The Wooden Nickel is a collection of roughly a handful of recent topics that have caught our attention. Here you’ll find current, open-ended thoughts. We wish to use this piece as a way to think out loud in public rather than formal proclamations or projections.

1. Volatility: A Matter of Yen Not If

Summer months have a habit of bringing volatility to risk markets and the causes, historically, have a wide range from Brexit to the Yuan depreciation of 2015, to last year’s QRA and Treasury issuance fears. This year is no exception thanks to two different sparks (although there’s probably some correlation in positioning going into events).

The most recent and dramatic comes from Japan and serves as a further example that the most foolish thing in investing is to believe that most market participants learn the lessons of past generations. The allure of cheap leverage is a temptation as old as time and no country has embodied cheap rates more so than Japan.

The Yen carry trade (whereby someone borrows money in Yen-denominated terms to purchase assets in a country with higher yields) has been very popular for a very long time by very fast money with lots of leverage. I remember having discussions with other money managers going back to January of 2022 wondering if the coming inflation would spark some rate hikes in Japan that would upend Yen borrowers, but those hikes didn’t come until more than 2 years later. As they say, being too early is the same as being wrong. That convinced plenty of other market participants to jump aboard the trade. Positioning against the Yen thus accelerated dramatically over the last two years.

Figure 1: Shorting the Yen Became Very Popular… (Source: WSJ)

Figure 2: …with Much of the Proceeds Going Overseas (Source: WSJ)

Bets against the Yen, and the perceived stability of policy rates, forced the dollar to appreciate by over 40% against the Japanese currency since January of 2022. The Yen reached levels that haven’t been seen since the late 1980s, capturing the attention of policymakers. The unrelenting selling pressure on the Yen throughout the spring and summer, and fears of sticky inflation in Japan, forced action. While the hike this spring was well known and telegraphed, the one a couple of weeks ago was not (Figure 3).

Figure 3: Most Market Participants Did Not Expect a Hike

Carry trades are an ever-present variable in financial markets and, in the normal course of activity, get closed out by either the long-end or short-end of the trade forcing it. But in the last month or so, participants in the carry trade got whacked by both ends in a very short amount of time. Not only was their short working against them (and the concurrent cost of financing the carry trade rising, eating into profits) but now the yielding asset was going to start earning less.

First came the CPI report in early July, showing deflation from May to June in the overall Consumer Price Index. This firms up the odds of a rate cut in September and thus lowers yields on those long assets (as of this writing markets are pricing in at least 1 cut and a greater than 50% chance that the cut in September is 50bps). Thus, the squeeze from both ends. But the weak jobs report for the month of July was an accelerant, opening up tumult on that positioning. Now, suddenly, you had people openly calling for emergency rate cuts. Now the potential yield on those carry trades was going to decline not gradually, but rapidly. As a result, everyone headed for the one door at the same time. That’s how you get days where the Nikkei declines 12% in a single session, via forced and indiscriminate deleveraging. 

2. Rotation or Recession?

While Japan, deservedly, has gotten most of the attention recently, it wasn’t the only source of volatility in financial markets. The S&P 500 broke the rather trivial streak of avoiding a 2% daily decline a week before the BoJ decision.

When the July CPI report was released showing an overall decline in the month-over-month Consumer Price Index, it paved the way for this dovish Fed to set course for a rate cut at its next meeting in September, barring some sort of summer surprise. It unleashed quite the reversal and while in theory lower rates should boost asset prices, the real world has other opinions. The S&P 500 declined 3% and the Nasdaq declined 8% over the ensuing 2 weeks, before the Japanese rate hike. Small-cap stocks, meanwhile, gained 10% in one of the most dramatic spreads in performance in market history. The soft landing was in sight. Or so we thought.

Then came the employment report on August 1st, with a rather dismal 117,000 jobs added to the economy. The unemployment rate jumped to 4.3% and triggered the dreaded Sahm Rule that historically coincides with the presence of a recession.

Figure 4: Sahm Rule Triggered

Now the question became, was the weak inflation due to a more benign pricing environment? Or was a weakening, or maybe even contracting economy, void of adequate aggregate demand? Bolstering the case of the latter was continued weakness out of the consumer sector (a recurring theme now since the Easter holiday), deterioration in the manufacturing sector, and jobless claims that have turned upward since the start of the year.

