Derek Biederman

Interventional Radiologist at @einsteinVIR

[Derek Biederman @dmbiederman]

@Billackman are we in a Duration Crisis? I believe the yield curve is wrong and the price of long duration sovereign bonds is being artificially capped by BOJ monetary policy. I wrote my ideas out here. I would love to hear your thoughts…

The “Duration” Crisis:
Key Points:
1) The current macro environment is exactly the opposite of the great financial crisis. We are in a duration crisis not a credit crisis.
2) 15 years of massive global central bank quantitative easing transformed the credit risk problem of the GFC into duration risk problem.
3) Investors are focused on the long and variable lags of the 500 basis points of fed rate hikes. The resilient U.S. economy and sticky inflation despite this rapid tightening suggest the long and variable lags of 15 years of easy monetary policy by global central banks may be under appreciated by market participants.
4) The yield curve is wrong. The global bond market is being completely distorted by the Bank of Japan’s (BOJ) monetary policy. Investors are being completely misled by the yield curve. The yield curve is signally abundant global liquidity and not a forthcoming economic slowdown. The stock market doesn’t believe in the yield curve, and neither should you.
5) Long duration treasuries are the wrong price (~200 basis points to low) and completely discordant with current and longer-term economic growth and inflation outlook as they are effectively being artificially being capped by BOJ monetary policy. This is incredibly bullish for stocks while it continues which are long duration assets valued against long term (not short term!) risk-free rates. Equity sectors with the greatest duration risk including tech and homebuilders have been and will continue to be major beneficiaries of this artificial yield cap in long term US treasuries until BOJ policy normalizes and a fundamental market-based price for long duration sovereign bonds is reached.
6) BOJ policy change is a major looming risk for global equity markets. The magnitude and volatility of this shock will be a function of whether this a more gradual voluntary policy change enacted by the BOJ on their terms, or it is a more abrupt change forced upon the BOJ by market participants.
7) Credit default swaps were immensely profitable in the GFC. Interest rate swaptions on long duration sovereign bonds could offer asymmetrical returns in the present market environment.

Credit Risk Crisis vs. Duration Risk Crisis:
Assets on a bank balance sheet contain both credit risk and duration risk. The great financial crisis (CFC) was fundamentally a crisis of credit. Consumers were either unable to make payments because of job losses or underwater on their homes making defaulting the most practical option. The deflationary impulse of this massive credit collapse translated into large gains for long duration assets with no credit risk such as US 20- and 30- year treasury bonds. In other words, if one could with the benefit of hindsight, make a playbook for how a bank or financial market participant could best navigate and profit from the events in the GFC it would be to go short credit (buy credit default swaps on mortgage back securities) and go long duration (buy long duration government bonds).
I hypothesize that we are presently in the midst of an economic crisis of a very different kind. One which is exactly the opposite of the GFC. A crisis of “duration”. A crisis which is the direct result of the long and variable lags of 15 years of massive and unprecedented Quantitative Easing (QE) by global central banks which transformed the credit risk problem of the GFC into a duration risk problem. I believe several Marco economic factors related to structural changes in the labor force, the unprecedented fiscal and monetary stimulus during the Covid pandemic, and the long and variable lag effects of 15 years of QE may combine to allow the US economy to navigate through the present cycle without a major “credit event”. I believe this to be a non-consensus call which would run counter to prior cycles.
In the past year there have been seen several instances of what I suggest may be evidence of a brewing duration crisis including the UK GILT crisis in October 2022 and more recently the failure of multiple regional banks in the United States with large unhedged duration risk exposure on their balance sheets. I believe that these early “duration events” which rattled markets may be the equivalent to some of the early tremors seen in the GFC such as the failure of Bear Sterns and that the major earthquake (Lehman Brothers) has yet to arrive. I posit the way to profit from this duration crisis unfolding in the present is the opposite of the theoretical ideal playbook for navigating the GFC outlined above. Simply stated: Be long credit and be short duration. Financial derivates which are short duration such as interest rate swaptions on long duration sovereign bonds could offer asymmetrical returns in the present market environment.

