like we see in the EUR.

The divergence will have to work its way out. If the protection buyers in equities are right and we get the explosion in equity realised vol, then maybe rates can close the gap on the US Dollar. It might not be enough though.

If they’re wrong and equities resume upward momentum, then vol returns to the typical 14-16 range and the Dollar may end up filling the gap while bonds continue to do absolutely nothing.

The only emergent theme in US macro seems to be concern once again about employment. I haven’t seen enough top-tier data to suggest this is actually happening, but we get the delayed payrolls number on Tuesday.

The only trade that keeps on going is my favourite - 2s10s. No reason to see this changing anytime soon.

There’s little solace in gold at the moment, with correlations to equity being as positive as they ever are.

This next week will sort it out one way or the other. Be careful!

To cover:

• Gold & silver: The driver (China) hasn’t changed but has just supercharged

• Dollar & Yen: The US is getting what it wants

Firstly, I want to advertise my latest mainline Macro Is Dead piece:

This piece talks about how a hard default for a country like the US is only possible if she so chooses - but this doesn’t mean that bondholders are immune from default-like capital losses.

The interaction between forward inflation and the Fed’s monetary policy has caused real capital losses for bondholders. I quantify this and show that despite pandemic-era inflation being far more subdued than in the 70s, losses for bondholders were far higher.

Precious metals

At time of writing, gold has so far posted a +26% return for January, and silver an incredible +66%. On my measures it puts gold for its best monthly gain since the just before the end of the 1970s inflationary period, and for silver it is the best monthly gain ever on my data (which goes back to 1970).

This has been matched with enormous traded volumes for ETFs that offer exposure to both metals.

I am not a metals expert, and for this reason I approach all research I read on the matter from a neutral position. I have read everything I could get my hands on and the only consensus I have been able to establish is that nobody really knows what is going on.

I would link some of these pieces, but since there are so many contradicting pieces of information about key pieces of the puzzle, I would be doing more harm than good directing you to them. There is also a “crypto-esque” type vibe about silver as an asset class which makes it even more difficult to discern what is relevant, and what isn’t.

Here’s a summary of the arguments made for why we’re here and why it will/won’t keep going. I’ll concentrate on silver since disciplined tick watching has silver driving gold (up until two days ago), rather than the other way around but many of the same arguments work for each.

Subscribe now

1. Chinese retail buying of silver as the core driver of the rally

This isn’t agreed fully between everyone, but it does sound like the most likely explanation for prices being where they are.

I wrote about this as a driver of gold prices in April of last year and it is likely it has had a similar effect on silver as well despite its more plentiful nature.

The reason that it has still been powerful is because US-China tariffs have led to the weaponisation of rare earth elements and now have extended into silver as well. Similar to the case of REE’s, a large amount of refining capacity is in China.

So, Chinese retail buying due to CNY devaluation risk and a banking system under pressure from continuing problems in property, supercharged by lack on silver imports due to a standoff on trade in the metal.

I like this theory and it seems to be well supported by the data and policy changes (especially in China with their new export policy licensing requirements which changed this month).

For further evidence of both technical drivers and the blind demand for silver out of China, please see the above post.

Subscribe now

2. Silver market technicals

The arguments surrounding the technicalities of the silver market (including paper-physical spreads, refining margins, COMEX inventories, producer hedging and the spread between Chinese and US exchanges) were much harder to get a handle on and had the most convincing arguments one way or the other.

COMEX inventories: Several “the sky is falling” accounts on X are starting to panic about silver inventories available for delivery are falling and could be consumed within 6 months. This idea here is that shorts wouldn’t be able to deliver physical and therefore need to buy back, driving the price higher.

While there doesn’t seem to be much disagreement about cause and effect here, with the volatility that silver trades with, 6 months is a very long time.

Producer hedging: Positioning data reveals that it seems to be the hedged producers who are buying back, likely due to margin calls on one side of that trade. Likely a real effect.

Shanghai spread: Participants looking at the premium of Shanghai traded silver to COMEX traded note the stretched spread of about $20/oz ($130 vs. $110), arguing that COMEX traded should lift to where Shanghai pricing is.

Where the argument becomes muddy is that some believe that this is the effect of VAT (16%) on deliveries in China, but others say it shouldn’t be in the price as it only applies at the point of delivery. They present the lack of a spread as 6 months ago as proof it doesn’t exist. Yet the “cheapest to deliver” of any futures contract should have delivery effects integrated into the price.

This one ends up in the unsure bucket with fights ongoing on X over this.

3. Industrial demand

Some claim a spike in industrial demand is behind the price rises. I couldn’t find much evidence to support this. As of 2024, industrials uses of the metal totalled around 60% of production.

The story of a new Samsung battery made with a high silver content is a story doing the rounds which doesn’t seem to have any basis in reality.

4. Conspiracies

• Banks have to cover shorts! No, they don’t

• The banks have stopped supressing the silver price! No, they never did

• Central banks are secretly buying silver along with gold! No, they aren’t.

Stepping back from the fundamental drivers, there is no denying a huge move that is supported by record breaking traded volumes. The trader’s rule is that volume confirms a trend, and on this measure, we don’t have a sell-off coming (yet).

For gold, my favoured measure of the trend since the start of the rally in 2024 has busted the upside of the channel, indicating that there a breakdown in the previous trend, which makes the “pick a number” forecasts from banks somewhat believable.

The problem here is that you can be bullish on gold, but the price action has now made it a gamble rather than “investing”.

In other words, the confidence that forward returns fit within the empirically observed return distribution for gold has vanished. Once it went parabolic, all bets are off, and even if you think gold can go higher (I actually do), if you are running a portfolio it is going to be difficult to warehouse an asset that can whip around 10% a day without any reliable correlation with anything else you trade.

It is now time for the degens and true believers and the market makers (who will win out of this) to take over.

Subscribe now

USD, JPY, AUD, CNY

There’s no other way to put it - the move in the Dollar this month has been swift and judging by how it has traded, painful for a lot of option desks after a decent break in support seen in the chart below.

My first impressions here are that this is just another indicator of the end of the pandemic inflation cycle where elevated rates kept the USD bid. This was eventually set to crumble.

The second is the interesting mirror image with the Trump 1.0 term which I’ve highlighted with the boxes above. The total downward move during Trump 1.0 was just under 10%; the current move is just over 9% down.

So, the USD should bounce soon, right? No, this is the part most miss. 2018 was defined by a Fed that was hiking rates more aggressively away from the zero-bound (even though this did start in 2016 and paused in 2017). It’s unlikely we’ll see the same thing this time around, especially with the noise around the new Fed chair.

Funnily, this isn’t what actual rates markets are doing though. Markets have projected a higher forward rates curve for the US against Europe.

The chart above shows the more recent divergence between rates differentials and EUR/USD. This is evidence that the “sell US” trade is back, but narrative trades like this can only be temporary unless justified by fundamentals. The Dollar move will be either confirmed through a lower rates track or will bounce to define the reality. To be fair it is more binary than it usually is with the uncertainty around the new Fed chair.

You can’t forget gold here either. Strong gold generally equals a weak USD, all else equal.

Within the broader USD story are individual currencies with their own dynamics.

1. AUD

The AUD has a number of things going for it, justifying one of the largest monthly moves outside of a recovery from a large equity drawdown.

The RBA is forecast with a decent probability to hike rates, ending a cutting cycle that started in 2024 after another hot inflation print for Q4. The RBA will need some creative communication to avoid hiking rates in February.

The AUD tends to be positively correlated with gold as well (in an opposite way to how it works with the USD).

2. JPY

A “rate-check” by the MoF gave the market jitters as it assigned the worst possible inference around any possible intervention, along with a skittish 30y JGB.

Moves in 30y rates were exacerbated by the key factor during “Greenland-week” this month. The market freaked out over Trump’s Greenland comments which aligned with a US holiday and Asian market liquidity not dealing well with the volatility by this headline. I was a little surprised with how much markets panicked on that day - have we not learned yet how Trump conducts business???

By all reports intervention never occurred and the Yen appreciated anyway because that’s what everyone wants.

3. CNH

The only one that really matters when it comes to broader trade policy. Interesting to note that the appreciation of the CNY here, but this does come with a caveat.

