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Where to hide in a correlated world
Much has been written about the inevitability of interest rates rising from current multi-generational lows; in fact, everybody’s models suggest that interest rates will rise considerably over the next decade. It’s not a matter of “if” rates will rise but “when” they will rise. Even PIMCO bond maven Bill Gross has publicly turned uber-negative on U.S. Treasurys, dumping all of the bond behemoth’s $235 billion dollar Total Return Fund’s holdings and taking the extra step of wagering on a decline in Treasurys by shorting 3% of the fund using derivatives and futures.
Gross’ investment strategy and world-view is widely followed and well-accepted which may explain why households liquidated Treasurys in the first quarter at an annualized run rate of $1.1 trillion dollars. Hardly a day goes by without somebody on CNBC or Bloomberg spouting off about the inevitability of higher inflation, interest rates rising and the immediate need to jettison Treasurys from portfolios, but there are equally compelling counterpoints. The money supply has grown exponentially, but that is ending along with QE2 and other stimulus programs as the nation increasingly adopts an anti-Keynesian orientation. More importantly, credit de-leveraging is inherently deflationary and a 200-basis point rise in rates is already built into the forward curve which reflects mainstream market place expectations of future interest rates. So the question isn’t “Will rates rise?,” it’s “Will rates rise more than the 2% that is already baked in the cake?”
It’s hard to imagine a scenario where interest rates don’t rise substantially so it’s not surprising that practically nobody is recommending the purchase of treasury bonds right now. What’s curious is that, simultaneously, everybody is looking for expanded asset classes and ‘alternative investments’ that will hedge the risk of a future market correction. In fact, hedging tail risk is the ‘new investment strategy’; it’s the defining strategy characteristic of the post credit crisis era that some are calling ‘The Great Echo.’ The number of institutional investors that have investigated, or are currently exploring tail-risk hedging, is absolutely massive.
Wall Street excels at selling things so it’s not surprising that British banking giant Barclays Plc. and others have launched a number of retail ‘Black Swan’ ETFs offering a way to profit in the event of a market collapse. Selling fear is big business and continues to rev up. In fact, investible products linked to the market’s ‘fear gauge’ – the CBOE Volatility Index – have created quite a stir in the market and already total nearly $2.5 billion. Morgan Stanley strategists estimate demand for tail risk products has driven a fivefold increase in the trading of credit derivatives that speculate on market volatility.
Goldman Sachs, Deutsche Bank and others are marketing institutional ‘solutions’ engineered to bulletproof investors but trading in the VIX will be adversely impacted by basis risk and subsequent negative roll return, presenting a stiff headwind that these instruments will have to overcome just to break even. Furthermore, protection doesn’t come cheap and it’s often very complex and packaged in illiquid, exotic investments like multi-strategy hedge funds. Limiting the impact of a market crash and catastrophic losses by adding exposure to different asset classes makes sense but a hedge fund is a compensation scheme, not an investment strategy. What matters is what’s in the vessel, not the vessel itself.
Tail risk hedging is the buzzword this summer but the quest for the perfect hedge may be unnecessary. Riddle me this: If clients want protection against tail risk, why don’t they just go out and buy Treasurys? Embrace simplicity. Thoughtfully reassess if we’re not over-engineering things. Overpaying for bearish hedges when premiums are historically elevated isn’t necessary when a low-fee, fully-transparent, buy-and-hold, permanent tail risk strategy like Treasurys is available. When you buy insurance, you need to be sure of your insurer’s ability to pay out. ETNs have credit risk, so in bankruptcy, ETN holders would have to get in line with other unsecured creditors who were willing to buy a VIX-derivative investment backed solely by a pinky promise from Barclays. Most importantly, nearly all tail risks are systemic risks in which correlations spike and investors simultaneously desire liquidity – and Treasurys are the ultimate in liquidity.
It’s a provocative perspective: We’re all trying to build ‘all-weather’, ‘volatility-buffered’, crash-proof portfolios and the perfect asset class for the cautious is Treasurys, but they’re universally dismissed because PIMCO and other outspoken proponents of competing investments have publicly declared them to be ‘bad’ investments.
We have all the respect in the world for the PIMCO machine, its superlative marketing capabilities and its immortal bond kings, but what if it’s not the new normal? What if it’s the same old normal? After all, Bill Gross’ infamous – but perhaps forgotten – Dow 5,000 call in 2008 never came true despite one of the worst meltdowns in history. In fact, in the three years since Bill Gross and his partner, Mohamed El Erian, coined the term “The New Normal,” and its secular outlook of muted investment returns, the market has defiantly gone almost straight up.
Ironically, the one asset class that can efficiently hedge crisis risk is the one that people are exorcising from their portfolios as fast as they can. Even the folks at J.P. Morgan who are defining a new framework for executing regime-based asset allocation policies (i.e. “Severe Recession”, “Strong Recovery”, “Stagflation” etc.) note how Treasurys improve portfolio resiliency and lower downside risk under a surprisingly wide range of changing economic scenarios. Their recent work shows that Treasurys perform well during large declines in real GDP growth; even an increase in the Federal Funds rates doesn’t have the inverse relationship that many would expect. There’s a negative relationship between interest rates and Treasurys up to a threshold of 1.6% but beyond that the relationship is so insignificant that Alan Greenspan refers to it as a “conundrum.”
Moreover, U.S. Treasurys are inseparable from the dollar – which also has no shortage of media critics – but history shows that large declines in GDP growth result in increased returns to the dollar as well. Those of us inclined to dismiss “white paper” results as ivory tower rubbish should take note that, in recent months, seemingly every currency has gone down against the US dollar when macro risk creeps in.
We all know that tail risk is out there. The cult of the black swan can trace its roots to 2008-2009 when diversification, which was promoted as a way to protect portfolios, completely failed. We now know that we live in a correlated world where seemingly unrelated investments can fall in unison and, therefore, recognize the need for an asset that will go up when the rest of the market is going down. Tail risk investing has taken center stage and a number of new-age, productized forms of catastrophe hedge have been introduced, but whether these new structures do little more than help pad investor confidence by pretending to tame uncertainty under the pretense of science, only time will tell. Regardless, a case can be made for going old school because Treasurys are an enormously underappreciated tail risk hedge. A wide swath of market participants is currently bearish on Treasurys but plain-Jane Treasurys may be exactly what investors need.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Source: Treasurys Are A Largely Under-Appreciated Tail Risk Hedge