Uncertainty, Volatility & Risk with David Dredge of Convex Strategies

There were all these articles about you'll think of England's steps and it does this and I wrote something saying in Japan. That's a Thursday Literally every day Every single day. So you went from being a partnership Where your job was to intermediate and get rid of risk to being an accounting Warehouse where your job was to warehouse risk that you could account for favorably for short-term compensation purposes We became rational accounting man, and that's a very dangerous thing During periods of global economic uncertainty and heightened financial market volatility It is worth considering how investors should think about risk when constructing portfolios To this end, I was delighted to have the chance to talk recently with David Dredge at Convex strategies in Singapore David not only understands risk, but he also delivers his great insights in a highly entertaining way He spends his time immersed in understanding sources of risk and developing strategies that mitigate their impact He does this by embracing convexity, which is buying pockets of cheap volatility as insurance against negative outcomes In conditions of uncertainty when should investors do this? He says just like ensuring your house Always he has strong views that contradict the accepted assumptions behind modern portfolio theory Which he calls sharp-world which in his view falsely equates risk with volatility David is full of anecdotes and illustrations of the risks investors assume in markets Regulated to a sharp world and operated by what he calls Rational accounting man, this episode is probably the most challenging one I have edited We spoke for nearly two hours and I could have happily gone on for longer I thought about making it two episodes But maybe take a break if you can draw yourself away and come back to it I've listened to this one a few times and I keep hearing new gems As ever, none of what you are about to hear is any kind of advice I hope you find it as entertaining and informative as I did But this should not be as the basis for an investment decision Please take personal financial advice before investing a penny of your money in these crazy markets And with that, please enjoy by conversation with the Maverick David Gredge Brought to you by Progressive Equity So David, thank you so much for joining Tell me a bit about your background to start with and what sort of influences have shaped your way you look at financial markets I grew up a simple boy in Utah Graduated from the University of Utah when I was quite a young man and found my way into Graduate Business School at the prestigious University of California Berkeley where I managed to study economics under The esteemed Jenny Yellen back in her days as a professor there and more importantly, probably financial mathematics under their chap By the name of Mark Rubenstein. This story really is I after graduated from Berkeley I joined Bank of America, which then was all run out of San Francisco and turned down jobs in New York because I wanted to stay close to home stay close to Salt Lake City and after a three-month training program They sent me to Singapore and so my ability to predict the future was late bearer fairly early On my life and then it got really a hammering when I arrived in Singapore the first Monday of October 1987 and two weeks later was Black Monday October 1987. I remember well, which we called Blacker Tuesday out here Yeah, it's we're down twice as much out here as they were in the US on that day The bank that senior guy is here who I was supposed to be learning under inevitably Lost more money in a blink of an eye that day than their Risk limits or draw down limits or the simplicity with which they measured risk then said was even remotely possible Yeah, literally it's sort of dawned on me then that I'm not sure these guys know what risk is And I've been searching for it ever since and I fortunately found my way to a place called bankers trust and You know we started to sort of be emerging markets business for them on this premise of constructing positive convexity and We went around and complex emerging markets on shore offshore clode limited access Undeveloped and with no option markets and created these things these weapons of mass destruction known as Structure products and embedded short-volody volatility in them to construct the appearance of enhanced yield to Financially repressed yield starved savers across Asia and that's really how I Tumbled through my years in emerging markets and running complex risk businesses and banks into my role today as I've retired from the Questionable ethics of banking industry into something where we're still just embedding ourselves in that food chain of volatility supply and trying to build pools of highly convex Negatively correlating long volatility Structures so that we can provide that convexity and explicit risk offset for our Clients investors for the business that go out and then take more Active aggressive participating risk and try to cleanse themselves of you know This sort of what I think of as sort of the structural flaw of the investment industry this dangerous assumption around stable correlations How do you think about and define volatility risk and uncertainty? What are the guiding principles here? Well volatility is not risk one of my trigger pet peeves this sharp ratio anything that assumes Volatility in itself is risk and treats upside volatility the same as downside volatility is Explicitly wrong not seems term a vick and steens ruler if you're using a ruler that you know is wrong To measure a table the table is telling you more about the ruler than that ruler's time by the table or more accurately telling you more about the guy using the ruler Sharp ratio is the vick and steen ruler of Investment management if somebody's using that as a measure of comparison of risk or portfolio performance You know that he either doesn't know what he's doing or he's intentionally misrepresenting what he's doing One of my mini dredgisms or catchphrases is that Risk is in what you think's going to happen risk is what hurts if it happens Risk is very subjective everybody's risk is unique risk is and oh, I think there's going to be Deflation or inflation if you think there's going to be deflation and you've positioned that way within your risk is probably inflation Risk is what hurts you risk is as a good friend of mine Harry Christian said in his book market trimmers risk is about vulnerability not predictability To us for the uncertainty is the key risk As Nassim would say if it'll hurt you you can't predict it and if you can predict it it won't hurt you And so it's really the things that you don't see coming the things that you aren't worried about That are the things that seem to get you every time and again risk isn't just Losing money although the negative compound is more painful than the equivalent positive compound But risk is also about missing opportunities. So in a pension fund Investment multi-year Investment path history is going to sense as his Path through time divergence from his commitment to deliver Terminal capital for somebody's retirement So missing opportunities on the