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The Texas Hedge

A Texas hedge is a financial hedge that increases exposure to risk. An excellent example in the current episode has been long duration fixed income as a “hedge” for equity. Over most of the past decade, when bonds were negatively correlated to equity, fixed income acted as a diversifier for risk asset exposure. The entire existence of traditional multi-asset, risk parity and volatility targeting strategies rest on this concept. Put simply, when equity prices declined, sovereign bond values increased (or yields fell). Of course, the current cycle since 2020 has been an “inflationary bear market” in contrast to the “deflationary” episodes including and post Lehman in 2008. Stated differently, the nature of the regime has changed (at least in a cyclical sense).

As we noted recently, a related feature of the post-2008 regime was the extended phase of low trend growth and inflation and the behavioural bias that it was a permanent state. That resulted in an extended phase of low (emergency-level) policy interest rates and quantitative easing supress the long end of the yield curve. In turn that contributed to excessive credit accumulation, risk-taking and balance sheet leverage in the system.

In the more recent cycle since 2020 that leverage has been focussed more on sovereign debt as opposed to private sector debt (in most countries). However, an imbalance in the current episode has been excessive allocation by pension funds and endowments into unlisted assets, not marked-to-market accurately to reflect higher discount rates and weaker cash flow fundamentals.

The allocation into private assets was driven by “volatility laundering” as described by Cliff Asness or the misguided notion that standard deviation is an adequate measure of risk. From our perch, “true risk” is the price you pay for an asset. That is the key driver of future returns. The paradox of the “Sharpe-ratio” (or value-at-risk) approach to managing exposure is that long periods of stability encourage market participants to take on more leverage when liquidity is plentiful. As a result, participants become short convexity and phases of stability lead to large episodes of instability.

An interesting recent development in unlisted assets has been the “forced” mark-to-market in some commercial real estate. We also note that one of the most infamous private real estate funds (where assets have been gated and NAV suspended) has had an offer around 35% below the current NAV (more on this to follow, but there is a risk of a much larger systemic reset if there is wider and larger mark-to-market on private assets like commercial real estate).

These developments are related to the increase in policy and market interest rates (the discount rate). Sovereign bonds, especially US Treasuries are the collateral for the entire system. The rise in Treasury yields (fall in bond prices) has reduced the value of collateral (reserves) for the banking system. Moreover, for governments with debt-to-GDP above 100% there is a question of constraint or sustainability if interest rates on that debt rise too far. Dave Dredge has termed this “the great stop loss risk”.

Ironically, the “good outcome” is that the current cycle ends in recession, equity and credit markets crash and there is renewed demand to buy Treasury bonds. The bad outcome might be a renewed phase of inflation with no willing buyers (at the current price) for sovereign bonds and yields rise even further. The big picture risk that has become clear is that the bond market selloffs and fiscal constraints become reflexive or self-reinforcing. Our sense given the leading indicators of the labour market is that the odds of a recession remain high and that will likely provide some relief for interest rates and bond prices. Of course, the implication might also be much lower equity prices. From a pure price perspective, the S&P500 or global risk proxy might have started to contemplate that risk? (chart 1). Of course, under the surface, the performance of banks, transportation, cyclicals, and emerging markets have been reflecting that reality for some time.

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