Macro investors have been getting killed in this latest bull market. And so a lot of people think that macro is out as a strategy. I don’t believe that and what’s happening right now in fixed income and currency markets tells you why. And I believe the Treasury market is the low-hanging fruit of macro investing. Some brief thoughts below to be followed by a post specifically for the investment-minded of you
Funds with a global macro strategy take long and short positions in assorted equity, fixed income, currency, commodities and derivatives markets due to a macro view on the economic and political situation of various countries. To do that effectively over the long term, you have to understand the nuances of macroeconomics as it relates to investing. And I am not sure that most investors do.
The Chinese macro example
Let me give you an example. This morning I came across a Wall Street Journal article that said the following regarding China’s Treasury position:
The nightmare scenario is that China, which owns about 8% of the U.S. government’s public debt, could drive down bond prices by unloading even part of its hoard of Treasuries. Such a move would likely send interest rates paid by the U.S. sharply higher.
Because Treasuries are a benchmark that help set rates for mortgages, business loans and consumer debt, such a move could drive up borrowing costs throughout the economy.
A decision by China to sell Treasuries could be the economic equivalent of “mutually assured destruction,” said Mark McCormick, head of currency strategy at TD Securities.
So China would be loath to weaponize its financial assets, analysts say.
That’s the premise of the entire piece: As trade tensions mount, China could blow up the Treasury market, but it won’t because it would blow China up too. Mark McCormick, head of currency strategy at TD Securities, is the one pushing this idea. And the Journal is merely reporting on it. But it’s clear the Journal writer buys into the idea given how he writes the article. And this is a widespread belief in markets.
This is totally wrong though.
The fictional loss of marginal buyers
The premise of the Chinese analysis is based on standard microeconomics. Prices of any item, good or service rise and fall due mostly to supply and demand. And if you remove demand for a product from the market, then its price will fall. In the case of Treasuries, the threat is of removing Chinese demand for US government debt. And the premise then is that when the Chinese leave the Treasury market, supply will outstrip demand and US Treasury prices will fall. Yields will rise.
But this isn’t even true empirically. From June 2016 through November 2016, China’s Treasury holdings dropped by 15% and the 10-year US Treasury yield was basically unchanged. And in the first quarter of 2018, the US Treasury issued a record of $488 billion of Treasuries. This increased supply has continued into the second quarter too. And yet again, the 10-year US Treasury yield is basically unchanged since early February.
Now, you could argue that there were mitigating factors in both cases that suppressed the yield of Treasuries. But I would argue that the problem isn’t the mitigating factors. The problem is the microeconomic premise for a macro event.
First of all, the currency is the release valve. If China actually were the marginal buyer of Treasuries, we would see their withdrawal from the market in the currency market, not in the Treasury market. Second, the Chinese are basically forced to buy Treasuries due to their current account surplus. They have to accumulate dollar assets as a result — or let their currency appreciate. And right now the Yuan is depreciating. So they are likely to buy even more Treasuries.
The macro story is wrong. And investing based on that story can lose you a lot of money.
That’s the low-hanging fruit
This is where macro strategies live and breathe. If you get the basic economics wrong, you’re not going to get the returns. We saw this with the widow maker trade in Japan. Investors bet on higher Japanese rates when the central bank was committed to lower rates. And investors thought the market could force rates higher. They can’t. The central bank is the monopoly supplier of reserves and sets target rates. End of story.
So over the past several years, we had a number of macro stories that simply haven’t panned out because the premise behind them was wrong. For example, John Paulson blew up because he was an inflationista who thought that QE would lead to inflation and bolster the appeal of gold as an asset. Didn’t happen
Hugh Hendry closed his macro fund last year because he got the macro wrong too. And he left saying, “fixed-income volatility really has only one direction it can go.” But is this really true? Why is it true? What are the macro assumptions embedded in that statement?
My own view is that getting the economics makes macro hard is problem number one. But just as big a problem is that macro investing is supposed to be contrarian. And contrarian bets work best when the world is in a panic and volatility is increasing. Most of the time — like right now — things are doing just fine. And so taking a contrarian bet is unlikely to pay off.
But the time for macro strategies is to return soon. My next post for investor-level subscribers will discuss that.
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