upside is also foregoing that compounding path through time falling into the trap of downside Risk is even worse, but both of those are a problem and so Uncertainty is the thing that really you need to solve for because it's the big winner that nobody thought of that you want to get a piece of And it's the big losses that you want to make sure you're protected from and you're not going to go and find the The solvency barrier and not being able to grow back out of it Time is obviously the ultimate complication in that path to get back to picking on a sharp ratio and stuff But it's not about ensemble averages. It's about time averages. It's about compounding through time not average Arithmetic needs in our you probably heard me used before our race car analogy The guy who wins a 40 lap race is the guy with the best breaks because he could drive the fastest safely and really would a compounding occurs in the fastest part of the race track So you want to be able to accelerate and in the most dangerous part of the race track the unforeseen curve And so you need to be able to decelerate and that is simply put my definition of convexity in your portfolio It allows you to accelerate your participation in good markets and decelerate it in bad markets Those as Chicago Professor Gary Becker I think his name was who wrote a paper about the impact of seatbelt legislation on people dying from road traffic accidents And the data suggested that in many cases where they legislated for seatbelts The number of people who died in road accidents increased Because the drivers became more secure and drove quicker So fewer drivers and their passengers died the more pedestrians died I'd intend consequences right and yes, that's almost all I'm writing about when I'm writing about Inbalances in the system Well those are getting created by exactly the example you've given. They're getting created by Suppression of volatility by policymakers. They're creating the fat tails because they're making people complacent And trying to target expected average lap speed is the correct answer to this problem But as Nasi Malui says if you're five feet tall don't assume you can cross a river that on average is for feet deep Yes, you can't get someone to understand something where whose salary depends on not understanding it I just wondered how much you reflect on this type of thing when you consider the Regulatory framework that we operate in today all the time The practice practically all I ever think about Last month's the February update that I wrote I titled rational accounting man And that's exactly what that is rational accounting man has been Program constructed Embedded in financial regulated institutions To behave exactly that way to say your incentive is to follow these rules and do what we want you to do Which most simply put it is absorb Prolific issuance of government debt that price is that no rational long-term investor would own with their own capital I want to hold that so we'll come back to it But before we do I think there's something I'd like you to clarify so my benefit and I would imagine for other people's benefit too Can you just tell us what convexity is and how an understanding of convexity can help investors? It's non-linearity that's in your benefit so in math class back when we were kid Something that was convex was a curve that was a smile Concave was a frown Something that was convex would hold water is my school teacher used to say would hold water a frown a concave function would spill water And what you want is your relationship To the market whatever you think of as your proxy for risk appetite in the market beta You want that to be something that is accelerating in good markets and decelerating in bad markets So that your relative performance Improves as you diverge from the mean of the expected outcome and most portfolios And I'm sure everybody's aware of this if they're being honest is the exact opposite because they've optimized to a sharp ratio mentality Which says the way to mitigate risk is to forego upside And so the more the market goes up the less you're keeping up with it because you've bundled things together in your modern portfolio theory diversified strategy Whether it's something simple like 6040 or more complex like risk parity or an endowment model That's foregoing upside to limit downside But measuring the downside is the probabilistic likelihood Based on historical frequency of something and so what you end up seeing without fail as people's Portfolio start to take on the impression of a short put where they're Bounded upside opportunities are not keeping up in years like the last two years when equity or markets were up 25% But are immediately keeping up when they go down like they did last week They talk about diversification as though correlation is a constant But correlation is not a constant and their portfolios will tend towards low correlation in good markets At high correlations in bad markets their concave which you'd like to construct in a positively convex portfolio Is that you have increasing correlation in good markets and decreasing correlation in bad markets You have what we would call a positive convexity ratio and that Because what will drive the compounding path will be the biggest numbers the biggest could Markets and the biggest bad markets will overwhelm all of the compounding in the most frequent markets And so your relative to performance as you divert is what will drive your compounding and the only true way To construct that effectively is through positive convexity in your portfolio. How would a typical retail investor How should they incorporate this idea of convexity Into the way they approach managing their portfolio or talking to the person who might be managing that portfolio You ask yourself if you're trying to manage your own stuff Certainly ask your fiduciary if somebody's helping you with that or doing it for you Pinching manager or wealth manager What are they doing about the asymmetry of their correlation How are they measuring correlation risk? How are they measuring risk Is it a probabilistic short term look back something like value at risk Yeah, then challenge them on how well that's worked over the last one two three decades Hasn't worked well at all How steady has their correlation been to large market drawdowns probably been really unsteady And then ask why aren't they doing something explicit and then ask yourself why can't you do something explicit How much of your risk seeking return seeking market participation portfolio Could be reconstructed through call options Through strategies that allow you to get all of the upside and mitigate the downside Where can you find a now again very difficult to manage Really efficient forever duration Long convexity portfolios like we do or like a professional does But you can still think about it. In fact, I would argue not just in your investment portfolio But everything in your life you should think about through the lens of convexity Now in life decisions. It's actually much easier for most people because they have what Palani would call passive knowledge. They have skin in the game You have this understanding. They know how to write a bike safely Without having