The first is that the CNH’s appreciation has underperformed the rest of the USD basket. So, while the PBOC has allowed their currency to appreciate against the US, this has been balanced by relative depreciation against the rest of the CFETS basket.

China keeps being China.

The long-term chart above also highlights how strong the Dollar is compared to the Yuan. This is a period that saw China develop the largest current account surplus the world has seen and yet the currency continues to keep trend depreciation.

EUR and CHF will have to wait until next week.

Subscribe now

The narrative tie-up

I haven’t mentioned the US “debasement trade” as drivers of either metals or currencies because it’s frankly not true. Neither is it the apparent threat of war or US political “instability”.

In fact, it seems likely that the main force in both gold and silver (Chinese retail buying) is prompted by local Chinese issues exacerbated by the continuing crackdown by both the US and China on metals which are the only real effect of US politics.

Concentrate on the real effects, not the wishes of those who dream about the fall of fiat.

My prior work in quantifying the direct effect on growth of fiscal stimulus, which, unlike monetary policy, does not have “long and variable lags” associated with it, has predicted the strapping pace of US GDP growth which at this point doesn’t seem like it’s going to stop.

The next natural question is: how long can this go for? Won’t the US government default if it keeps on going down this path?

The short answer is the US government will only default if it explicitly chooses to. It will, however, continually cause losses to bondholders like it did in the 1970s and through the post-pandemic inflationary episode. Negative real returns are economically no different to a default and restructure in terms of losses to capital.

Warning: This newsletter is long. Skip ahead to the section entitled “the truth and beauty of inflation” to see the hard numbers on bondholder haircuts. It’s bigger than you expect.

Misinformation about hard defaults is rife. For a country like the US, I can categorically say that:

• A default won’t happen at a random failed auction for US government debt.

• A default isn’t any more likely because measured bid-ask spreads in government debt are getting wider or any random liquidity measure is degrading.

• A default won’t happen because foreigners all of a sudden have decided not to buy government debt (even if we assume they can collude without fault on this).

Ignore anyone peddling these theories because, frankly, they have exactly zero merit.

The fact is that any country that has sovereignty over their own currency always has a choice over whether it defaults or not. If a country has the ability to create its own currency, it can always manufacture a buyer of its own government’s debt. This is an undeniable fact.

This requires us to change how we think about default for developed nations with sovereignty. A “default” need not be just an inability to deliver on promises of coupons or principal. They can be any action that results in a negative real return for bondholders, since the link between fiscal policy and inflation is strong.

Stoking inflation by spending with no regard to debt growth reduces the value of nominally defined government debt. A common misconception here is that the creation of the money is what causes inflation. This is wrong. It is the spending of irresponsibly generated money in a resource constrained system that creates inflation.

Print as much as you want and leave it in a vault and it will have no effect on inflation.

Buying debt is a transaction where you exchange your current dollars for a payment of interest which should more than offset the erosion of the future spending power of those current dollars because of inflation. If that value is eroded by more than you expect then you have taken a loss that is no different to a hard default and a haircut on your capital. These two things are one and the same.

A negative real return on a sovereign bond can be classified as a “soft” default. Whether it is a soft or hard default is irrelevant to the bond holder, as it is still a loss of capital.

The pandemic was a dangerous mix of supply-side contraction and demand expansion, something which (thankfully) made it unique. The outlook isn’t as clear now. The same countries we worry about inflation-driven defaults about also run large deficits with an exporting powerhouse that is doing everything it can to reduce prices of its exported goods - a strong deflationary impulse.

These effects make it very hard to anticipate when stresses that large fiscal deficits cause become too big to ignore.

All that is sure is that the floor for 10-year+ government bond yields is much higher than it has been in 50 years. This doesn’t mean that the immediate impulse is for higher bond yields - just that nearly every other risk asset presents a better outlook than bonds do.

Subscribe now

Domestically, the power is all yours

As a general rule, a sovereign that has a central bank that can (and is willing to, if “independent”) fund the local currency denominated banking system to an unlimited scale cannot default on its sovereign debt.

To understand why, it is important to know how government bond auctions are carried out.

While exact methodologies differ between countries, most advanced countries issue government bonds through the banking system, who then conduct the process of allocating that issuance to the final investor. The key part here is that the banking system (operating as primary dealers) implicitly funds the entire issuance. This occurs through repo funding any gaps and through backstop support through facilities such as a discount window at their local central bank. The result is that the banking system underwrites the entire issuance of a new government bond issue (with the important help of unlimited support from the central bank).

The final investor sets the price for bond issue, however. In normal circumstances, the bank will only hold onto the amount of debt that it wants for its trading desk or perhaps for regulatory purposes. It lets the rest of the market set the price, which is made up of mutual funds, insurers, other financial institutions and households.

Sometimes demand wanes for some reason. This generally happens when the near-term outlook for bond yields may not be favourable, so less demand comes through than normally does. Sometimes new issuance may be mispriced on the yield curve, although this is rarer given the consultation with traders that occurs before an issue goes live.

The famous “bid-to-cover” ratio that are published at every US government bond auction has very little correlation with subsequent bond price performance over any time period.

For those that are familiar with equity markets may be confused as to how variable demand doesn’t just kill issuance. It is true that IPOs can live or die based on whether they are oversubscribed or not.

Government bond markets are different. The difference with sovereign debt is that it is not only the bank that underwrites the deal, but the central bank as well. Most advanced economy central banks have a litany of programmes that allow them to accept government bonds as collateral in return for funding.

While these programmes may have different names and mechanisms, they all are a slightly different form of creating central bank warehousing space for risk the market doesn’t want to take for whatever reason.

This is difficult to say, but technically Modern Monetary Theory cultists are right; just spending more doesn’t necessarily cause a problem and is without limit. Where they are wrong is that just making new money in the form of debt doesn’t change the true limits of labour, manufacturing capacity and raw materials availability.

Subscribe now

The foreign buyer of government debt

Second to the debunked possibility of a failed government bond auction is the constant threat, regularly pushed by the financial media, of foreign governments that can just stop buying your debt at any point in time. This fills many with fear, and on the surface makes my assertion that developed economies with control over their own currency can choose if they default, false.

In some ways, it does make it false. A country that has control over its own currency but also has a very large current account deficit is more at risk of an uncontrolled default than a than one that has a balanced current account. The bigger the current account deficit, the more your country relies on capital inflows in the form of equity or debt to pay for your over consumption relative to the rest of the world.

This risk increases the smaller a country is. A country small enough can experience a buyer’s strike on their debt, and while this doesn’t affect the ability of the government to raise funds through debt issuance, it does affect the willingness of other countries to accept their currency as payment for imported goods and services.

“We’ll only sell to you if you pay us in a currency you can’t create out of thin air, please. And if you can’t, why am I selling it to you at all?” will be the very appropriate question asked by exporting countries.

This thought process is why small and open countries peg their currency to another (“hard”) currency instead. This avoids this question being asked at all, while introducing a whole host of other compromises.

Within this argument, size clearly matters. A small market for foreign goods like Argentina is easy to switch off. A larger market like New Zealand is harder as export competitors who are willing to take that currency risk (or find a way to structure around it) may step in and take your market share.

An Australia, Canada or UK will be more resilient to foreign buyers strikes for their debt because of their bigger size. If you want to sell your stuff to a country, you must accept their currency as payment (which is analogous to saying you accept their debt).

The US is the end of the road for these comparisons. It runs the largest trade deficit in the world is currency equivalent by far yet still finds reliable buyers for its debt offshore. Why?

If foreigners want to keep selling their wares to the US, they need to accept payment in USD denominated assets. That can be equity, debt or anything in between. They don’t care what it is, because the US has a market for most goods and services that is unmatched by anyone else. A small business can become huge with only a small footing in the US.

This is without mentioning the size of the offshore market for US dollars. The Eurodollar market is as large as it is because so many foreign entities (both sovereigns and corporates) love borrowing in US dollars because of the stability it provides as a medium of exchange. Finding an investor for your government/corporate is far easier when everyone agrees on a valuing currency as a starting point.

The reality is that it doesn’t matter what they buy in the seniority ladder. Each will cycle money though the US economy, allowing it to continue to spend and maintain its external imbalance. Similarly, the availability of funding through the external imbalance encourages over-consumption.

