Hey Russell, thanks for the post

I was thinking of creating my own substack eventually but here's some thoughts for now:

In the 2012-19 era if you recall there was a popular strategy popularized by David Zervos "Spoos and Blues" - long SPX and long equal risk-weighted Eurodollars (https://macro-man.blogspot.com/2015/11/knowing-where-to-look.html)

It actually worked very well pre-COVID, because like Risk parity the underlying intuition is that the Fed is the main source of incremental liquidity: risk assets are effectively backstopped by the Eccles Building, and if equities dip they will ease, so Eurodollar futures rally.

In the post-COVID 2021-present era, if you subscribe to the belief that the US has gone pro-labour in policy but that the BoJ is the marginal supplier of incremental liquidity then it follows:

a) US interest rates will remain relatively high (at least compared to post-2008 history) while the BoJ adheres to low rates (despite NIRP ending soon)

b) the Yen will continue to weaken and remain weak (I think that this is why the VIX is so low and carry-type trades continue to perform so well despite all the problems in the world right now)

c) Japanese equities will do well in JPY terms

d) the USD/JPY interest rate differential is largely determined by the Fed; if the Fed cuts the JPY will rally (and Nikkei fall)

e) but then if history is a guide, Fed cuts are very bullish for Gold prices

Thinking about portfolio construction

the core of the portfolio is Japanese equities, hedged against Yen weakness

you also earn a positive carry this way because JPY short rates are substantially below USD short rates

Looking at DXJ (Topix hedged into USD) vs EWJ (vanilla TOPIX) you can see this performance differential clearly



Additionally, in an environment where DXJ has been breaking out since 2021, the price of Gold in USD terms has been flat-ish


Unfortunately as I'm not a financial industry professional I don't have access to a Bloomberg terminal or other reliable data source handy. I'm sure that with access to such, constructing a portfolio to maximise sharpe ratio would be relatively trivial. Do get in touch if you think my idea has merit, or not :P

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Russell - I like this analysis and/but have a different theory to offer:

Here in the US, new treasury issuance has been skewed more towards bills and away from longer duration notes & bonds. While I too thought that higher short term rates would drag down equities and other risk assets, there's a good rationale why they haven't. Treasury bills are the de facto risk free rate of return; risk free because unlike long bonds, there's no duration risk due to the strong pull to par.

In this context, the increased bill issuance is easily absorbed by mkts because the cash that buys them would have otherwise sat in a bank or MMF (so basically the Fed's RRP). There's essentially unlimited demand since buying bills with cash doesn't alter one's risk profile. But buying longer-duration paper with cash does alter a portfolio's risk profile, so its notes & bonds that compete with stocks for liquidity - not bills.

By skewing new issuance towards bills, the Treasury is blunting the effect of the Fed's QT. Or put another way: the Fed controls the demand for treasuries by being a buyer (QE) or not (QT), but the Treasury controls the supply of treasuries via its auctions and ratio of coupon & non-coupon issuance.

I don't think these two theories are mutually exclusive.

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USDJPY the ultimate hedge?

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Interesting thoughts! Are we sure the BOJ's mission is to "help the working class" in Japan, though?

It seems like they do what they're told by the US. The geopolitical stakes with Russia, China, and Iran are very high right now. Japan is being asked to make some more sacrifices to shore up US hegemony. At least that's my take.

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What's the mechanism that leads from a weak yen and QE there to a high S&P 500 in the states?

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Really interesting analysis here. this is especially so given the growing certitude among many that the BOJ is getting set to tighten policy. I guess the question is, will simply going from NIRP to ZIRP be enough to rattle the speculative fevers or will we need to see 25bps or 50 bps before it matters? because, if all that is required is a change of stance, things could get quite hairy later this year based on Ueda's comments lately. a slow move is a move nonetheless.

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