to write down the probabilities of it And so they go about paying so that they don't have a crash that they don't have a solvence an insolvency event that they don't get an uncurable disease They try to defend against that and yet they allow their pension fund manager to operate on a two-stander deviation 18-month frequency look back when frequency has Give or take nothing to do with the success in an investment portfolio Magnitude is what matters magnitude of downside magnitude of upside about frequency of downside or upside the dilemma of what I'm hearing is the in order to manage the convexity in a portfolio you need to use Options and derivative contracts the in sharp world are considered literally weapons of mass destruction the proliferation of or the acceptance or the encouragement to retail investors To forgo convexity in their investment strategies to sell options whether they know that's what they're doing or not Is ubiquitous? Everybody's always advocating covered calls strategies right calls against your things or caller strategy sell calls to buy puts or all sorts of things that are foregoing convexity and yet it's almost like Satan whispering in your ear if somebody comes along and says why don't you actually take on convexity now obviously the entire sophisticated financial system who's advocating to all of their clients in the whole world to forgo convexity is on the receiving end of that convexity they're foregoing So somehow some way You know jp Morgan and citadel are all make it buddy even though they're telling all their clients They'll that's great to make money is to sell volatility If someone said well when should I pull volatility in this market? Well it wasn't this week and it probably wasn't last week The improvement of compounding is a always right. It's not a bayard. It's not about timing the market It's about time in the market people whose portfolios are protected by explicit Negatively correlating convex protection or a lot less anxious Than those who are relying on assumptions of stable correlation right now You should always be on you should always just like you buy health insurance you buy car insurance you buy The ship insurance if you're in the shipping industry you buy fire insurance if you're in the restaurant industry You should ensure things Whenever you can get the right price for doing it But now again to get back into the challenge of managing that which is very difficult for the retail guy The simplest thing for a retail guy or the guy who's trying to manage his own thing that doesn't have access or capability again Is how much of your portfolio can you reconstruct through owning call options if you call options When the price was right and the opportunity was right well then last week wasn't that big a deal for you Maybe you gave up some of your previous gains, but you knew explicitly what your potential downside was So you're not the guy who's getting forced out of positions after a negative drawdown Because he doesn't know when his potential downside is and he was probably relying on Bonds as his principal risk mitigate and turns out they had days where the downside was even worse than the equities last week My impression is that markets are becoming less correlated than they were a few years ago Is that right and does that make The type of risk mitigation strategies you're talking about more important The basic premise of modern portfolio theory You know everybody's diversification is the only free lunch when you go on you look and you say we're doing this period These things have had low correlations. So I'm going to bundle them together Into a portfolio that allows me to take more grossly risk than I would otherwise because of this correlation benefited Education then you get to get even more dangerous aspects of that of the guys who then lever that correlation again Risk parity or the likes like that. Well if it's a correlation benefit, let's leverage it. I get even more of it My ability driven investment schemes Look at this in the interim. Yeah, and so what happens is that through that growth period that stable period those correlations look lower and lower and lower Things appear to be less and less related as leverage is getting added and positions get it added But when it gets to whatever point where that starts to Unbundle and the sort of self-fulfilling nature of it as that leverage gets on wound is correlation start to misbehave So as we go that other way and the correlation benefit starts to become a disbenefit forcing the leverage that it has attracted To get on wound because now you must be gross that portfolio because it's riskier than you thought it was because the correlation wasn't as low Because you thought it was which then becomes self-fulfilling and reflexive and that's exactly why markets grind up and Spiked out when you go up the escalator and down the elevator and that's exactly it people say But you don't know the risk in my portfolio. I say I do it's correlation and I like no we our risk is no it's correlation Because that big drawdown the big drawdown even if you think your risk is Equities or emerging markets or whatever that big drawdown is when it's correlated it's when there's a Squeeze of liquidity out the entire system. I'm sure you've heard my Forest fire analogy. It's self-organized criticality leverage in the form of dry brush connecting trees builds up in the forest after years of rain and hot summers rain and hot summers and growing And then eventually a spark comes along and that lightning strike or whatever exogenous in the vent that we In hindsight blame the fire on that lightning strike only catches one tree on fire Every other tree on the forest catches on fire because of its connectivity through the dry brush with the trees next to it As long as you own enough trees that lightning doesn't strike all of your trees. You're okay But if the fire spreads because there's been too much leverage dry brush build up on the forest floor Then all of your trees are going to burn and so it comes down to any diversified portfolio of any seeds Then yeah, I know the answer to this question all the time when I meet people I'll say well, how do you measure risk? Well, they're almost without fail. They'll say well our equity beta is this I say well, I think your risk is correlation and they say when you say that and I say well, how do you measure your correlation risk? And there's just silence you mentioned your Early associations with the former secretary of the treasury How would you mark her out of ten for the job she did you put me in a task fire but I'll do my best Professor Yellen is a lovely lady. She reminds me very much of my mother They're both sure and have gray hair and a little bit round Both extremely well read my mother's an attorney and reads history books and knows everything But knows absolutely nothing about money and they both share that as well Which is okay because my mother's an attorney not so good because professor Yellen teaches economics and Chared the fed and then ran the treasury. So professor Yellen lives Maybe as much as anybody I've ever met inside sharp world. She believes The models of neo-cansianism dynamics stochastic general equilibrium models the