As is the ultimate point of this newsletter, when you are big and important enough, you get to choose your outcome, which includes avoiding a hard default. In this timeline, the US chooses to overconsume by accepting foreign capital, and foreign exporters choose to keep on funding overconsumption, and seemingly encouraging it.

Either side could choose to end the status quo, but they just…don’t. If China decided tomorrow to stop accepting the US dollar as payment and as a result stop exporting to the US, who would that hurt more? Similarly, if the US government decided to close its fiscal deficit in a day, it would take the whole world with it.

Subscribe now

We’ve seen defaults in the past, haven’t we?

Up until now, all it sounds like I’m saying that a sovereign can’t default unless it can. And, whilst rare, we’ve seen a number of defaults, with some of those within history of trading markets for some.

Did Greece hard default in the Euro crisis? After a flip-flopping by the Greek government of the time and basically reneging on a referendum by the people, it accepted the “help” of the German government and the ECB to provide the same support a large country with the ability to backstop government issuance could.

Greece suffered from large (larger than anyone apart from Goldman Sachs knew) fiscal deficits and, like most peripheral European countries, a very large current account deficit which mostly persisted with their saviour country, Germany.

I personally count Greece as a sovereign default, as the subsequent terming out of existing Greek debt was effectively a haircut to holders. This sort of restructuring, common in corporate defaults as well, is just a more orderly form of default over the chaos that would occur if there was a sudden stop.

The ECB’s commitment to buying the debt of its member states likely saved Spain, Portugal, Ireland and Italy from the same fate. For these countries no other losses were taken as they were for Greek government debt. Just an important example of how having co-operation of your central bank (and the ability to print your own currency) is important to the inherent choice of whether you default or not.

The European crisis also shows that buying your own debt and employing monetary measures (or as I prefer calling it, financial engineering) to avoid default doesn’t necessarily cause inflation, when paired with austerity.

This lends more credence to the theory that financial engineering doesn’t matter, it is only fiscal prudence (or the lack of) that does.

Most other defaults in the 21st century are filed under sovereigns that didn’t have control of the currency their debt was denominated in. Argentina and every country the experienced trouble during the Asian Financial Crisis falls in this bucket.

We need to go much further back to analyse examples of sovereign defaults that were significant but looked different.

16th century Spanish fiscal spending on naval projection was paid for with a constant inflow of silver from the new world. The reliability of this inflow helped to maintain the spend required for Spain to be the equivalent of a world “superpower” in its day.

This inflow brought economic problems that are shared with the US today. Inflation caused by this monetary inflow both killed productivity within Spain itself, reducing a once powerful industrial machine back to an agrarian economy. France and Britain increased their output of capital goods at the same time, further placing Spain under pressure.

This all eventually led to defaults on debt owed to other European powers. The parallels present here with the modern-day US are concerning both from the perspective of large inflows causing inflation, and the offshoring of industrial capacity eventually destroying the ability to service the debt attached to these inflows.

The Ottoman empire experienced something similar in regard to defaults associated with offshoring of industrial capacity.

Both the Spanish and Ottoman experiences are something I will revisit in a future newsletter because the history here is important. Modern financial systems are more adept at putting off crises, but the lessons from history still hold true. Large persistent capital inflows will eventually cause issues.

The most damaging of these issues is inflation.

Subscribe now

The truth and beauty of inflation

We’ve established for a sufficiently large country with control of its own currency; default is a choice that can be taken at any time it serves itself.

Within this small subset of examples, the experience of the US in the 1970s is one that is incorrectly attributed to only the external factor of the oil shock, and the monetary factor of Arthur Burns not raising rates early enough in the late 1960s.

The inflation of the 1970s was caused in large part by the spending plans of LBJ. The expansion of the welfare state was unprecedented and caught an economy that was still running on all cylinders unaware.

Was monetary policy mismanaged? We can work that out on whether bond holders took an effective haircut (a soft default) or not.

The chart above tracks the subsequent real return the buyer of a 10-year Treasury note would receive, expressed in total return over the entire 10-year period (rather than a per annum figure).

Looking closer at the chart above, if you bought a 10-year Treasury note at the end of November 1971, your total real return (i.e. not per annum) on that bond would’ve been -23.27%. This was the worst time to purchase a 10-year bond in this entire episode. The investor effectively experienced a haircut of a quarter of your capital (in real terms). This is the sort of loss a bondholder might receive in the restructuring of corporate debt in a mild bankruptcy.

For the decade of negative real returns (1964-1974), bondholders achieved an average real return of -9.27%. This includes a slight period of positive returns in late-’69 to mid-’70. This experience was distressing enough that it took 50 years for bonds to stop offering enormous real rates of return. Similarly, it shouldn’t be hard to understand why bonds found their way into every optimised portfolio given this performance!

The inflation episode of the 2010s and ‘20s also lasted a decade starting in April 2012 and ending in August 2022.

Important note (also covered here): Future inflation is estimated at 2.7%. These results don’t change by much if you assume inflation falls back to 2% by 2028.

The worst time in this episode to buy a 10-year bond was in July 2020, where the total real return was -25.61%, worse than in the 1970s!1 This seems surprising. Inflation didn’t get as high, rates weren’t hiked as much, but losses were bigger. The answer is that inflation rose faster and there was too much of a lag for rates being hiked. The gap was larger for longer than in the ‘70s for this reason.

The average real return over this period was -9.90%, again worse than during the oil shock. This average is worse than in the ‘70s as the large negative real returns in 2016 and 2017 (due to ZIRP) drag down the results in this century.

So not only was the Fed too slow to hike for 2021 inflation, but it ran such loose policy for so long that the average outcome was even worse.

So, while the recent inflation episode wasn’t as bad as in the 70s, the lower starting yields made losses far worse.

I struggle to understand why bond market participants worry about losing “independence” at the Fed. It’s not like an independent Fed treated them well anyway!

The average for the entire 75-year period is 25% total real return on a 10-year bond, or a 2.25% real return per annum. Most of this real return comes from the general decline in inflation over this horizon, giving a boost to real returns.

Considering all of those other asset classes is outside the scope of this newsletter. Equities, most real assets (and gold) kept up with inflation. This is to be expected, however. An soft default by the government should benefit those sectors that received the benefit of the excess government spending. A default it nothing but the crystallization of previous value transfer from one group of individuals to another, after all.

Cash (or bank account) holdings are worth considering as well. They are the lowest hurdle benchmark, but more importantly the outcome on cash balances which is more sensitive to the central bank’s response to the inflationary episode. Cash returns are nearly perfectly correlated to central bank interest rate (unlike the 10-year yield which is only about 70% correlated), so if the central bank adjusts rate correctly for the inflationary episode, a “default” can be averted.

Cumulative losses in the 1970s here were better than that for bonds, but only slightly. Returns under paced bonds as inflation fell, leading to an average real return of zero on cash over that period.

The real losses on cash in the 21st century that surprised me. From the point that Fed policy became focussed on deflationary risks, real returns on cash turned negative (as did the equity and bond correlation). This was the (misguided) point of ZIRP.

This chart directly illustrates why bonds became strongly negatively correlated with risk assets. Once this ended, so did that negative correlation. See below for more.

The large difference in average real 10-year returns between cash and bonds also highlight the benefit of a normal shaped curve. The difference (~25%) is roughly 2.5% per annum over the 10-year measurement period - the average yield curve steepness over that time.

The last cut to the Fed Funds rate has suggested that the Federal Reserve is comfortable with an inflation rate that is closer to 3% than 2%. This in itself will be a major determinant of forward inflation rates (by far the single most important factor for inflation expectations is inflation of the recent past).

Losses on bond positions can be thwarted by either a reduction in the US fiscal deficit or a China that is able to continue to deflate export prices at a greater rate than they have been able to in the past.

If neither of these conditions can be met, then bonds will struggle.

Does anyone benefit from this haircut? Again, if we liken it to a corporate restructuring, the main beneficiaries of that default are all of those who were paid prior to bankruptcy - either through selling an asset to the insolvent firm at an inflated price, or from getting paid to do work that otherwise wouldn’t have been done.

