Convex Strategies CIO on Investment

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00:00I think we can obviously talk about what's top of mind for you today, but I think, is it going to be the bond market and what we're seeing there?

00:07Well, hi. Thanks, Annabelle. Thanks for having me.

00:10Yeah, I think I'm in the business of risk mitigation, risk protection.

00:15I'm not in the punting business or the predicting business.

00:19And I think structurally everybody's well aware, and I've been writing and talking about it for years, maybe even decades,

00:25about the structural imbalances and the global holdings of fixed income.

00:30This sort of myth that was constructed through the regulatory application of bad financial mathematics that bonds,

00:39particularly sovereign bonds, sit somewhere in the regulated financial industry between riskless, 0% risk-weighted asset on banks,

00:48to risk reducing in liability-driven investment schemes where levering bonds is meant to reduce the risk of the portfolio.

00:55Or most simply in a 60-40 balanced portfolio where the bonds are considered as risk mitigating, risk reducing.

01:03But what we've learned, certainly in the last four or five years, is the bonds are the risk.

01:09And what we're seeing again and again is the bonds driving the risk cycle and driving the policy cycle as people try to cope with that.

01:17Obviously, Japan and U.S. Treasuries last week.

01:20Well, exactly. That's what I was going to bring up is that auction, for instance, we had with the 40-year bonds in Japan this week.

01:26And investors really seem to want more of a premium now.

01:29Well, I think the problem is a structural imbalance in the existing holdings, what I've dubbed as the hunger games of bond issuance.

01:37As the traditional buyers of bonds, which in the last 15 years have been predominantly central banks buying their own bonds,

01:47foreign central banks buying bonds for their FX reserves,

01:50and regulated financial institutions, banks, insurance, pension, loading up on bonds at terrible, terrible prices,

01:58extraordinarily artificially manipulated low yields, with tons and tons of leverage saying that that's not risk-taking.

02:05And now those people are full.

02:07They've had enough.

02:08And yet the supply of issuance keeps growing and growing and growing.

02:11And the examples last week, certainly with the long-dated bonds in Japan and around the world,

02:17the noise we had a few weeks ago in Taiwan,

02:21get down to this structural problem in the asset-liability mix of these financial institutions.

02:26So insurance companies who loaded with favorable accounting treatment on duration

02:32to accommodate the massive expansion of their liabilities as interest rates got forced to zero and below,

02:38now as interest rates rise, they need less duration.

02:42But the hidden implicit leverage in how they owned callable note structures or levered gilts,

02:48in the case of the UK LDI structures,

02:51they're actually growing in their duration exposures just as they need to buy fewer bonds.

02:55And that's creating a bottleneck in the bond issuance.

02:58But something else that also can play into it is the moves of government as well.

03:03Because, for instance, in the UK, and you just bring it up there,

03:06but there's the plans for Treasury to gain backstop powers.

03:10Yeah.

03:11So I wrote a note.

03:12I write notes every month that go up on our website for our investors.

03:15And I wrote one back in 2022 called, Is Sharp World Closing?

03:19Sharp World is what I call the whole mythical fantasy land of financial mathematics

03:24that gets overlaid in regulation to financial institutions.

03:28And I said, because of this dynamic, that people won't want to own the bonds.

03:32And the guys who do own the bonds have been fiduciaries doing it with somebody else's money

03:37regulated to do so with bad financial math.

03:40And exactly what you said, I hinted in that note that we're looking at a future of financial repression

03:45and even, in a sense, capital controls.

03:48And so when the UK says we're going to force UK pensions to own UK assets,

03:53well, that's a form of capital controls.

03:55When Scott Besson says he's going to permanently exempt the SLR for U.S. Treasuries for U.S. banks,

04:03well, that's a form of capital controls.

04:05Now you can apply leverage in the banking system to your domestic sovereign bond

04:09at a preferential rate relative to other zero-risk-weighted assets.

04:13So why wouldn't Japan do the same and exempt JGBs

04:16to incentivize Japanese banks to own JGBs over owning other zero-risk-weighted asset bonds?

04:23So all of that feeds this same problem, who's going to buy the bonds.

04:28I want to talk about capital control maybe in a different market

04:31because China, of course, is another market that has those kinds of measures in place.

04:35The bond market there has looked pretty different, though.

04:38So how does that also factor into your thinking?

04:42And also, I know you've got a view that they've been the sole contributor of credit impulse

04:45in the world for a decade now.

04:47How does it stack up exactly?

04:49Yeah, China's such a critical player and obviously critical in the current.

04:53Tariff trade imbalance correction issue.

04:56So China, again, has its own structural imbalances,

04:59really driven by its explosion of credit post-GFC,

05:04as I said, being sort of the sole credit impulse for a decade post-GFC,

05:08all the while maintaining extremely high capital controls

05:12and essentially a pegged currency, even in the last three years,

05:16going away from their own basket methodology of how they fix the currency

05:20and essentially just holding it against the dollar, give or take 7.2.

05:25Well, that allows these imbalances to build up and not correct as the market mechanism

05:29of all the borrowers and savers and investors and hedgers and importers and exporters

05:35deciding amongst themselves what they think the fair currency value is

05:38and where investment should go.

05:40And so China obviously is going through a large deflation pressure

05:43at the tail end of that credit buildup, unsustainable that it was.

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