The Irony of a Perfect Symmetry:
Elon Musk quipped his favored variation on Occam's razor: “the most ironic outcome is the most likely.” This certainly would hold true when juxtaposing the events of the GFC with the events of the present. I was in high school when I had one stock pick for my dad: Lehman Brothers. This was based on no fundamental analysis. It was “cheap” and looked poised for a rebound. Looking at today’s macro environment I almost feel like it may be fair to jokingly say that I wasn’t wrong, just a decade and a half early.
Lehman Brothers was the quintessential GFC victim: Leveraged long credit risk with little to no duration risk. They loaded their books with mortgage-backed securities (MBS) comprised of homeowners with low FICO scores and/or no income verification and enticed these buyers with short duration variable interest rate loans with low initial teaser rates. When the housing market cracked, and owners were underwater on their home equity there was little incentive to pay when the higher adjustable rates kicked in. Couple that with an oil price spike, a recession, and economy wide job losses creating situations where some owners just couldn’t pay, and it is easy to see how losses for Lehman Brothers quickly went parabolic.
Consider hypothetically, how Lehman Brothers would be doing in today’s economic environment. Imagine if in 2020 a bank built a large loan portfolio comprised of homeowners with FICO scores in the 600’s and issued 5-year adjustable-rate mortgages rather than 30-year fixed mortgages (no banks I am aware of actually put this trade on in size). Given the macro conditions which have unfolded in the last 3 years I believe this hypothetical bank would be the envy of all its financial peers. Currently, unemployment is near historic lows, job openings remain quite elevated, and wage growth has been sticky well above pre-Covid trend levels at over 5%. Despite mild declines from peak levels owners are still above water on their equity compared to pre-Covid levels. Given the job market and home equity dynamics even with a mild economic slow there is tremendous motivation for these owners to make payments at all costs. Defaulting on a mortgage now would be financially devastating as any accrued home equity would be lost and the owner being foreclosed on would now need to find a new place to live in housing market with very little supply and mortgage rates now hovering near 7%. Given this it would take a near economic calamity of the scale on the order of magnitude of the great recession for an able body working homeowner to default on their home loan. Couple that with the unprecedented fiscal and monetary stimulus of the last two years, consumer balance sheets in good shape, and savings rates above pre-Covid trends and that MBS full of variable interest loans to 600 FICO score owners might actually deserve those AAA ratings they infamously received by the rating agencies in the GFC in the today’s macro environment. It is truly ironic that if Lehman Brothers ran it’s 2005 playbook in 2020 Dick Fuld would be laughing all the way to the bank. He may have even earned an invitation to capitol hill as the leader of a financial institution serving as a beacon of exemplary risk management for the rest of the industry to model itself on.
Now let’s consider the banking troubles of the present. Today’s banking problem children are Silicon Valley Bank (SVIB) and First Republic Bank (FRC). Unfortunately for them their management teams “learned” from the last financial crisis. Translation: leveraged long duration risk with very little credit risk. Rewind the clock 15 years and their management teams would be heralded as financial geniuses. They would be stand out banks in a banking sector teetering on the brink of failure because they were over leveraged on credit and under exposed to duration. Indeed, loaning to multimillionaires at fixed rates would have been incredibly profitable during the GFC. Despite the tremendous hardship imparted on the general population during the GFC I am fairly sure Mark Zuckerberg would have been good for his 1.5% fixed rate interest only loan famously provided by FRC. Long duration fixed rate interest only loans made to multimillionaires with essentially no credit risk would have been a completely winning strategy during the GFC. Unfortunately for SVIB and FRC the opposite situation is true today.