federal reserves for they call furbus TSGE model is true And she believes that the real world should behave the way her models as it should behave and that as they will always say everything else held constant If I change this one thing then this should happen Wait a minute It doesn't work that way there are a number of complications that you ignore the see non-linearity credit rest of the world time all of these things Seem to matter in the real world and are neglected as your model and this belief that they have and you know Well, give her the benefit of the doubt that she actually believes she's not by nature evil. I don't think I hope not She actually believes that she can turn one knob and affect the things that the assumptions built into her model say will be affected Despite the fact that there's Zero empirical evidence that that has ever been the case and there's no mathematical rigor theory behind it And yet they carry on doing it Headless to as we were talking about to the unintended consequences the second order affects the fact that they're the ones Building the boom-butth cycles that they claim to be fixing as I stuck the little cartoon And I know again this month that I've used before Question to a person working at a desk. What are you working on? I'm trying to fix the problem created when I tried to fix the problems. I created when I tried to fix the problems I created and I tried to fix the problems two things that professor yelling would always say If you challenge the assumptions of her model she would say what's your model? Yes Because if you're going to argue her religion it's got to be a comparative religion argument It can't be against religion in general and number two When she said well to fix that problem you do this and if you said well Clearly you're not creating wealth. You're just time transferring it or Reallocating it from here to there. So you must be creating some other problem And she would say well when that happens will fix that problem. So literally okay fix the problem we created when we fix the problem We created would yes exactly in recent weeks I found myself thinking a starting out thinking that Scott Bessent is the great hope for the bond market and the underpinning of our financial markets Now I'm not so sure and I just wanted to see where you stood on all this and how you would grade Scott Bessent relative to his predecessor I said why do he needs to try to Reverse the negative feedback loop that basically everybody's trapped in You've got big deficits which drive higher inflation which lead to higher interest rates Which make the deficit bigger because of the size of debt which leads to more inflation which you got to reverse that feedback loop and that To do that you need to reduce the deficit get lower interest rates which reduces the deficit more We always get lower inflation and which gets lower interest rates Nobody's going to believe you're going to make an impact on the deficit So the first thing you have to do is make a whole bunch of noise That you're going to impact the deficit now in reality You basically can't impact the deficit until September because you're already locked into the fiscal spending that's already been passed and then repaste at each debt ceiling Continuing resolution all along the way But sure enough they came in and they made a lot of noise right yes Elon Musk we're going to cut a trillion we're going to cut two trillion Etc. And Besson comes out and says the right thing we're not pressuring the fed to cut rates We're trying to get the 10-year yield down just exactly the right thing right he wants to get the 10-year yield down What's that's down and there's buyers of that that he can start issuing more 10 years and they look like that stress as he was working Yeah until it didn't I compare it obviously back to my forest fire analogy once you've got enough dry brush and trees build up Doing a control burn is the right thing to do but it's really hard to keep it under control He hasn't managed to do the control burn so far He's in a really tough spot because everything is so fragile and so sensitive in particular the bond markets And not just his bond market everybody's bond market my hunger games analogy You know there's this hunger game only one will survive fight to issue your bots which sort of inevitable when you get the entire World that matters beyond a hundred percent of debt to GDP and inflation takes off and interest rates go up and then the whole fiscal dominance Financial dominance can they raise rates enough without bankrupting the government or blowing up the financial system And you're sort of in this trap which is the whole fiscal dominance financial dominance analogy that makes it really hard and so I think along your point that's what they're trying to do I think they're finding it very difficult to do it now. I've said for a very long time Another catchphrase is that is very likely that the recession is the good outcome If you get the recession people buy the bonds you can't create a scenario where people voluntarily buy the bonds You got a problem because that's a bigger problem. We have to force them to do it. But this is Rational accounting man being drafted in to become Besson's best customer as he is self-described as America's biggest burden salesman The only real change that got any real change that mattered post GFC in terms of bank regulation was the Institution of the SLR the statutory leverage ratio which was a gross leverage ratio to go along with the tier one capital against risk-weighted assets. Well, they waived that in the U.S during COVID so that the banks could absorb more bonds and Scott Besson is saying well, we just waived it permanently We're just exempt banks permanently and we can go back to where it was pre GFC where you could hold effectively infinite amounts of zero risk-weighted assets the whole premise of sharp world the whole premise of Janet Yellen and the policy makers in their beliefs is Let's suppress volatility and everyone will do what we want them to do and we'll pay fiduciaries to do this with other people's money and incentivize them with short calendar period annual compensation taking on you know multi-year multi-decade risks And they create the very fat tails that makes the whole system so fragile And if you think through history, I mean we talk about it in our business all the time What we're out looking to construct is convex payouts around those fat tails where uncapitalized risks exist and so if people can lever zero risk-weighted assets in the form of treasuries today or in the form of super senior tranches of subprime CDOs in 2008 There will be no capital to protect that risk when it tumbles and the price for buying that insurance will be at its cheapest at exactly the time that the risk is the greatest Because it's measuring risk as frequency when there's the last time we had a forest fire Or it's been a long time so the risk is really really low But we happen to know that's when the risk is really really really high Shot well doesn't seem to be replete with people who understand economic history Does seem to be a complete absence of any acknowledgement of what has gone before Listen to any discussion by central bankers