In the case of a default of a company that built an asset that wasn’t economically viable, the default allows future users of that asset to benefit from something that wouldn’t have otherwise been built if it wasn’t for the “donation” by the bondholders.

The beneficiaries in these examples are theoretical and tough to identify, but they do exist.

If it was government spending that caused the inflationary episode, then it was those who benefitted from that government spending (and managed to invest it in assets that did keep up with inflation). If it was due to decree (a change in law that constrained supply) then the benefits accrued to those industries where prices went up the most.

Identifying those groups in the US that benefitted is politically dangerous. With social security and other benefits making up the lion’s share of spending, it is the poor, the sick, and the elderly that may have benefitted from it the most.

Ironically, it is inflation that has made it unlikely that these groups have been able to subsequently invest this money into assets that have appreciated in a real sense. Therefore, it is corporate US that is the ultimate beneficiary of the spending this fiscal deficit has funded, and the buybacks they’ve enabled.

No wonder US equities perform as they do.

Subscribe now

Bonds aren’t the only loser

The outcome for Treasury notes from the pandemic inflation worked out worse for bondholders than the 1970s inflationary episode largely due to the lower starting point for interest rates.

ZIRP policy left almost no premium in bond yields for the possibility of inflation unexpectedly exploding like it did, so ex-post returns were worse despite a much lower peak in inflation.

The inflationary episode of the 70s also birthed a 50-year bull market in bonds. Much of this is from the very high starting point for yields after an economically rough decade and the normalisation of inflation coupled with falling “economic volatility” (the uncertainty of what GDP growth or inflation will be).

Another important trend was academic consensus about the power of monetary policy in defeating inflation. Soon after most central banks around the world had an inflation target within their mandates. This didn’t happen until the 90s however, so bonds took a while to react as this consensus built.

It was this same consensus that eventually led to central banks thinking they could also defeat deflation, which resulted in ZIRP, which led to the losses bondholders (and central banks themselves) have worn.

This is the key to predicting whether we are in for another epic bond rally like that which started in the 80s. Will central banks cut to zero again?

I have said repeatedly that the prospect of another unexpected jump in inflation is very unlikely, but that persistently sticky core inflation between 3-4% (with panic at the higher end of that band) testing the Fed’s resolve.

Political norms are no more, so it is a fool’s errand to think that the Fed (or any other central bank) can’t cut to zero again with core inflation at 4%. Would this give us our bond rally? Probably not; the 10-year would continue to price in the corrosive effects of inflation on bond returns through higher nominal yields.

The only way we get a sustained bond rally is if both inflation falls below 2% (and the market believes it will stay there) and central banks cut with it. The second conditional outcome is more likely than the first occurring on its own, but it is non-zero while China is exporting deflation like it is, even if that force is up against services inflation which continues to be a problem.

The politics will ultimately determine destiny here. If there is a willingness to repair the twin-deficit imbalances, then the environment for a monster-rally will arrive. The politics is a million miles away from this being a possibility.

The politics is almost permanently stuck in “muddle-through” state. Changes and reform are becoming impossible, if they aren’t already. Populism means that there will be a push from both sides to keep interest rates low.

This puts us back in the loving arms of the yield curve steepener.

The only real critique I read about the steepener trade is that it is the consensus trade.

Adherence to this sort of thinking would imply that trend isn’t a reliable factor in attributing market returns - but it clearly is.

The consensus trade in bond markets since around 2008 was that there was never any point in shorting bonds. This was a heavy consensus trade, with several slogan emerging from the period such as “buy bonds, wear diamonds” (a saying I find a little cringe to be honest).

The “everyone likes steepeners” of today is the “everyone likes bond longs” of the 2010s. The themes attacked in this newsletter are the real underlying force for this view and are ultimately driven by the general belief that fiscal austerity no longer suits the objectives of most western states.

The steepener requires on-hold or easing central banks. Is this not just a repeat of Arthur Burns?

I believe Arthur Burns had a principled (if not ideological) viewpoint on why he didn’t intervene to position monetary policy in direct opposition to what the government had signalled it wanted by expanding fiscal policy as much as it did.

Governments can tax as they will. When the ability to tax runs up against the wall, the next best thing to do is to perform a soft default on your debt. There is no better way of doing this than to cause inflation, even if interest rates go up to compensate for the inflation the government caused by its spending.

Low rates and high inflation create rolling soft defaults, where real returns on bonds are perpetually negative. The market’s only way to protest this outcome is to buy assets that benefit from negative real interest rates.

While I’m confident in the floor on 10-year yields, I am also confident that bond markets won’t become unhinged because of loosening views on inflation control. Cancelling bond buying is almost impossible, both domestically and from abroad, while China’s push to deflate goods prices can’t end for similar reasons.

It is a hopelessly poor equilibrium to be stuck at.

Subscribe now

Ignore the clickbait

Whenever you see the articles that predict a crash in government bonds or reveal how the market for Treasuries will suddenly crack, please don’t click on them.

Apart from most of these articles being factually incorrect about the mechanics of government bond markets, they miss three important facts.

The first is that government bond markets have become far more crucial to the functioning of the entire financial system in recent years. This isn’t only because of its size (this is also important), but its elevation as the default form of collateral for nearly everything due to changing regulation means that it can’t do anything but be saved.

The second regards central bank independence. Independent or not, they don’t care for bond holders either way. Rates will never be high enough to compensate for the threat of higher inflation. Central banks facilitate losses during inflationary episodes.

The third is that they’ve missed the boat and its already happened. This is the key point of this newsletter.

Spending too much led to inflation which led to deeply negative real returns. These real returns were so negative in fact that bond and cash holders experienced real returns that were even worse than that of the 70s crisis.

For those that owned these assets, they indisputably got poorer. They got poorer just like a bond holder of Lehman Brothers or Countrywide or Ford. They just might not have realised it.

The German DAX had an incredible run from the US election last year up until the end of Q1, registering gains of nearly 20%. Trump meant a push back on European defence spending, and domestic political pressures combined with a lagging economy finally put German fiscal spending on the table.

Since then, little has happened. The DAX has traded in a tight 5% range since the Liberation Day recovery in markets. The Eurostoxx has fared better with a bigger tech exposure.

Asset allocators jumped on the narrative and tilted their portfolios towards Europe over the US. For those that got in late, the switch hasn’t treated them well.

Recent GDP data has the Euro Area growing at 0.2% QoQ, with Germany basically posting (once again) zero growth.

The breakdown doesn’t deliver any good news, with exports and consumption dragging. Inventories are climbing. Bulls will say this is historical data that doesn’t point to where the economy is going.

Q1 should see German stimulus starting to be deployed. The market has done its thing and priced this equity market friendly stimulus, but the slow delivery has many asking questions, and those that are doubtful have had the hard data backing them up.

Views fall into 2 camps:

1. Bearish: China has weakened the German export machine too much for the fiscal impulse to overcome.

2. Bullish: The slow delivery has tempered expectations, and Europe will over deliver in 2026, while exports will bottom.

Let’s have a look at both.

Subscribe now

The bear case

The core of this argument is that the Chinese external balance is only going to increase with the push to grow exports.

This has a large effect on Germany (from Goldmans)…

…with rising Chinese imports into Europe not being met with trade in the other direction.

The chart on the right above shows how dire this has been, with European volume share shifting entirely to Chinese exporters.

Germany was a winner in the rise of China. For much of the last 20 years, the Chinese relied on high value-add intermediate manufactured exports from Germany to enable their industrial machine. You couldn’t make a factory without German parts. This helped Japan as well.

Now Germany runs a deficit with China, and it seems to be getting worse.

The currency continues to be an issue as well. With the ECB either done or with only 1 more cut to come, respite from a better exchange rate is unlikely.

Goldmans estimate that a rising Chinese trade surplus with Europe will further slow growth by 0.6% over the next 3 years. If the core thesis stays intact, this is a significant headwind.

This has seen Germany struggle. While very mild, German GDP is still below the 2022 peak.

Part of this issue has been productivity, something which has affected many western countries. This is all while labour availability has been low (which has driven a low unemployment rate).

The nature of the planned fiscal stimulus (defence and infrastructure) is great for stocks, and it’s important to divide the two here (I’ll get to this later).