[Derek Biederman @dmbiederman]

Tremors before the earthquake:
While I believe the GFC and the present macro environment are in many ways perfect reciprocals, I also believe the time course over which they unfold will share a lot of similarities. The GFC did not play out over weeks or months but rather over years. It famously frustrated many market participants who saw the writing on the wall for years. I expect the present duration crisis to be no different.
One of the early manifestations of potential credit problems during the GFC was the failure of Bear Sterns in March 2008. The stock market subsequently rallied into the summer of 2008 before the realization that the Bear Sterns was just a tremor. The credit risk earthquake arrived in October of 2008 with the bankruptcy of Lehman Brothers and near failure of multiple other large systemically important financial institutions. The major market events of the last 12 months where volatility spiked, and equity markets sold off were all “duration events”. The October 2022 stock market low was coincident with the UK pension crisis where pension funds who were leveraged on long duration sovereign bonds were forced liquidate their holdings to meet margin calls thereby necessitating intervention from the Bank of England which reinstated temporary QE to stabilize their sovereign bond market.
The next duration tremor came in the form of multiple regional bank failures beginning in March 2023 including SVIB and FRC. Both these banks had massive duration mismatches of their assets compared to liabilities. Credit has not been an issue for any bank failure thus far. SVIB and FRC had assets comprised of securities with very little credit risk, but they were massively exposed to duration risk. This led to large losses which were forced to be realized when deposits rapidly declined.

Bank of Japan: the “Lehman Brothers” of this Duration Crisis?
As the long and variable lags of 15 years of easy monetary policy continue to work their way through the system, I believe the “Lehman moment” of the present duration crisis has yet to arrive. The Bank of Japan (BOJ) is the most leveraged long duration player in modern financial history. After nearly a decade of yield curve control (YCC) and unlimited QE the BOJ owns over 80% of outstanding 10-year Japanese government bonds (JGB’s). Inflation in Japan is running well above their 2% target despite government subsidies. Recently, wage growth data in Japan has come in below expectations leading to dovish BOJ statements about continuing their massive monetary easing policy (apparently it is surprising to the Japanese central bankers that QE is a suboptimal way to create real durable blue collar wage growth).
While unlimited QE may be having disappointing results in spurring wage inflation in Japan it appears to be working quite well in area where QE is known to accel: inflating asset bubbles. The Nikkei is up nearly 12% in the last month and continues a steep uptrend. This may be getting the attention of BOJ policy makers as they recently alluded to the “unintended consequences” of their monetary policy. I do not believe it is entirely a coincidence the Nasdaq happens to be up nearly 10% over the past month as well. Currently the BOJ predicts no Change in its YCC policy in its upcoming June meeting.
I believe that inflation globally will be higher and stickier than the prior decade because of deglobalization, onshoring of supply chains, underinvestment of fossil fuels, and the transition to green energy. Additionally inflationary pressures in Japan while certainly less than other western economies appear to be growing. These factors combined with pressure on the Yen will result in what I believe to be an inevitable exit by the BOJ from decades of unprecedented easy monetary policy. This has the potential to be a major shock to global sovereign bond markets. The magnitude and volatility of this shock will be a function of whether this a more gradual voluntary policy change enacted by the BOJ on their terms, or it is a more abrupt change forced upon the BOJ by market participants. These effects will be minimal to non-existent on the short end of yield curve but will have a massive impact on the long end of the yield curve.

