In July of 2012 I wrote in
Trading the Wrong Playbook Bubble
that negative interest rates took the discount out of the discount
rate. The idea was that the reason so many asset managers
(especially hedge funds) were underperforming was that while they
were focused on the fundamental discount, the market was being
commanded by the grossly underinvested flow:
"By manipulating the yield curve to generate negative interest
rates, Fed policy has taken the discount out of the discount rate
and thus removed the ability for markets to correctly price assets.
Fed policy has essentially turned all assets into commodities
subject not to valuation but simply the supply and demand for the
Since the market reaction to tapering and the ensuing rise in real
interest rates, market participants have started to reassess this
idea that QE removed the discount mechanism in the discount rate.
In Thursday's Bloomberg Economics Brief, a commentary by Guy
Haselmann of Scotiabank titled "Fed's 'QE-Infinity' May Send
Monetary Experiment Awry" was published:
"Price discovery had already been distorted by QE1 and QE2, but
it was QE-infinity that demolished it. Financial assets are valued
by aggregating the discounted value of future cash flows. Yet, when
QE was not given an end date, the market had to accept ZIRP as
extending infinitely into the future. Thus, the discount rate used
to value those cash flows was assumed to be zero in perpetuity.
Dividing a number by zero equals the empty set."
Pay attention, this is important. Haselmann continues:
"It was only when QE was viewed as actually having an end-date
during 'taper talk' in May that a forward increase in interest
rates was priced into the discount rate mechanism. This is why the
market adjusted after May, leading to a more than 100 basis point
increase in bond yields.
"Furthermore, QE-infinity destroyed the foundations of the capital
asset pricing model (CAPM) by flipping the capital structure upside
down. Interest rates had been forced to such artificially low
levels that risk/return characteristics became skewed and an
asymmetric distribution arose the closer interest rates and credit
spreads got to the zero-bound. Government bonds, which converged to
par, offered limited upside potential and greater risk. Equities
became the preferred asset class simply because they provided
uncapped price appreciation that bonds did not. Many asset managers
even moved into dividend-paying stocks as a substitute for fixed
income exposures. This shift in perception has had a material
impact on asset allocation models, and has significantly increased
As I've been saying repeatedly, it's not the QE flow, per se; it's
negative real interest rate discount that is governing asset
prices. The inflation premium in the bond market, due to the
massive QE liquidity injection, produced negative real interest
rates. These negative discount rates had a profound impact on asset
valuation, turning asset allocation into a guesswork nightmare.
This past week I accidently came across some research that expands
on this asset-allocation conundrum and I think correctly questions
the implication of how it gets resolved. On August 15, 2011, in the
midst of what was the QE 2 asset correlation unraveling, former
Morgan Stanley FX strategist Stephen Jen, now running his own macro
hedge fund SLJ Macro Partners, and his colleague Faitih Yilmaz
published a research paper titled
"On the Beta Convexity Puzzle"
"AUD and CHF are not supposed to have appreciated simultaneously
against the dollar. Neither should both gold and equities have been
bought en masse in the last two years. Some assets are low-beta
(i.e., winter assets: assets that tend to perform well in a
recession or when investors are in fear), while other assets are
high-beta (i.e., summer assets: assets that tend to perform well in
a recovery or when investors are greedy). Until two weeks ago, both
high- and low-beta assets had performed well against the US dollar.
We call this the 'Beta Convexity Puzzle.'"
It is interesting to me that they discovered this dislocation in
the currency market but also that it transcended asset classes.
Essentially the beta convexity puzzle shows that since the onset of
QE, both high-beta, pro-cyclical assets and low-beta
counter-cyclical assets performed the same regardless of the
economic growth trajectory the asset represents.
"AUD (a summer currency) and CHF (a winter currency) tended in
the past to perform well at different parts of the business cycle.
However, after the Great Recession, both currencies have performed
well against the US dollar. Beyond currencies, we also observe
that, until recently, investors were busy buying equities (a
risk-on trade) and buying gold (a risk-off or uncertainty-on
trade). These are highly unusual market traits, distorting the
linear relationships between return and beta for the global asset
markets. While the world has indeed changed since the financial
crisis, we are not convinced that this 'beta convexity puzzle' is
What is the difference between a high-beta and a low-beta asset?
In a general sense, assets can be broken down into two categories:
pro-cyclical and counter-cyclical. Pro-cyclical assets are thought
to be aggressive, high-beta securities with exposure to higher
market volatility, generating most of their return from economic
growth. Think stocks. Counter-cyclical assets are thought to be
defensive, low-beta securities with little exposure to volatility,
generating most of their return from income. Think bonds.