For GDP, is German stimulus enough when nearly all of the rest of the EU is tightening policy?

The more bullish banks have German growth at above 1% next year, from effectively zero this year. The bears don’t think this will eventuate, and even if it does, they think it won’t be enough to lift all boats.

Subscribe now

The bull case

Expectations are where the bull case is strongest.

Expectations are already very low. The easy side to take is the bear case because the trends have been so strong.

Seeing how this quarter’s GDP print has evolved over time is enough. Dire.

On the other hand, the periphery is still doing well. Spain is the standout after finally ditching the ball and chain of post-GFC deleveraging. Even France surprised much to the upside this quarter on exports and business investment, delivering 0.5% QoQ in the middle of the disruptive political situation.

PMIs are heading in the right direction, as is business confidence.

This has been seen in business investment and housing activity as well.

Even recent German auto demand shows that trends can reverse.

Consumption is also looking up. Wage growth combined with (ironically) the falling price of imports act as tailwinds.

This is reflected in goods inflation above. Inflation in Europe has been at target for a while now and unlike most other countries, is looking weaker. This might allow the ECB to come into the picture again, especially if the immediate effect of German fiscal stimulus is below ECB expectations.

Subscribe now

You can’t trade GDP

The bear case might be missing the point a little. Even if it is correct and the trends which have put stress on the German export machine continue, there are other things that might matter more.

1. You can’t trade GDP. Even if they are right and German GDP growth ends up below 0.5% for 2026, fiscal stimulus is directed right at the companies that make up European indexes, and the trade is in equities, not in broader economic growth.

2. Declining capacity utilisation might work for higher equities. German companies such as Continental and Volkswagen are redirecting labour and factory capacity to companies such as Rheinmetall. Directing fiscal into supply constraints is usually the worst outcome - declining export demand could actually help the efficacy of the fiscal effort.

3. Continued Chinese export dominance might force the ECB’s hand. There is evidence that rate cuts are starting to help with consumption and credit starting to grow again. Slowing inflation would cause the ECB to deliver more, with benefits extending to the currency as well.

Low expectations have put the German fiscal narrative on the backburner. If a mean reversion happens, the upside is likely bigger than the downside.

One very widely spread post made some crazy predictions. Be warned, my ranting response is below (nothing too new for long-time Charts & Notes readers).

You can appreciate that the moves are important without resorting to “it’s the end of the global system as we know it”. I didn’t comment on it last week because this week was quite an important one when it comes to the forces driving the Yen and Japanese bonds weaker.

Where my view differs is my belief that bonds are actually trading better than you would expect given nearly every single factor is suggesting higher long-end Japanese yields.

The two key events this week was the new Prime Minister’s fiscal plan, and inflation.

Spending is expected to be about 25 trillion Yen more than last year, Mizuho forecasts that the increase on JGB issuance will be lower at 10 trillion Yen after accounting for increases in revenues. Market participants are almost certain to interpret this as confirmation of the Takaichi administration’s proactive fiscal stance.

The market has been concentrating on the 30-year point of the yield curve but it’s likely to be the 10-year point that will bear the brunt of increased issuance.

Why? The MOF wants to shorten average issuance maturity because of the lack of demand in the 30-year sector (explained by the primary headwinds of decreasing domestic buying across insurance and the BoJ).

Since Liberation Day 30-year JGB yields have risen by about 0.8% but the 10/30-year curve is about the same. With rising rate hike expectations, the 10-year part of the curve should get richer (i.e. the yield should fall relative to the 2-year and 30-year), as this is the general relationship.

This was happening up until September, where you see the peak in the 10/30-year curve above. More recently it has gone the other direction likely because dealers are expecting to see (and probably want) issuance in the 10-year sector.

These effects are very technical and apart from providing some education on how the yield curve twists and turns with all of these macro happenings, it is mostly designed to show how prices and yields moving aren’t the end of the world.

Last week’s inflation prints were in-line with market expectations so in general not that interesting.

The levels might surprise some. Core and Core-Core (ex-housing) are printing near 3%, with YoY figures rising more recently.

Inflation numbers at this level should keep the BoJ hiking and put it at odds with the Takaichi view on rates.

Most of the market has inflation moderating next year, as do inflation break evens. There have been some one-off effects like rice shortages driving some huge price increases that should subside.

The Yen is a little different. It has sold off by more than yields would suggest and USDJPY is back towards record highs.

This is at odds with interest rate differentials as seen in the chart above. US yields have outperformed globally and, when compared with Japanese yields, indicate that USD/JPY should be trading lower rather than higher!

The chart above shows how directionally aligned the currency has been for the last few years…while the levels may not perfectly align, most of the time rate differentials inform on the direction of the currency.

This has broken since Liberation day. Reduction of USD hedges (because of elevated costs) is likely the explanation however it’s very easy to look like a fool trying to explain moves in FX land!

Subscribe now

US data is back!

Employment numbers made a return and were a mixed bag in September: 100k+ payrolls with 4.4% unemployment rate.

September surged by 119k, higher than the market’s consensus. However, the last two months were revised down by 33k. The unemployment rate increased from 4.3% to 4.4%, but for reasons of an expanding labour force.

These numbers make a hold in December more likely in my opinion. It doesn’t really matter though because the Fed will end up getting to 3% one way or another.

I dislike betting on individual meetings, and this one doubly so…

..probabilities are flying all over the place.

There won’t be any more key data released before the meeting and this factor would be what would tip me over into the “no move” bucket.

Speaking of data, Goldmans did an extremely boring piece on bias in delayed economic releases. The only interesting part was the chart above relating to CPI - so keep this in mind when playing the chocolate wheel of economic releases!

More on point is the release of funds from the TGA. The monetary vacuum caused by the shutdown will be reversed and will drive strong equity performance into Q1.

Remember that US equities had one of its worst relative years in 2025, especially against Europe and Japan. It’s time to make up some ground.

Subscribe now

Macro is Dead

This PMI summary just highlights how dead the business cycle is. Since there is no cyclicality in government spending, neither will there be in the business cycle it mostly supports.

While this proposal was later withdrawn, it is very important to talk about how it elevates financial contagion private credit presents.

Stress in this asset class can filter to revolt by investors very quickly. Exposures aside, I believe there are some core reasons why a revolt is inevitable.

The thread above goes through the initially proposed terms of the merger. In short, the non-traded fund will merge with a traded fund, where redemption liquidity is provided by trading shares.

The kicker is that the traded fund is trading at a much more realistic 20% discount to NAV, resulting in the investors in the non-traded fund losing their “sell at NAV” put and taking an immediate hit of 20%.

For this particular investment, it seems to be the underlying exposures which have caused some concern recently.

Oracle and Coreweave CDS have widened recently within a similar theme. Oracle (above) hasn’t seen a material widening in my opinion - moving from 50bp to 100bp isn’t a crisis but just reflective of the size of the capital expenditure they’ve committed to. This commitment should cause pricing to correct.

Offering the free option to redeem at NAV is ridiculous in its own right as it’s obviously unsustainable, but this points to why the growth in the sector is a danger to itself.

Blue Owl (wisely) withdrew the proposal after blow-back. This doesn’t change the underlying dynamics. It also leaves the question of what they will do now. If redemption requests were too large in the first place to encourage such an idea (and surely they will only get worse now), they will either have to borrow to fund redemptions or gate the fund. Selling assets will be unlikely as it won’t reconcile with allowing redemptions at NAV.

Allow a revalue to drop NAV and their redemption problem will just increase. The core of the private credit problem.

Subscribe now

The core problems with private credit

I believe that Private credit offers unique exposure to the right investor. It isn’t inherently bad in itself, it’s just that it’s illiquidity encourages poor behaviour and incentives from most managers, while simultaneously playing on the uninformed desire for investors to own an asset with what appears to have no volatility.

Most of the time private credit will exhibit almost no volatility. This is exacerbated by the behaviour of managers when producing valuations for holdings in their funds. Without any traded markets, they are incentivised to never deviate their marks from par unless there is a very serious chance of non-payment.

This leads us to issue #1:

Investors (especially retail) do very poorly with investments that experience an extremely sharp change in volatility.

