Looking Back, Looking Ahead 2023 Edition

A Happy New Year to All! While 2022 turned out to be one of the worst years for financial assets, it turned out to be one of the best years for common sense. A decade of macro distortions caused by central banks were sharply unwound, as central bankers realized that they were working with the wrong theories, wrong approach, and wrong forecasts.

Many investors anticipated this problem, and positioned for a world of rising volatility, illiquidity and lack of financial market support from the government. As I wrote about a year and a half ago (here), inflation came and crushed the theories of the gods of money printing. And as of this writing, inflation is still running high, interest rates are still relatively low, and assets purchased as part of quantitative easing are still in the trillions. Of note, there is one central bank, the Bank of Japan, which is still fighting fundamentals by pinning the level of yields.

I see three great opportunities for investors in the year(s) ahead:

1. Inversion of yield curves: The US government yield curve is the most inverted in over four decades as a consequence of a hyperaggressive Fed who is ready to break the economy to bring inflation back into control. Not to mention that holding trillions of long duration assets that were bought as a consequence of multiple rounds of QE is keeping long term rates lower than they would otherwise be. Despite talks of a “conundrum”, i.e. long term rates not rising even though short terms rates have rocketed up, I believe there is no conundrum – just a simple self-inflicted distortion.

With the Fed trapped fighting inflation even at the cost of tanking the economy, the front end of the yield curve today provides one of the the highest yields anywhere, along with a built-in “option” against a stock market crash and the protection of sovereign credit. Typically as short rates rise and the curve inverts, things start to break. Last year we saw the UK almost break, the digital asset industry break, and I have no doubt there are other skeletons in the closet that we have not yet discovered. When things break, yield curves steepen, or maybe a steepening of the yield curves makes things break. The causality is not that important. What is more important is that long-term rates are too low relative to short-term rates, and odds are that the yield curves globally are ready to start re-steepening. These trends can take multiple years to work themselves out.

2. An impending implosion in Japan: The yield curve control (YCC) of the Bank of Japan has been sticking out like a sore thumb. Japan was not only the first one to try out quantitative easing many years ago, but has also been the one central bank which has so far defied the rest of the world by keeping short-term rates negative and ten-year yields pegged. A few weeks ago, without any prior announcement, they let the ten-year yield jump from 0.25% to 0.50%. When one looks at the Japanese yield curve, we find that the BOJ now owns almost all the bonds in the 10-year futures sector, because they have had to print increasing quantities of money to keep these yields pegged. In other words, this is a poker game between one man (Haruhiko Kuroda) and the global financial markets. But Kuroda is ready to leave, and who knows what the next (“non-lawyer”?) central bank head decides to do. Odds are any rational person would let yields drift up. But more important, the asymmetry from shorting Japanese government bonds is obvious. With yields at 0.50% and inflation running over 2%, there is a lot more room for yields to rise than to fall. And at some point the markets will refuse to take the Yen at current prices if this facade continues – last year was one of the worst for the Yen in recent memory, and this year could be worse if the YCC policy goes unchecked.

3. Say no to negative: One simple rule of thumb that has worked has been to “say no to negative (yields and spreads)”. This started with shorting negatively yielding bonds in Europe as well as shorting negatively yielding TIPS in the US (negative real yields). As many of you know, I put out a monograph titled “The Incredible Upside-Down Fixed Income Market: Negative Interest Rates and Their Implications” (free download from the CFA CFA Institute website here) in 2021 (good timing!). What’s next? In my view, negative swap spreads (difference between government bond yields and interest rate swaps) in the long end of the US yield curve are next for re-equilibration. For those who don’t follow this market, interest rate swaps have recently migrated from LIBOR to SOFR (Secured Overnight Funding Rate). For investors who are looking to hedge their liabilities for a long term, the simplest way to “buy duration” has been to receive a fixed coupon in a long maturity swap versus paying some version of SOFR. Since swaps do not require putting up the full value of the bonds, these investments are made on margin. As short term interest rates rise, yield curves invert, and the financing cost of these strategies at some point will become more expensive than the liability hedging benefit they confer. Since as of this writing, long-term swap spreads (the difference between government bond yields and swap levels) is deeply negative, so shorting long-term swaps vs government bonds is a “long-option” on this swap unwind dynamic, while earning positive carry! After three decades of trading in the fixed income markets, I have come to appreciate the value of owning options and getting paid for them! But to be very sure this perverse dynamic has been in place for a long time, and only a regime shift like the one I envision can start the normalization process – the timing is hard to pinpoint, but ultimately gravity should win out as it usually does.

So far, I have not said much about non-fixed income markets. There are two reasons for this. The first reason is that all the “action” is in the bond markets today, because that is where the distortions got to be so enormous, both in terms of magnitude and direction. When non-economic players, like central banks, trample financial markets like elephants and then begin to reverse course, great opportunities can arise. Over the last few years I have come to be more and more convinced that central banks have become the de-facto “opponents” of financial market participants; and to use an analogy from poker (which, thankfully, I am really bad at so don’t play at all), most of the money that you win in such scenarios comes not from the brilliance of one’s own play, but from the ineptitude of your opponents, especially if they are acting under constraints.

If I extend the fixed income themes to other asset classes, I suspect that equity markets won’t do much in aggregate, but will be volatile as they parse the intentions of the Fed. However, within the market, some types of investments will likely do really well and many others will likely do very badly. Due to the size of the index fund market, a new dynamic has emerged. When index funds or ETFs sell assets, they also force the good to be thrown out with the bad. A great example is the Ark Innovation ETF (ARKK ARKK ) that is the poster child of the recent bubble and bust in tech stocks. Our research shows that the ETF has lost close to $10 billion for its investors since its inception. And yes, the compounded returns from inception still show a slight positive return, because when the fund had positive performance its size was very small, thus distorting long term return metrics which pay no heed to the cash inflows and outflows. As the liquidity cycle has reversed, this and other ETFs have had to dump underlying assets. Since throwing the baby out with the bathwater is never a smart idea, it creates interesting opportunities for investors who are looking to buy great companies at the right price.

I also think that for now the US dollar is the best place to be. First, in periods of market upheaval, there are very few places other than the US financial markets where you can get liquidity to park money and take out to invest at your whim. And when such parked liquidity provides one of the highest yields in the developed markets, it is hard to justify moving assets to more risky domains. Yes, the time will indeed come when the US dollar is not the reserve currency of the world, but we are probably a few years away from that point. I simply cannot justify a lot of negative carry betting on this rather remote probability. Maybe a small toe-dip into emerging market currencies and equities for now.

Finally, gold. For the last few years I have believed that until real yields stop rising, gold is probably not going to do much. Real yields have risen a lot and in the middle of 2022, we flipped from being short TIPS to long TIPS, as real yields went from minus 2% to plus 2%! At this point, TIPS provide a real yield of 1.5% and they guarantee a contractual protection against inflation. So if inflation stays above 4% in 2023, which is my central forecast, then we pick up a yield of 5-5.5%, in government securities. If the financial markets keel over and the economy falls into a recession, we probably get an additional price appreciation from yields falling. So all else being equal, the right time to buy gold will likely be when a recession becomes inevitable.

As an option trader, I always look for asymmetries. With so much distortion in the financial markets today as a consequence of years of unchecked central bank activism, the opportunities looking out appear enormous.