Conventional asset allocation theory states that you should
structure your portfolio to optimize your return relative to the
amount of systemic risk (beta) you are willing to accept. The more
units of beta risk you take, the more return you make. But what if
the market didn't differentiate between the two?
In June of this year as the tapering debate began driving an unwind
of short US dollar levered positions both in the US and in emerging
markets, Jen and Yilmaz wrote a follow-up piece positing whether
the beta convexity puzzle was getting resolved. In
"Tapering by the Fed and the Beta Convexity
" they write the following:
"QE3 has been a 'success' as it has achieved its objective of
artificially inflating the values of both bonds and equities. While
its timing and the pace are uncertain, in theory, the Fed's
prospective tapering may mark the beginning of the unwind in these
asset price distortions, with simultaneous declines in both bonds
and equities being a risk, if corporate earnings don't
re-accelerate to compensate for the tapering effects.
"Since the tapering discussions began, global bonds and equities
have experienced a sharp rise in volatility, and some of the assets
(gold and the
(INDEXNIKKEI:NI225)) have experienced extraordinary declines in
value. The chart below shows the asset returns relative to beta
since April 2013. What used to be a convex relationship (the
previous chart) has turned into a concave relationship (the chart
Beta Convexity Vs. Beta Concavity
"One major problem in portfolio management is the lack of a
balance between bonds and equities. As discussed above, if bonds
and equities are positively correlated, as are gold and oil, it is
very difficult for portfolio managers to construct hedged or
balanced portfolios. If we are right, that, as the Fed tapers,
there is a transition period where a concave relationship dominates
in the beta space, then it is not clear what one would buy if
he/she cuts back on both bonds and equities. Of course, when the
Fed normalizes its policies, we should in theory see the normal
beta relationships, and not just convex or concave relationships.
But getting from here to there, we fear that the Sharpe ratios in
general will likely be inferior than they were in the past four
Click to enlarge
This beta convexity puzzle is not some new paradigm. This is a
product of falling real (negative) interest rates. The rising
inflation discount lowered real yields, pushing them negative,
which raised the net present value of nominal cash flows. This
revaluation trickled up the yield curve and down the risk curve.
High yield bonds were priced like investment grade credits, and
this translated into higher multiples for equity risk regardless of
fundamental performance. Multiples have been the principal catalyst
behind the rally in risk, and it's occurring in an environment of
Five-Year Inflation B/E Vs. S&P 500
This was the Fed's intention and it worked. The problem is that it
severely dislocated asset class valuation, and it's not likely this
will be without a cost. The Fed believes it can gently raise
nominal rates by maintaining high inflation expectations and thus
controlling real interest rates. This is why it decided against
tapering and why it wants to extend guidance on when it plans to
raise Fed funds. Inflation expectations had declined considerably
and real yields tightened market conditions.
The market, on the other hand, may have different plans. This is
the key to how this plays out. Can the Fed reengineer inflation
expectations, or more importantly, convince the market that it is
committed to its inflation target? Will the market reflate beta
How this gets resolved by the market is going to potentially
dictate asset performance for the foreseeable future. Thus figuring
out how to position for coming out of the other side is going to be
the holy grail of asset allocation. Which wing survives the
adjustment process? That depends on what dominates the cycle,
deflation or inflation, and thus what happens to inflation premiums
and real interest rates.
The whole macro debate is whether we are on the verge of a
deflationary deleveraging cycle or whether the Fed's QE has
successfully reflated us into an inflationary growth cycle. How
this beta convexity puzzle reconciles will be a function of which
cycle prevails. The convex and concave relationships that have
governed beta and asset allocation will return to a linear
relationship based on fundamentals.
As interest rates normalize, so too should beta convexity. The
first stage of the normalization process was turning the beta
convex relative performance into a concave relative performance.
The next stage will likely see the emergence of the beta asset that
will govern the coming cycle. Was the Fed successful in reflating
economic growth that will be bullish for high beta, or will QE have
failed to engineer an increase in aggregate demand, thus benefiting
low beta? The market is going to answer this question, and I
believe it's going to happen over the coming months.
Thus far coming out of the September no-taper decision despite the
reflationary bias, inflation expectations have been muted and the
performance has leaned towards low beta. Both the S&P 500 and
gold (NYSEARCA:GLD) have reversed their initial rally. Bond yields
are lower with nominal yields outperforming real yields. It's too
early to draw any conclusions and there are a lot of moving parts,
however the market has made a significant opening statement.
If the Fed is successful, real yields are going to push nominal
yields higher and high beta is going to outperform low beta. If the
deleveraging cycle persists and aggregate demand remains subdued,
nominal yields will remain low, lowering inflation premiums and low
beta is going to outperform high beta. The key metric will be
inflation expectations embedded in the yield curve.