If they are used to an investment that only increases by the accrual they receive, a sudden 5 or 10% drawdown will have an outsized effect on their interest in the investment, where an investment that is highly volatile investment will be more likely to avoid redemptions even with a much larger drawdown.

It’s really all about expectation. They have been trained to expect little to no volatility, so any change will cause a revolt.

This is rarely limited to the funds that actually have an underlying issue with their holdings. The GFC is littered with examples of credit funds that returned all of investor’s capital many years after they were gated for redemptions.

We can be sure that there are many investors that are susceptible to this because public credit funds have been around forever and haven’t experienced anywhere near the same increase in size. More diversification was a convenient explanation, but the real underlying reason is the volatility history for private versus public credit funds.

This profile isn’t bad for investors that understand it and can live with drawdowns when they occur. For this type of investor private credit makes a lot of sense as it offers far more diversification than public markets, and exposure to industries through specific funds that wouldn’t have been able to be obtained otherwise.

Insurers are an example of this. Insurers tend to invest their “float” (premiums paid but that have been unearned) in fixed income instruments. Private credit is a better way to obtain this exposure, as an insurer would generally hold to maturity anyhow.

The lack of volatility is also partially irrelevant to these institutions who might have an accounting classification would’ve resulted in valuations being kept at par anyway if they held them directly.

It really depends on the type of investor and their expectations on whether having a volatility smoothed outcome is good or not.

Moving on.

Issues #2 and #3 surround credit quality and their interlinked incentives regarding fund raising for private credit funds.

Issue #2: Private credit managers have yet to show that they are better lenders than the banks.

Are private credit fund managers better or worse at choosing credits (whether they be by name or industry) than banks are? Nobody really knows.

Initially the bumper liquidity premium available on private credit lending delivered better outcomes for private credit funds even with the same relative losses. This premium has eroded with the growing size of funds under management, but to be fair this is very difficult to measure this precisely.

Direct lending portfolios seem to have very low arrears rates at the moment, but so do the banks.

If they aren’t any better than the banks, can we expect the same 10-year cycle in bad lending? This cycle generally isn’t deadly for the banks (even though sometimes it can be) but combined with issue #1 they can be for private credit.

Issue #3 covers incentives for lending:

Issue #3: Bank lending is driven by demand for loans; private credit lending is driven by demand for private credit as an investment.

This last core problem is the tinder for the other two issues to come into focus.

The underlying reason for the GFC was that banks were aggressively expanding into low-quality real estate lending because of:

1. Profit competition between banks

2. The regulatory capital arbitrage for the rating on this lending

3. Bank wholesale borrowing to fund this being practically unlimited

Adjustment of capital requirements has broadly fixed all of these problems to the point where banks are now driven primarily by demand for credit rather than trying to create their own supply of it.

Private credit has different drivers here. If applications are coming into your funds, you have to find someone to lend to otherwise the dilution will diminish returns for other investors. This is dangerous.

Add to this the presence of performance fees, which align itself with the 1st GFC problem. You need to lend riskier to drive returns and earn performance fees, just like the banks did in 2005 and 2006.

The private credit sector has grown immensely, and with that comes the risk of poorer lending as all inflows have to be invested.

The most dangerous known-unknown

I’m not revealing anything new here about private credit, as many share the same concerns.

When it comes to financial crises it is very rare that lightning strikes twice in the same place.

There is always a new innovation, a new market or a new type of security that goes under the radar and doesn’t get properly regulated until that crisis happens.

Financial crisis and contagion is one of my favourite topics. Please see one of my older posts above to understand how they start, what path they take to spread, and how they can be self-sustaining.

You might need it as the private credit sector tries anything it can to avoid the dreaded “gating”.

I’ve seen people talking about bond volatility as well. Most have pointed out the move higher in the MOVE index, an index of swaption volatility produced in the old days by Merril Lynch (the “M” in MOVE), which is now Bank of America.

It has picked up, but clearly from cycle lows. Swaption vol is forward looking and represents market participant’s forward view on volatility derived from the pricing of these instruments.

Backward looking realised volatility tells a different story.

US 10-year note volatility (estimated by the Average True Range above), is it cycle lows, and is now in-line with most of the 2010s when ZIRP was in full force.

If I adjusted this by yield level it would look even lower (which is more correct as daily trading ranges should be higher when yields are higher, all else equal).

A similar calculation on the 2-year confirms cycle lows, but it is still a little higher than during ZIRP.

You can see something similar when you look at the front-end of US rates curve. The Dec-2026 SOFR trading range has collapsed to about 30bp. This is partially because Dec-2026 is getting closer, but I would attribute it to fast decreasing uncertainty about the journey towards the end of the cutting cycle.

So why did forward looking volatility pick up? My guess would be that it fell too far as a result of the removal of possible volatility events as a result of the US government shutdown.

Since the shutdown is now over, traders can start to price in events once again which should make buying vol more expensive.

But would it have made a difference anyway?

Subscribe now

The ghost economic data points

It is highly likely that the missing data points (which are unlikely to be recreated, according to White House messaging) would have only introduced volatility through mismeasurement rather than actually revealing any change in the underlying trend.

Alternative data reveals that nothing has changed in the broad employment picture. The US continues its slide towards zero employment growth as the current administration reports net negative migration.

Goldmans confirms a similar outcome.

If the data was released and showed these trends, I don’t think realised vol would’ve been any different. You can’t price out a chance that the BLS delivered a +200k or -100k at one of those prints though!

Other measures are less convincing, but don’t really show a change in trend.

We may or may not see a cooling in investment led by data centre rollout.

I’ve never heard of the Dodge Momentum index, so take the above with a grain of salt but investment elsewhere looks higher as well. Good for GDP.

Subscribe now

Equity and credit are a different story

Average True Range in equities is rising.

The Average True Range above is represented in % moves to account for the higher index value.

Those with some more experience are watching credit at the moment, with most indexes drifting wider. I’m not sure this is a concern.

Using CCC spreads as a proxy, this market is just trading wider with a pickup in equity volatility in an almost 1-for-1 fashion.

Everyone draws different resistance-support lines, but on DB’s measure above we are at the support line, despite the apparent intensity of the post-April rebound.

Passive (led by retail) hasn’t been missing. While the construction of the above measure might be a little suspect, it is still interesting to digest.

The inflows are just insane relative to history. The above chart is adjusted for the bigger nominal size of the market, and even then, the buying is record breaking.

In my mental model, slowing employment growth should act as a brake on this. However, still large fiscal and current account deficits are undeniable tailwinds for inflows.

Subscribe now

Youth unemployment

One of the saddest aspects of the Euro crisis in the early 2010’s was the alarming rise in youth unemployment.

The numbers in Spain and Greece were astonishing. Thankfully this improved as Spain rebalanced, and it sits at about 25% today.

Developed markets trended in the other direction over that time. But that has now changed, and it is developed markets that are experiencing rising youth unemployment.

The US (above) has had broad youth unemployment rising for a while now, with graduate unemployment rising the fastest. While not at a dangerous level, it however is occurring outside of an economic slowdown.

No surprises what is driving the online youth political discourse.

In the UK, the youth unemployment rate is a little more concerning. This is something both the left and the right have issue with, despite assigning blame in different ways.

Tariffs, IEEPA and SCOTUS

After losing in the Court of International Trade, the Federal court and D.C. District court, Trump’s team has taken the challenge that tariffs can’t be imposed under IEEPA (International Emergency Economic Powers Act) to the Supreme Court.

I write on it because the hearings are going on now and it doesn’t seem to be going well for Trump, with some doubt from the friendly justices so far.

Unlike the bulk of cases brought against Trump’s orders, this one is genuinely a question of law and the reading of the legislation.

The case rests on SCOTUS’ view if tariffs are taxes or not, an argument that has played out endlessly on X since April. Those that are generally anti-Trump just view tariffs as a cynical way to raise money from citizens, while those that agree with Trump’s stance on international trade see the revenue raising as a side effect of the primary goal (which is to manage external trade).

I’m in both camps. I do agree that China’s dominant position as the world’s goods manufacturer wasn’t earned fairly and that some action needs to be taken. However, I also know that tariffs can’t work unless they raise prices for domestic consumers and thus raise taxes for the Federal government!