Christine the guard is one of the best at this. She's got absolutely perfect Control of the knobs and levers yet to guide the economy into the future All current problems and past problems had nothing to do with her past policies and levers They were all the result of unforeseeable events The fact that the forest floor was absolutely clogged with dry brush and trees Had nothing to do with the fire. It was the lightning strike But now we are going to completely guide the forest in the future perfectly through our decisions So the inflation the price instability of 2021-2022-2023 Was because of the pandemic it was a supply shock. It was Ukraine It had nothing to do with the greatest longest period of ever of zero interest rates negative interest rates Quantitative easing asset buying policies that when they were telling us they were putting him in They were pulling levers and turning knobs because they were going to use these policies to what Reignite inflation But when they got inflation it had nothing to do with those policies nothing whatsoever Right, so they are the greatest deniers of history you will ever meet because to them history Is a random series of exhaustious events. Yeah, in the future. They have perfect control over Either they don't know what they're doing and we'll all talking about one of my Dearest friends is the economist bill white and bill is an honest economist who will say, you know I used to believe this when I was in the bank of Canada I used to believe that when I was at the bank of England that but I figured out We don't know what we're talking about. Oh, yes. We can't control any of this stuff We can't target inflation. We can't target growth. We can't target employment We have no control over anything our models are wrong He is an enormous Advocate that it's a complex adaptive system What are your thoughts on this sort of rotation out of us big tech and us assets General broadly into a sort of more Russell maypia like world of national capitalism and multi polarity I think that's the inevitable and that there's going to be more and more Pressure for you know, it's macron set again just recently French pension funds have to invest in France. They have to hold French government bonds and invest in fridge equities all kinds of talking The UK about forcing UK pensions to invest in the footsie stocks and not invest in High performing US tech stocks and stuff. So I think that's inevitable. It's happening. It's part of my Hunger Games analogy this competition for capital You didn't really have to compete for capital when every central bank in the world was doing QE backs and interest rates were at zero And there was virtually unlimited leverage Allowed in the banking system and hidden leverage galore inside pensions and insurance companies and et cetera Begin liability driven investment strategies or the accounting treatment given to Taiwanese insurance companies in duration enhancing short volatility Colable note structures and all of this stuff was allowing just infinite expansion of leverage into the system There was no competition for capital now. There's an ever-growing competition for capital because Central banks in some form another are doing QT not QE although a lot of people after last week seem more confident The QE is coming back soon to a theater near you And so this competition is happening and you're seeing that's forcing now. Obviously the thing that became the biggest Overweight. I don't know if I want to call it an imbalance, but the biggest overweight was US It's been the top performer arguably maybe the top performer because it's had the largest fiscal spend Creating the greatest fragility and instability in the future and revving up corporate profits as they poured all that fiscal spending out into the system and now that overweight as we say wait a minute the Comfort we have with Parking capital in a foreign environment even if it's the US is less comfortable And so once that starts to rebalance that overweight starts to rebalance It can build some momentum now the good thing about equities in general relatively speaking equities don't have a lot of leverage Relative to the capital of the people who own them so equities to a great extent You know in an LDI investment portfolio The pension plan the equities are levered only the bonds are levered banks don't own equities with leverage like the Japanese Banks did back in the 80s. They own bonds with leverage. Yes, assurance companies don't own equities with leverage They own bonds with leverage and so you saw again last week The same thing we saw the third week of March 2020. There was a whole bunch of tolerance from the Trump administration and the tariff Hounds whatever you want to call them To equity markets coming down. They were all launched a lot about it one bad day of bonds and they were back and off Yeah, interesting. Yeah, yeah same thing in 2020, right? Remember yes The last week of February 2020 the equity markets went down just as much as they did the first week of April Nobody said a word But by the third week of March when bond markets were selling off The Fed stepped in on March 23rd and bought everything you know the pretty strong reversal in the dollar Most particularly the euro, which is something I noted through several of my notes last year when I draw Red circles around where the risk is where the endogenous risk is built up I was drawn circles around charts of euro effects volatility. It's rare in my lifetime in my world That the largest you know highest volume traded market in the whole world is the place. It's the cheapest volatility in the biggest risk You don't see that very often usually at some place you know a remote dark corner of you know Rean interest rates or Japanese credits or something, but euro and you saw that last week as this euro is reversed is the dollars weekening and the euro strengthening You logically explained by the fundamentals of this overweight in us and a reallocation By Europeans back to the home by other parts of the world saying I own too many treasuries. I own too many us equities I'm going to move that to Europe the early strength in the European equity markets not so much in the last couple of weeks as well So there's logic to that, but there was a whole bunch of Implicit leverage that build up around the stability of exchange rate parodies after many many years Of monetary policies that tracked each other Raised down together rates came up together rates stable so this world of national capitalism also implies a divergence of central bank policy, which is something We are seeing but what about Japan Japan is always struck me as a Outlier, but it's a big economy. It's a massive owner of us government debt And I'm not at all surprised that after doing a lap of honor in Buenos Aires Scott Besson seems to be principally focused on Dealing with Japan. What could possibly go wrong here? I'd probably write about Japan more than anything else What a buy-up session A session I share with you and I've never been there once and I love the country, but it is the closest I think I've ever been to leaving earth In terms of totally not understanding the world I had landed in there are some amazing attributes But as someone