Bond Market Distortions:
Currently the Yield curve (2yr/10yr and 3m/10yr) is near a record level of inversion which is being interpreted by the market as a sign of impending economic calamity. I believe this inversion is completely artificial and an obvious outcome Japan capping its 10-year JGB yields at 0.5% and the inherent fungibility of global sovereign bonds (A US treasury is effectively the same as a JGB when combined with an FX swap). The term premium on 10-year zero coupon bonds is currently -0.4% compared to a historical average of ~1.5% (it was positive even in the depths of the deflationary shock of the GFC for historical reference). The spread between 30-year MBS and 10-year government bonds is also a record near 300 basis points. I believe all of these non-sensical “bond market signals” are directly result of spill through of BOJ monetary policy into global sovereign bond markets.
Market participants are placing way too much weight on the yield curve as predictor of macro-economic outcomes particularly now, given there is such a glaringly obvious non fundamental reason for this historically large yield curve inversion. Stated somewhat differently, Japan’s yield curve is positive 0.5% compared to our negative 1.7%, in an era where global economies are highly linked, how is it that one G7 yield curve is curve is signaling a rosy economic outlook while other is supposedly signaling a massive global recession? To my knowledge there is no historical precedent for this. The aforementioned bond market anomalies could quickly revert to much closer to their historical averages should the BOJ change policy.

The VIX: Complacency or Clue?
The continuous and relentless decline in the volatile arguably ranks behind the banking crisis and the AI boom for biggest surprise of 2023. Is this just complacency by market participants, the proverbial calm before the storm? Perhaps it could also be a subtle but important signal. I think there is an imperfect but potentially import relationship between corporate credit and stock market volatility. Being long corporate credit is from a risk/reward standpoint very similar to selling a put option on a specific equity or equity index. In both cases your upside is capped, and your downside is “unlimited” in the sense that if there is a corporate default the common equity is wiped out and the put option you sold is paying out the maximum; owning the corporate credit in that scenario will result in the same maximum loss. If this isn’t a credit crisis and being long credit is the solution, not the problem, then it’s not surprising to see the VIX behaving this way. Investment grade and high yield credit are tracked by retail investors through the ETF’s: LQD (investment grade) and HYG (high yield). However, in making the distinction between credit and duration which I believe to be crucial in navigating this cycle I believe it is more important to follow the ETF’s: LQDH and HYGH which are the duration hedged versions of LQD and HYG respectively. Both of these ETF’s have low trading volume and are more illiquid than their unhedged counterparts. If this is a duration crisis and not a credit crisis both HYGH and LQDH should be good longs. However, I do not see an obvious way for retail investors to make asymmetric returns going long credit compared to the asymmetric returns which I believe are possible with the short duration trade. The suggested relationship between credit and the VIX does have potentially important implications for hedging in this cycle. I think equity index puts and/or calls on the VIX will continue to disappoint as a hedging instruments until the next big duration event. Equity index puts are not the best way to play this duration crisis.

Conclusion:
In summary, I believe we are in the midst of a duration crisis not a credit crisis. The stock market and credit market supports this view currently. The sovereign bond market is saying the opposite. I believe the reason for the large discrepancy between the stock market and the bond market is spillover of the policy of massive monetary easing by the BOJ (the most leveraged long duration player in financial market history) into global sovereign bond markets which is creating artificially low long term interest rates for sovereign bonds yields globally. This is imparting a huge easing force counteracting the fed rate hikes on the short end of the yield curve thereby loosening financial conditions and making the federal reserve’s inflation fighting job much more challenging. This is incredibly bullish for stocks while it continues which are long duration assets valued against long term (not short term!) risk-free rates. Equity sectors with the greatest duration risk including tech and homebuilders have been and will continue to be major beneficiaries of this artificial yield cap in long term US treasuries until BOJ policy normalizes and a fundamental market-based price for long duration sovereign bonds is reached.
I believe this duration crisis will resolve itself with BOJ shifting to a more normal monetary policy. This will result in the resolution of the aforementioned bond market distortions including the yield curve steepening to the point of no longer being inverted, a reversion to a more historically normal pre-QE era term premium for US Treasuries and sovereign bonds globally. The abrupt change in these bond market distortions will likely come as a big surprise to market participants who are mistakenly looking to the bond market as a predictor of future economic outcomes.