There is also the issue of how sympathetic the court is to the concept of Presidential power, balanced against the using arguably arcane statutes to implement that power.

Justice Gorsuch is making his views clear on this one.

Jonathan Turley, usually a supporter of Trump, is also sceptical.

This could go either way. A decision wasn’t expected until the middle of next year, but some say it could arrive before the end of 2025. After that will come the questions of tariff refunds to importers, on which Justice Alito has said that the court should rule on that simultaneously (another bad sign for IEEPA tariffs).

Goldmans have provided the table above summarising the facts (although it was produced before the hearing which would change the “likely vote split”).

The administration likely has plans to shift most of those IEEPA tariffs (those targeting goods from China, Hong Kong, Canada, and Mexico mostly) with other types that would likely reduce the ability for Trump to change them when he needed to, resulting in a slower process through Congress.

In the table above, Goldmans estimate that the current 11% average tariff rate is made up of 7.6% of IEEPA tariffs. If they were switched to other types, the total tariff rate could still fall by 1 to 3.5%.

The size of tariffs compares to all takings due to corporation tax. Reversing this would introduce another unknown, which would be as big as the introduction of tariffs themselves.

Technically, the tariffs tightened fiscal policy this year, although this was into modest loosening through the OBBB. If the tariffs are removed and repaid, then it is equivalent to a loosening of the same amount!

This should drive 10-year bond yields higher, but this would ignore the downward effect on inflation from tariffs no longer being an inflationary impulse.

At this point it would be scary to give the US economy any more fuel.

Subscribe now

Long-term nominal growth

Deutsche did a short piece this week on very long-term nominal growth and its link with equity returns.

From DB:

Today’s CoTD uses data from the study to show rolling 25-year median nominal GDP and nominal equity returns for global, EM, and DM markets, using annual data up to the end of 2024. The pre-1900 data should be treated cautiously as equity markets were smaller as a share of GDP, but over the past century there has been a strong gravitational pull from nominal growth to nominal equity returns. In the long run, equities can’t outrun nominal GDP — it drives earnings, incomes, spending, rates, and fiscal capacity.

I broadly agree with their assessment above, although they may have the causality the wrong way around. There is a strong link between the creation of money (debt growth) and nominal GDP.

The creation of money facilitates growth in the circulation of it, resulting in higher spending, and earnings.

Since 1900, global nominal GDP (in USD) has grown at an average of 5.7% a year, peaking in the inflationary, high-growth decades around the 1970s. Excluding that surge, it’s averaged roughly 4.8%, and the IMF projects about 5% growth through 2030 — broadly in line with history. EMs have outpaced DMs since the 1970s, while developed-market nominal growth hit lows in the 2010s that hadn’t been seen since the Great Depression.

In the post pandemic era we haven’t been far off this average that DB has noted above.

Note that this historical average growth was during times of much greater population growth and technological development. These days it’s just debt.

If Q3 & Q4 GDP print anywhere near what the GDPNow model thinks, my forecasts from the article above will finally be true for the second half of the year.

Subscribe now

Random markets charts

Bond volatility continues to fall. This is opposite of what usually occurs when a new monetary policy cycle starts, but in this case, it is not driven by emergency (either a growth or inflation driven emergency).

Ignore the “QE era” shading on this BofA chart. The huge run of nominal GDP growth has actually reduced asset/GDP somewhat from the post-pandemic highs, but the level of debt accumulation is still causing it to grow faster than trend.

Part of the reason for this in equity markets is due to the low supply of equity securities. Partially due to buybacks, and partially due to the lack on enthusiasm for PE-backed IPOs.

FOMC

The chart above was produced before the Fed cut rates again yesterday. The 2-year window chosen by BofA above is handy for this purpose, but the point it makes still stands.

The decision yesterday was the textbook definition of the “hawkish cut”.

To quote Powell:

A December cut is not a foregone conclusion…FAR FROM IT.

Emphasis mine.

This saw a repricing of the front-end as December (as I mentioned last week) WAS a foregone conclusion. Dec-2026 rates stepped back around 20bp from the equity volatility influenced highs.

The other interesting tidbit is highlighted by Jim Bianco below.

I can’t blame Powell for looking at this measure - I look it at the same way. There is little his monetary policy can do about the added inflation from pass-through to consumer pricing because of tariffs.

The only piece of data to emerge from the government shutdown was CPI last Friday. This report was soft, with tariffs effects being snuffed out by another low print for Owner’s Equivalent Rent (OER).

From Goldmans:

The owners’ equivalent rent (OER) component decelerated to 0.13%, its slowest pace since 2020, mostly reflecting a normalization in small Southern cities after a spike last month and a noisy drop in New England to the lowest pace on record.

Core CPI rose 0.23% in September, below consensus expectations, and the year-over-year rate ticked down to 3.02%, continually landing pretty much where everyone expects it to be, mostly because that is where the Fed’s untold target is now.

Core goods inflation was firm at 0.22%, largely reflecting increases in apparel, recreation goods, household furnishings, personal care, and new car prices.

On a 6-month annualised rate you can really see the effect of tariffs in the purple above.

Subscribe now

Australia

Upside down Australia saw the opposite occur, with rents picking up on very low vacancy rates which has turned a market from expecting interest rate cuts into the end of the year to now talking about hikes!

The latest CPI annualised at more than 4%, putting the RBA in a difficult position when many were saying it was too early to start the cutting cycle.

DM central banks rarely deviate much when it comes to narratives. Remember the real legacy of a central banker is in the eyes of their peers and not what politicians or citizens think of them.

Subscribe now

Engagement bait

The post below got plenty fired up on X this week.

Most replied with their view that this was financial stupidity as the rate is so low that keeping a balance in your mortgage and investing it almost risk-free elsewhere makes much more sense.

On the numbers you can’t disagree with this at all.

I would argue that there is some monetary value in the psychology of being debt-free. The utility of this would differ for everyone.

I think that this is only useful in the case where you have a lot of other liquid investments, however. If things turn south in your life, holding onto that (low cost) capital can see you through a period that where you can’t earn. Once you pay it back to the bank, there is little chance you’ll get it back if life circumstances mean that you aren’t earning an income. Getting back at that rate is obviously impossible.

Many also commented on how ecstatic the bank would be seeing this mortgage paid off. That really depends on how you look at it, because banks hedge themselves against this sort of prepayment risk.

A bank would account for some prepayments by what many would deem as “irrational” customers. The further your low mortgage rate drifts from the level of the current mortgage rate, the number of people prepaying would decrease, but it’s never zero.

So, while the bank might be very happy this man decided to pay off his low-rate mortgage, they also might be seeing far fewer prepayments than their model would have otherwise predicted!

There is still a lot of those low-rate mortgages out in the wild, with current rate mortgages (>6%) still below those <3%.

While we await this week’s inflation print bond yields print new recent lows.

Apollo (and others) produces a chart which suggests that prices paid will lead to higher core CPI. Note that the same uplift happened in 2018 - the first lot of Trump tariffs. This should be ignored.

Bond yields definitely aren’t trading like this pickup in inflation is a risk. Longer maturities have fallen below September lows as the front-end regains ground from the fade of rate cut excitement.

This led to a decent flattening of the curve. The main driver has been oil, with a heightened equity volatility the secondary catalyst.

The correlation between bond yields and oil has been decent recently, but of course they are heavily related for fundamental reasons and are self-feeding.

The fall in oil prices this month were a combination of supply drivers (OPEC increased), while demand slowed (US gasoline consumption). Renewed chatter of Russian sanctions have recently rescued oil prices.

Lower oil can signal lower demand and thus lower economic growth. To complete the feedback loop, lower oil also means lower inflation which reduces breakeven inflation and thus nominal bond yields.

Subscribe now

China growth update - fighting too many fires

I’ve highlighted the positive impulse from a big step-up in central government spending a number of times as a factor that is positive for global risk. China is (reluctantly) on that list.

The Chinese fiscal impulse firehose seems to be getting eaten up by a number of ongoing fires that seem to just be getting worse or require too much water to stabilise.

Q3 GDP and its partials don’t tell a good story. While growth will likely hit the “around 5%” marker with quarterly growth now estimated at around the 1% mark its unlikely we are seeing an acceleration. If anything, next year will be even more difficult.