We were now firmly in a world of dueling economic narratives that possessed dramatic contrasts: was the economy continuing to progress and the market simply rotating the winners from tech stocks to other players or was there a more bearish take to adopt that would necessitate dramatic action.

As in most, if not all, economic environments there are things going right and things that are quite weak and concerning. And this cycle, still feeling some of the distorting effects of Covid in some pockets, does seem to be more unique or difficult to wrap one’s head around. While both bulls and bears have reasonable, and in some cases, persuasive elements to their respective cases, if there’s one thing I’ve learned when dealing with this type of contrast, especially in sudden moments, is to take a breather and look at the credit markets. Oftentimes, especially with fears of economic contraction, the bond market sniffs it out further ahead in time than equities, where positioning plays an underappreciated role in price movements (see the Yen carry trade as an example).

While yields have come in a little bit (signaling some flight to safety), credit spreads, the excess demanded over risk-free rates for a counterparty to access debt markets, have hardly made a blip.

 Corporate Bond Spreads Aren’t Stressed…

…High Yield Spreads Aren’t Either

Spreads are off their lowest levels. And they are so low that it does create worry about their value as a prospective investment for the asset class. But as a harbinger of an economic cliff, they’re not flashing anything of concern.

The case for rotation, however, does not necessarily bode well for the overall indices. Things have gotten so top-heavy and concentrated among the Magnificent 7 that it is theoretically possible for technology shares to sell off while other sectors gain and for the overall market to stagnate or even decline.

3. A.I., GLP-1s, and Jevons Paradox

One of the more difficult things to cognitively internalize in life and that is quite apparent in investing is the non-linearity of events, their consequences, and the web of relationships among a system’s variables. It’s especially apparent within new technological paradigms and is one reason why we like to pay attention to and learn from phenomena like the Norwegian oil boom, as one example. Insights that appear to diverge from the rigid instinct of economic “laws” can be both illuminating and profitable when they reveal non-obvious truths.

The Jevons paradox is one example, and it has begun to resurface in light of the disruptive potential of both A.I. and GLP-1 drugs. For those unfamiliar, Jevons paradox refers to an observation from English economist William Stanley Jevons on the impact increasing efficiency of a new technology had on supply and demand. Traditional economic theory would suggest that, ceteris paribus, increased efficiency for an input would lead to less demand for said input as it’s easier to accomplish the intended output with less resources. In fact, Jevons observed the opposite. His experience centered around the use of coal in the 1860s. Jevons observed that the improved efficiency of the Watt steam engine led to a surge in the demand for coal rather than a decrease. The improved efficiency meant more uses for the steam engine existed and that the elasticity of coal usage centered around the job to be done, not the efficiency of a single engine.

I wonder if similar mistakes are being made when considering GLP-1s and A.I. Consider a scenario where GLP-1s lengthen life expectancy so much that people who take the drug end up consuming more health care services over the course of their whole life while needing less in any given year compared to before taking the drug. A more direct parallel to Jevons’ observation centers around the energy intensity of A.I. and the data centers housing the power-hungry servers. I’ve seen a number of chip startups, some with high-profile backers, tout the energy efficiency advantages of their chip design over Nvidia’s market-leading products as a solution to the power needs of A.I. servers (I recommend reading the testimony of AEP’s CEO to the Senate Committee on Energy and Natural Resources as one of many examples of the power dilemma). But despite the power problem, there’s been no consideration of the odds that increasing the energy efficiency of a single chip increases rather than decreases the problem; the elasticity of usage may explode and overwhelm the unit efficiency advantages.

Figure 5: The A.I. Power Dilemma, Source: Bernstein

For a less theoretical exercise, consider the case of Zendesk, a software company that firms frequently employ for customer service needs, including handling support issues for things like e-commerce. Early indications are that the firm’s use of A.I. is indeed making customer service employees more efficient in handling a single ticket. The problem is the volume of tickets and support requests has exploded and overwhelmed the efficiency gains.

I don’t consider the case of Zendesk or the power dilemma fatal or prohibitive of the development of technologies; I think it’s part of the growing pains of new technological advancements. But they do show the perils of traditional linear thinking on economic relationships and I don’t think they’re going way any time soon. Nor do I think they’re necessarily strictly microeconomic problems but rather have the potential, if not likelihood, of spilling over into the domain of economic policy.

4. Recommended Reads and Listens

print