who follows markets in economies it is an outlier of some magnitude My August 2023 update and title of which was Compounding imbalances in the era of time And I talked about the math of compounding and what we do but then I talked about a history of global imbalances And those big global imbalances where we go looking for fat tails for uncapitalized tails for clogged up dry brushes where people have been resisting the natural functioning of markets Few places have done that more or more significantly than Japan in the last 30 graders. I was working in Japan. I set up the interest rate derivative books in Japan in 1991. I have a fairly long history with it. It was trading it from there even before But you know after 30 odd years of zero interest rates quantitative easing active monetary manipulation to try to Write out the correction of the bubble of the 80s Yeah, and avoid a great depression or a major recession and the massive transfer in terms of the contribution To the economy to economic growth to the government away from the private sector so for 30 plus years The government grew their debt to increase their spending as the private sector households and corporates And they dragged that out and dragged that out and dragged that out until here we are today and finally they've got inflation again More inflation than anywhere else. I yeah, yeah, they've got the most negative real rates and the highest nominal inflation rate Of any g7 country and they're still going so talk about building the pressure Obviously, you've seen that in the last three years with you know the yen depreciating by 50% an emerging market level devaluation In the third largest economy in the world and the government kept printing more yet through the whole thing They were still doing YCC and QE and Rindbans in scale. I remember jokingly saying when Bank of England had to step in to buy GILTS in the LZI crisis and they stabilized the market. I think they bought one and a half Billion dollars or something one day. There were all these articles about you know Think of England steps ahead. It does this and I wrote something saying in Japan. That's a Thursday I'm literally every day Every single day. There are no crisis or anything So Japan has this epic Challenge of rebalancing their economy. Well logically the government needs to sell less bonds Now there is very little discussion around that But there's no other logical solution to this problem where bank at Japan through their ever increasing Efforts to buy bonds ended up owning 50% of the bond market in a country that has 250% of debt to GDP. Yeah, it's absolute mind boggling craziness and then the implication that's had on the currency And so you've got this dynamic and I've said this for years I laid out the sort of three big imbalances in the world Japan 30 years of zero interest rates China 25 years of pegged currency and the most prolific credit creation In absolute and relative terms the world has ever seen way more than what Japan did in the 80s way more than what you as did Pre GFC and Europe 25 years into one of the only experiment ever of its scale of an internal currency peck And the imbalances that build up around that with no ability for them to correct by the you know shock absorber effect of Italy weakening their currency as their deficit gets too big with Germany Everything just gets bigger and bigger and bigger and bigger and those three imbalances are massive in the system And obviously related because Japan is the biggest foreign creditor in the world Japan's the biggest foreign owner in every other bond market in the world Including France and Italy and Netherlands and Germany and the UK and the US and China and Austria everywhere GPIF the Japanese government employee pension fund the world's largest density fund by a long ways has a simple allocation waiting 25 25 25 25 25 25 25 percent domestic bonds 25 percent domestic equities 25 percent foreign bonds 25 percent foreign equities so the world's largest pension fund in Japan has 50% of its assets overseas because What choice does it have and 25 percent of those are in bonds makes it one of the biggest bond owners One of the biggest equity holders almost everywhere in the world And if the government's going to keep issuing bonds at the same pace and make it Japan's going to buy them at a slower pace at some point Somebody's going to say we think GPIF should own more local bonds We've already seen norin chuken bank the policy agricultural bank liquidate their unrealized losses and eat it in their US treasuries and the interest rate losses and repatriate the money They're going to presumably get told to buy JGB's with that money And so all of that has this implications meanwhile big problem for Scotland big problem for Scotland big problem for France And the problem for UK big problem for China. So China Yeah, having been almost the sole generator of credit impulse in the world post GFC for 10 years Yeah, now a taker they need to roll over all the debt and they've decided that printing money endlessly isn't such a good idea So they're now a taker of money. They're trying to attract money and holding their pegged currency stable Even against their own official methodology. So three years ago they stopped following Their basket methodology that allowed the Remimbi fixes to move up and down with a basket of currencies Now it's basically just hard pegged back to the dollar it has been for three years Is it possible to respond from China to what's going on with the tariffs to Devalue the Remimbi So there's one strong faction that thinks that's inevitable. I'm one who says why didn't you follow your own Basket mechanism and the dollar strengths that we've seen up until just recently Would have allowed your currency to weaken like every other currency against the dollar as you're going through this deflation problem because they've got explicit deflation Yes, it has of collapse of their property bubble and a massive collapse of their stock markets and etc But instead because they're so afraid in my opinion of the capital flight Because every day they fix it it trades right at the 2% maximum fluctuation bad Because everybody's trying to get their money out and so they are trying to keep this facade of stability and hopes that money will come in Not go out so they're so scared of triggering and avalanche obviously the Bessent and friends are saying you need to strengthen your currency. We want the dollar weaker We're going to charge you tariffs because we think that you're keeping your currency too weak And you're running this massive trade surplus and so maybe you listen to my friend Louis gov Louis going to say they're running a massive trade surplus the currency needs to strengthen You need the consumption build up to balance the trade imbalance by having a stronger Chinese consumer not a weaker one You've got to stop the cycle of China Driving grow through the massive investment in the manufacturing infrastructure They've run the investment as a share of GDP more than any country in the history of the world 70 plus percent finally enough the exact mirror of the US running the largest consumption at 70 percent And now somebody's trying to rebalance that and that is