This is all despite a big ramp in government spending and other demand-side initiatives.

The main problem is that China’s engines for growth are still slowing, and the fiscal response seems to be barely sufficient to offset these effects.

Subscribe now

Housing & fixed asset investment

The huge surprise from the Q3 GDP numbers was the fixed asset investment numbers which are showing a huge drop-off. While weather may have been a factor, headline FAI dropped by 0.5%, the lowest growth in a decade.

The anti-involution (please please don’t sell stuff below cost) drive is likely having some effect on slowing manufacturing investment here. Every slowdown in supply growth helps. Manufacturing investment, one of the highlights of the post-housing investment China, slowed to 4%.

Take out housing and FAI grew by 3% year-on-year.

After some positivity at the turn of the year, monthly falls in housing prices seem to be increasing again. In year-on-year terms there is still improvement, the current path doesn’t look good.

While debt growth from government is up, it is working against a slowing of loan growth elsewhere.

Steel demand is also slowing…

…which is reflected in steel prices (despite the fact that iron ore is still trading stronger).

Retail sales

While industrial production is still a bright spot (see exports further on), retail continues to struggle and is slowing rapidly as demand-side incentives peter out.

Consumption, a key 2030 goal, is lagging. Most of the improvement you see above is due to investment slowing, rather than consumption growth meaningfully increasing.

China realises that it can’t rely on investment forever. There just isn’t an endless supply of economically accretive projects you can dedicate capital to! At some point capital investment is suitable for your level of development (or in China’s case the demand for its exports).

A helpful chart from ANZ above shows how far China lags behind its neighbours.

Inflation

One fire that has been tempered has been the deflationary problem.

Core CPI is ever so slowly increasing, but this may also be partially tied into the consumer goods trade-in programme which has helped absorb supply. This effect is ending.

The GDP deflator (inflation implied in the GDP figures) is still negative. This puts nominal GDP growth in China well below the US. The days of projecting the nominal size of the Chinese economy to be greater than the US are long gone. These charts were a favourite of every macro commentator in the early 2010s.

Exports

Exports to the US have collapsed and haven’t recovered as I pointed out last week.

Where they have growth is to Africa. Chinese interests in Africa are ever increasing and are surely driving this trend. It remains to be seen how useful this will be for China in the long run.

Demographics are destiny, as they say.

While the trigger may have been a resumption of the tit-for-tat on US and China tariff and export controls, the move (especially in the last 15 minutes of trading) was a reflection of a feedback loop back from crypto.

While I don’t trade crypto and am unlikely to ever do so, I found the above helpful to understand what happened. It’s quite technical, but in the end, it seems to be a combination of two main factors:

1. A vulnerable collateral valuation methodology used by Binance which…

2. …triggered in-built liquidation rules in decentralised crypto systems exacerbated by…

3. …too much leverage.

The tariff trigger was just big enough to light the fuse which saw many altcoins down more than 70%.

Auto and general private credit worries are picking up. Zions Bancorp revealed a $50 million charge-off tied to alleged loan fraud, while Western Alliance Bancorp announced similar issues and legal action against a borrower. These disclosures triggered contagion fears, leading to steep declines of 10–13% in major regional bank stocks and a 6% plunge in the S&P KRE Regional Bank ETF. This was the steepest single day drop since April.

I’m personally very sceptical of credit growth in private credit vehicles, and this sector represents the largest “known-unknown” in markets.

There’s a reason banks operate as banks do and why they have the backstops they do. Private credit funds may have less liquidity calls given their closed-end nature, but this alone doesn’t stop contagion flowing to other open-ended funds.

As a follow up to last week’s Charts & Notes the market got thrown a curveball with the reappointment of the just resigned Prime Minister, followed by a promise to suspend pension reform until 2028. This outcome wasn’t even an option on Polymarket!

This will avoid a snap legislative election which reassured the market with equities up 2% and the OAT spread in substantially.

This does also mean that the long-term deficit will likely stay above 5% of GDP. A credit rating downgrade below AA is still on the cards here. While France may not be important on its own to a lot of you, the same politics will play out in a lot of other countries in the future.

Subscribe now

Powell’s Speech

Quantitative Tightening (QT) is likely coming to an end very soon, in-line with the plan to continue to cut rates. This is happening under the cover of “weaker” employment markets and no concerning information on inflation.

(Note that the BLS will release the CPI figure on the 24th of October, despite the government shutdown.)

The expectation is that it will end within the next 3 to 6 months and the Fed’s balance sheet will stop contracting.

The real target for QT is balances held by banks at the Fed in the form of reserves. These reserves are created when the Fed acquires a Treasury bond from the bank. QE should make reserves increase, while QT makes them decrease.

The chart above shows that reserves are at roughly $3trn, above the $2-2.5trn from before the pandemic (it is generally accepted that the liquidity crisis caused in 2019 was a result of letting reserves drain too much).

It is probably the right time to stop anyhow. The banking system is far bigger than it was in 2017 (approximately 48% bigger by total assets), putting reserves at $3trn about right…

…but any lower than $3trn (which is starting to happen now) we start to see some tightness in funding markets as the thread by Guy above explains.

Changes to the Fed’s role in the banking system through regulation necessitates a much bigger balance sheet than before. This is key to understanding why the Fed can never get the balance sheet much smaller than this.

I wrote a piece on this (above) which goes through each part of the Fed’s balance sheet and why it needs to stay at an elevated size.

I underestimate the effect of QT on total balance sheet size mostly because of Janet Yellen’s (now implemented by Scott Bessent) decision to start issuing bills instead of notes to fund the deficit. This reduced the need for the Fed to run a reverse repo programme to satisfy demand for short-term debt and caused the balance sheet to shrink further.

If this is ever changed (unlikely), the Fed’s balance sheet will grow to accommodate.

They’ve been leaning into it more, with auctions sizes increasing. From BNY:

In December 2019, 6% of all U.S. public debt outstanding was represented by T-bills. With the increase in government spending that ensued with the pandemic, by December 2020 bills represented 13% of all government debt outstanding, and by the end of September this year, they were 17%.

Why would you stop though? When you issue more, they just seem to buy more!

This has the primary benefit of keeping long-end yields in check. After the scare in April, it’s no surprise Bessent wants to avoid poking that bear.

In a rare contrition, Powell flagged that the Fed’s purchases of MBS during COVID may have been too much given the strong housing market during the pandemic recovery. With the clarity of hindsight, he believes the Fed should have stopped asset purchases sooner. That said, Powell acknowledged it is unclear whether stopping sooner would have made a difference to the economy’s trajectory.

The speech was an opportunity for Powell to push back against October rate cut pricing, but he didn’t.

This would imply October and December are a lock for rate cuts. This has played into a stronger bond market than we’ve seen in a while.

Goldman’s have attributed strong GDP growth outpacing weak employment growth as a productivity story…

…while the currency in the grips of debasement (sigh) is performing despite a fairly certain rate cut path. US economic outperformance no doubt helping here.

Subscribe now

It’s tariff time again

The new 100% tariffs were sparked by head clashing over rare earth minerals (or more accurately their processing). I wrote a whole Charts & Notes on it here.

The chart above highlights the gap. China processes EMs share of rare earth extraction. Most western countries don’t want the ESG issues relating to it.

A by region breakdown above highlights how China exports have shifted this year. Some would say China has found new markets; I would say they’ve found new markets to tranship from.

Highlighting how important the customer is, BHP have agreed to price 30% of their Chinese exports in RMB (not the fake news 70% I reposted above). Still worth reading the thread however, as the points about USD sensitivity in crisis still remain.

Goldmans have updated their tariff pass-through analysis, with the eventual amount paid by US consumers at 55% (much lower than in 2019).

They estimate that tariffs have affected Core PCE by 0.44% so far, with 0.60% to come.

Subscribe now

Sundry charts

Citadel track equity ownership by a number of cohorts. For households under the age of 40, equity ownership has skyrocketed.

While I haven’t had the time to understand the structure of all the new AI announcements, it does seem that all the value created is front-loaded in the announcement.

I’m not at all equating OpenAI with Enron, but they were very good at doing something similar around the dotcom boom in relation to announcing anything “internet”. Announcement first, justification (and technology) second.