[Derek Biederman @dmbiederman]

@Billackman are we in a Duration Crisis? I believe the yield curve is wrong and the price of long duration sovereign bonds is being artificially capped by BOJ monetary policy. I wrote my ideas out here. I would love to hear your thoughts…

The “Duration” Crisis:
Key Points:
1) The current macro environment is exactly the opposite of the great financial crisis. We are in a duration crisis not a credit crisis.
2) 15 years of massive global central bank quantitative easing transformed the credit risk problem of the GFC into duration risk problem.
3) Investors are focused on the long and variable lags of the 500 basis points of fed rate hikes. The resilient U.S. economy and sticky inflation despite this rapid tightening suggest the long and variable lags of 15 years of easy monetary policy by global central banks may be under appreciated by market participants.
4) The yield curve is wrong. The global bond market is being completely distorted by the Bank of Japan’s (BOJ) monetary policy. Investors are being completely misled by the yield curve. The yield curve is signally abundant global liquidity and not a forthcoming economic slowdown. The stock market doesn’t believe in the yield curve, and neither should you.
5) Long duration treasuries are the wrong price (~200 basis points to low) and completely discordant with current and longer-term economic growth and inflation outlook as they are effectively being artificially being capped by BOJ monetary policy. This is incredibly bullish for stocks while it continues which are long duration assets valued against long term (not short term!) risk-free rates. Equity sectors with the greatest duration risk including tech and homebuilders have been and will continue to be major beneficiaries of this artificial yield cap in long term US treasuries until BOJ policy normalizes and a fundamental market-based price for long duration sovereign bonds is reached.
6) BOJ policy change is a major looming risk for global equity markets. The magnitude and volatility of this shock will be a function of whether this a more gradual voluntary policy change enacted by the BOJ on their terms, or it is a more abrupt change forced upon the BOJ by market participants.
7) Credit default swaps were immensely profitable in the GFC. Interest rate swaptions on long duration sovereign bonds could offer asymmetrical returns in the present market environment.

Credit Risk Crisis vs. Duration Risk Crisis:
Assets on a bank balance sheet contain both credit risk and duration risk. The great financial crisis (CFC) was fundamentally a crisis of credit. Consumers were either unable to make payments because of job losses or underwater on their homes making defaulting the most practical option. The deflationary impulse of this massive credit collapse translated into large gains for long duration assets with no credit risk such as US 20- and 30- year treasury bonds. In other words, if one could with the benefit of hindsight, make a playbook for how a bank or financial market participant could best navigate and profit from the events in the GFC it would be to go short credit (buy credit default swaps on mortgage back securities) and go long duration (buy long duration government bonds).
I hypothesize that we are presently in the midst of an economic crisis of a very different kind. One which is exactly the opposite of the GFC. A crisis of “duration”. A crisis which is the direct result of the long and variable lags of 15 years of massive and unprecedented Quantitative Easing (QE) by global central banks which transformed the credit risk problem of the GFC into a duration risk problem. I believe several Marco economic factors related to structural changes in the labor force, the unprecedented fiscal and monetary stimulus during the Covid pandemic, and the long and variable lag effects of 15 years of QE may combine to allow the US economy to navigate through the present cycle without a major “credit event”. I believe this to be a non-consensus call which would run counter to prior cycles.
In the past year there have been seen several instances of what I suggest may be evidence of a brewing duration crisis including the UK GILT crisis in October 2022 and more recently the failure of multiple regional banks in the United States with large unhedged duration risk exposure on their balance sheets. I believe that these early “duration events” which rattled markets may be the equivalent to some of the early tremors seen in the GFC such as the failure of Bear Sterns and that the major earthquake (Lehman Brothers) has yet to arrive. I posit the way to profit from this duration crisis unfolding in the present is the opposite of the theoretical ideal playbook for navigating the GFC outlined above. Simply stated: Be long credit and be short duration. Financial derivates which are short duration such as interest rate swaptions on long duration sovereign bonds could offer asymmetrical returns in the present market environment.