really tricky And then Europe where you've got this problem again. It's only internal hunger games If the Japanese leave the fridge bond market and Macron says will the fridge Need to leave the Dutch bond market and bring the money back and then the Dutch need to leave the You know, and this is something that Russell's obviously written about and talk about the risk of internal capital controls inside the Eurozone Do you have any thoughts on little glitzy in the UK You know this The benefit of being independent is you are responsible for your own actions So you can make good decisions or you can make bad decisions So you have the opportunity to deal with the world to go and make a trade agreement to engage with the US In a far cleaner direct way than Austria does where Brussels is always going to be in the way and Brussels is going to try to balance How important the tariff is on line versus tomatoes versus cars for Germany, Italy and France Yeah, respectively You might have a situation where France says we're willing to make a deal because we don't want you to charge the tariff on champagne But Brussels says well you can't make that deal because we still want to charge a tariff on tomatoes Yeah, to protect the Italy tomato growers. I'm just making stuff up But yeah everything with the Eurozone and the EU is so complicated Because everyone sits around one great big huge table But the decision-makers in another country's got a he's come to the Meeting in Brussels or the meeting in Frankfurt and discuss it with everybody But then he's got to call his boss back in Milan to say well, can I agree to this or not? And so it's incredibly complicated thing and incredibly fragile and I think probably to get in my imbalances Japan can fix their imbalance and is complicated and and potentially Incredibly fragile and China can fix their imbalances complicated and incredibly fragile I'm not sure the Eurozone can fix their imbalance and still be the Eurozone I don't know how you can solve the problem and still maintain the currency pick Well, you have to go the whole whole clue you you have to then have a common fiscal regime You have to become one country when Germany made their announcement that the outgoing government was going to repeal the constitutional debt break And ignore the EU stability and growth pack Yes, and everybody cheered everybody said that's fantastic. Isn't that great? Well, it's Germany Yeah, and so you know, I raised my usual question that I've been writing again, maybe longer than anybody Who's going to buy the bonds? Is it going to be the guys who currently own french bonds or the guys who currently own the Italian bonds? Are they going to is Germany a partner in bond issuance with the French and the Italians or they are competitive? Yes, and so when I floated that on social media somebody had said some comment about how great it was I just said who's going to buy the bonds and somebody replied back the central bank Yeah, I said which central bank. Yeah. Is the ECB going to buy it? Meaning that everybody else can ignore this stability and growth pack because France and Italy and Greece have wanted to ignore that for a long time So is the ECB going to buy all their bonds too? And if ECB is not going to buy it is the Buddhist bank going to buy it and the Buddhist bank buys it Is there still a euro? It's a question for the world though. Who's going to buy the bonds? Well, that's the whole world question. I've been asking it for many many years now And 0% I mean the whole premise again back to sharp world and rational accounting man, right? bonds have been a tool of financial repression for Certainly since QE started maybe longer since it got ridden into BIS regulatory capital guidelines that it was a zero risk-weighted asset Since IAS 19 he said that LDI risk parity type strategies could count levered bonds is risk-reducing on the rest of the portfolio Since solvency 2 said that insurance companies could Mask duration and treated as a different duration than the actual duration on their balance sheets and not account for it The whole premise around 60 40 modern portfolio theory said that by definition the bond is risk-reduced to the portfolio It has a negative correlation a negative correlation that has only existed since the 90s when Alan Greenspan Innovated the central bank reaction function of cutting interest rates would equity price as file prior to that that correlation was never negative So it's not a natural correlation. It's created by shop well Brushingly created my sharp world has been in part of getting rational accounting man to follow these rules and load other people's money Into these things that have no hope of generating retirement savings in a future cost of living quality of life Target but everyone's loaded into them under the rules of correlation benefit and low volatility so you can apply it leverage We get rid of the SLR infinite leverage in the banking system to it But now we are four years in might say six years in going back to 2019 Into the thing that the stability of their price stability measure Inflation they call it yeah, right that they targeted and maintained at the lowest volatility of that measure for two decades That the world's ever seen in all of its history now that obviously led to declining and low volatility and correlation benefit of the interest rates on top of that That low volatility of that measure has gone away in the last six years and the Stability and directionality and correlation of interest rates has also gone away Yeah, and so the entire logic behind the rational accounting man benefit of putting other people's money into bonds as a risk Midagent is gone So who's gonna own the bonds if the bonds have no correlation benefit Dark low volatility Don't have sufficient yield to justify long term investment returns for retirees There's not stable inflation All these bonds are trapped in these sharp world entities where rational accounting men Spend paying himself bonuses on the accrued interest until somebody figures out that Silicon Valley banks Unrealized losses are bigger than their direct capital on their treasury holdings For the answer to your question of who's going to buy the bonds in this framework is they've got to create more Balanced sheet capacity. They've got their own balance sheets. They've got the public balance sheets. They've got the treasury balance sheets They've got the central bank balance sheets. They've got the clearing bank balance sheets. They're going to go after other balance sheets They need to enhance the leverage capacity inside Real money managers insurance companies pension funds. I wrote about it last month about the bond bases bond swap risk The hedge funds in the system running all this leverage on the moral hazard of effectively They got bailed out last time and somebody's just written a note saying there should be an explicit bailout facility for them But they're literally just standing in between as a warehousing of leverage in between the insurance company and the bank Why is that leverage on the insurance companies balance sheet? Well because that's too dangerous Well to your point it won't be too dangerous at some point It'll get regulated. Oh now that's okay because they need somebody to own all these bonds because the price or the yield required For somebody who's investing their own capital in these bonds Is much higher than the way I yield yeah that the Governments can afford to pay with their unavailable fiscal capacity It's little under the code price is doing what the code price is doing exactly in and back to our previous question As we go down this path and obviously last week was a bit of an accelerant down this path The idiosyncrasies of how people deal with this is going to have major implications on their currency parities Because if one guy says I'm going to deal with it by letting interest rates rise to a point. I attract capital from willing buyers The other guy who says I'm going to do QE and put a cap on it and go back to Massive financial repression. Well those two guys whose interest rates with doubted up together And a currency has been historically stable are not going to be Gold has obviously been very popular With reserve managers in my part of the world correct reserve managers who arguably On a relative to GDP or relative to population size You know are massively overweight in government bonds the big and Asian FX reserve accumulators Yes, you know forget China and Japan the smaller countries who have massive outsized FX reserves Not least of which the one I'm sitting in you would argue are cognizant that they own too many bonds That the only solution to the issue of those bonds is to debase the value of those bonds And so they've had a pretty good appetite in the gold market for the last two or three years I noticed that you have an involvement with the monetary authority of Singapore which Forgive me, but I suspect that's a central bank of Singapore. So you are actually a central banker. No, no, no, no No, no, no Singapore is a very unusual central bank the monetary authority is the central bank the markets committee Which like probably the current longest serving member Okay, maybe the maybe the longest serving member ever is a joint regulator industry committee that exists in every major money center That is for the purpose of developing the industry setting industry standards Solving problems. Obviously we were very active in solving problems like the Capital controls in Malaysia 1998 very active and creating the standards for offshore non-deliverable currency I'm sort of the historian. So when they say how did we solve this problem? 30 years ago Dave you remind us what we did. Okay, I get a friend of mine who I did a podcast with last year Out of the blue ask me, you know, what would you do if you put in charge of the fed and yeah, I'd never really thought about it But the you know immediately I said I'd reimpose glass legal first thing right? Yeah, it's a reimpose glass legal And this is the way you go the way with it a bank is trust But you don't want anyone else to get away with it. Yeah, well like your trust was a Spectatually good place to work when glass legal existed because My performance objective even though I ran what would have been considered a franchise business My performance objective was a capital allocation Okay, and my first responsibility was risk in growing that capital Yeah, once glass legal went away and we went inside BIS Yeah, I performative objective is annual accounting revenue and follow these regulatory risk rules So the risk became the regulators responsibility our job is to maximize Rational accounting man compensation linked revenue you took all the skin out of the game So you went from being a partnership Where your job was to intermediate and get rid of risk to being an accounting Warehouse where your job was to Warehouse risk that you could account for favorably for short-term compensation purposes We became rational accounting man, and that's a very dangerous thing And that's you know why the whole you know guys like me and not seem me here in not seem in New York You were arguing strongly against the embedding value of risk in BIS regulatory guidelines in battle one Say yes, you put value or risk in there you're gonna end up with the GFC Yes, anyway, we were telling that 20 years earlier So I think one and Scott best and talks about this he is of the opinion and I don't disagree with him That the Fed should be independent for its monetary policy But it needs to get out of the regulation business because it blurs some lines is QE To bail out the banks or is it a monetary policy tool? Well, it's pretty unclear When they use it in the event of the fire and then keep using it years and years and years after the fire And so I agree with Besson on that that the Fed needs to Shed is regulatory responsibilities It's been a very bad regulator in my opinion and it has been dominated by what Bill White calls financial dominance And increasingly dominated since it facilitated the growth in governments to fiscal dominance And so first thing I would do if I took over a central bank is I would Say it's not our job to regulate financial institutions We shouldn't be making decisions based on that we should be making prudent decisions about credit and money growth in the system Which is what inflation used to be yes was credit and money growth now inflation is the angel change of a price index We've changed the whole definition and meaning of the word inflation it tries to be nuts I've taken up a lot of your time David. I really appreciate it I could carry on chassing for another couple of hours How do people find out about you find out about convex strategies and follow What you do and the way you're thinking about the world We have a simple little website at convex-strategies.com We post up on that website the portion of our monthly investor letter that I write every month So I I don't are there's six years of monthly notes up there that talk about risk and imbalances and the paths of compounding and Ergidicity and all that stuff There's also a tab of various media things that this will go up on where if I do an interview that gets recorded or End up on a podcast we put it up there So there's just reams of stuff up there that talk about how we look at the world and What we do sort of philosophically to help people improve terminal capital outcomes in their investment strategies and For good breaks on your car so you can confidently safely drive faster So if people want to fix the brakes on their car then I know who to call Yeah, and then I'm on is you know, I'm on linkedin. Yeah, David Dredge I'm not active particularly but I post when we put up the new updates onto the website I link it on linkedin and on x at convexity dredge good name for me at convexity dredge on x And every now and again, I might comment if somebody says something that triggers me about the benefits of selling valve I can't resist myself anymore Somebody said something and a report the other day saying that the solution is to diversify better and I just about lost it Just do it better. That's great. Thank you so much And I look forward to following your future updates I find them very informative and very entertaining and given the subject matter you're covering I think that's a great achievement. So thank you. Thank you Jeremy. It's been a real pleasure Brought to you by Progressive Equity.