The Irony of a Perfect Symmetry:
Elon Musk quipped his favored variation on Occam's razor: “the most ironic outcome is the most likely.” This certainly would hold true when juxtaposing the events of the GFC with the events of the present. I was in high school when I had one stock pick for my dad: Lehman Brothers. This was based on no fundamental analysis. It was “cheap” and looked poised for a rebound. Looking at today’s macro environment I almost feel like it may be fair to jokingly say that I wasn’t wrong, just a decade and a half early.
Lehman Brothers was the quintessential GFC victim: Leveraged long credit risk with little to no duration risk. They loaded their books with mortgage-backed securities (MBS) comprised of homeowners with low FICO scores and/or no income verification and enticed these buyers with short duration variable interest rate loans with low initial teaser rates. When the housing market cracked, and owners were underwater on their home equity there was little incentive to pay when the higher adjustable rates kicked in. Couple that with an oil price spike, a recession, and economy wide job losses creating situations where some owners just couldn’t pay, and it is easy to see how losses for Lehman Brothers quickly went parabolic.
Consider hypothetically, how Lehman Brothers would be doing in today’s economic environment. Imagine if in 2020 a bank built a large loan portfolio comprised of homeowners with FICO scores in the 600’s and issued 5-year adjustable-rate mortgages rather than 30-year fixed mortgages (no banks I am aware of actually put this trade on in size). Given the macro conditions which have unfolded in the last 3 years I believe this hypothetical bank would be the envy of all its financial peers. Currently, unemployment is near historic lows, job openings remain quite elevated, and wage growth has been sticky well above pre-Covid trend levels at over 5%. Despite mild declines from peak levels owners are still above water on their equity compared to pre-Covid levels. Given the job market and home equity dynamics even with a mild economic slow there is tremendous motivation for these owners to make payments at all costs. Defaulting on a mortgage now would be financially devastating as any accrued home equity would be lost and the owner being foreclosed on would now need to find a new place to live in housing market with very little supply and mortgage rates now hovering near 7%. Given this it would take a near economic calamity of the scale on the order of magnitude of the great recession for an able body working homeowner to default on their home loan. Couple that with the unprecedented fiscal and monetary stimulus of the last two years, consumer balance sheets in good shape, and savings rates above pre-Covid trends and that MBS full of variable interest loans to 600 FICO score owners might actually deserve those AAA ratings they infamously received by the rating agencies in the GFC in the today’s macro environment. It is truly ironic that if Lehman Brothers ran it’s 2005 playbook in 2020 Dick Fuld would be laughing all the way to the bank. He may have even earned an invitation to capitol hill as the leader of a financial institution serving as a beacon of exemplary risk management for the rest of the industry to model itself on.
Now let’s consider the banking troubles of the present. Today’s banking problem children are Silicon Valley Bank (SVIB) and First Republic Bank (FRC). Unfortunately for them their management teams “learned” from the last financial crisis. Translation: leveraged long duration risk with very little credit risk. Rewind the clock 15 years and their management teams would be heralded as financial geniuses. They would be stand out banks in a banking sector teetering on the brink of failure because they were over leveraged on credit and under exposed to duration. Indeed, loaning to multimillionaires at fixed rates would have been incredibly profitable during the GFC. Despite the tremendous hardship imparted on the general population during the GFC I am fairly sure Mark Zuckerberg would have been good for his 1.5% fixed rate interest only loan famously provided by FRC. Long duration fixed rate interest only loans made to multimillionaires with essentially no credit risk would have been a completely winning strategy during the GFC. Unfortunately for SVIB and FRC the opposite situation is true today.

[EinsteinVIR @EinsteinIR]

Acute MCA occlusion. Type 3 aortic arch. Sometimes it takes an arm and a leg to get the job done. #itsallinthewrist #radialaccess #thrombectomy @dmbiederman @SIRRFS