A SECULAR BOND BEAR DOESN’T PRECLUDE SIGNIFICANT COUNTER RALLIES

We have been very adamant, and we got lucky at calling the lows back in July of 2016 –
as yields were around 1.35%, 1.36% – in saying that we thought the low was in in Treasury
yields. And I mean the low. And one of the reasons for that, Erik, is that I think people
frequently misinterpret the bigger picture.

The bigger picture is really set, to a large extent, by demographics. And I think a lot of people
draw inferences to Japan and say, look, 10-year Treasury yields have to go toward 10-year JGB
yields. To me, that’s wrong for a couple of reasons.

Firstly, Japan is a little unusual. It eats what it kills. So it does fund its own deficit. The United
States is a little different. It actually relies on overseas funding of deficits.

So, when you look at that, you have to consider a much broader demographic pattern. Because,
broadly speaking, the way that demographics works in asset prices is quite simple.

• You’re in your 20s, you start to work.
• And into your 30s you live it up. Okay? And we’ve seen that with the
  baby boomers in the ‘60s and ‘70s – drugs, sex, and rock ‘n’ roll – and don’t care about the
  consequences.
• Unfortunately, during that process you end up getting your girlfriend pregnant and you have a
  child.
• And so you go from spending, where you’re not physically saving, and that means the
  money isn’t going into Treasuries and it isn’t going into the equity market.
• And then you start to save as you build that family.
• And, definitionally, this is when bond yields start to fall.

Now, when you look at the broad pattern for the United States and the people who buy US
debt, we’re hitting an inflection point. We hit that inflection point in about 2015–2016. And that
is these people are now starting to retire. And, definitionally, when you retire, you become a
dis-saver.

Maybe we could do what the Japanese have done – which is why, remarkably, the Japanese
working population hasn’t really peaked yet – is we can keep working people till they die. The
average age of a Japanese farmer is almost in their 70s. They literally attach little exoskeletons
on these poor buggers so they can reach up to the plum tree to pull the plum down.

But the point is, if we don’t, as people retire they are going to become dis-savers. And they are
going to start – now they spend on far less sexy things than they did in their 20s and 30s: adult
Depends and health care. It’s not nearly as sexy as sports cars and living it up. But, nonetheless,
they dis-save. And as they dis-save, bond yields should rise.

So, big picture, I don’t believe there is any structural change in the story whatsoever.

But this is relatively glacial stuff. And the reality of the situation is – and we’ve been saying this
to our institutional clients – we said the process of higher yields and higher rates was never
going to be linear. And, in fact, we borrowed the phrase “two steps forward and one step back.”

We’ve been pushing this short in the fixed income market as a way – because we’ve been
saying, look, we’re just running this car way too hot. We’ve had financial conditions, basically, at
50-year lows domestically here in the United States and we need to raise those financial
conditions.

And the way we’ve been believing it would happen, predominantly, was via a combination of
higher Treasury yields and, to some extent, a stronger dollar. But the thing that worried us, Erik,
is that – when we look at the world, we think that we’ve actually recreated some of the
excesses of prior cycles.

As rates rise, they actually create quite a lot of damage. And so you can’t just have this straight,
rip linear up-moving rates. They move up, they do some damage, they come back.

And the two areas that particularly worried us have been housing and stocks. And as those have
started to correct, we can see that the fixed income trade has become a lot more difficult.

If we move on to Slide 4 in the slide deck, just to illustrate some of our concerns about these
excesses that have been created in the system, the first one we want to highlight is in the US
equity market.

If you look at this slide here, what it shows is the relative performance of the US equity market,
USMSCI versus the rest of the world ex the US.

• The first thing I would note is we have never seen relative performance of this extreme a level. This is beyond anything we’ve seen since the early 70s.
• The second thing is it’s highly unusual to see any US out-performance in any environment where the Fed has been tightening. The only time in history – and I’ve highlighted it in purple here – where we’ve seen the US equity market outperform at all, was in that very brief period in the ‘90s.

What we have now is really, really incredible. Really incredible out-performance of US equities.
And I would say it’s almost – the danger is this has become a reflexive bubble. In other words,
we’ve had this situation where – courtesy of the Trump stimulus and a very, very lax gradually
raising Fed, whose financial conditions were made ridiculously easy despite the fact that they’ve
been hiking Fed funds – this has created this growth adrenaline rush which has allowed, along
with dollar strength, this out-performance of the US equity market as dollar strength has helped
to suck in money from the rest of the world. So it’s almost arguable that it’s a reflexive bubble.

When you look at the next slide, Slide 5, there is no question where that risk is concentrated.

It is definitively concentrated in the Nasdaq. Most global equity markets – you can see here –
have sort of come back to where they were in March of ‘09.

If you look at Slide 5, you’ll see that the excesses have definitely concentrated in the US and
most acutely in the Nasdaq. If you look up most markets, most markets have made about 100%
returns since March of ‘09. The S&P and the Dow have made about 300%. But the Nasdaq has
done 500%. A five-fold out-performance versus the rest of the world. This is definitively
excessive.

Now, as we’ve just seen today, and we’re talking – I’m sure Erik will remind everyone – just
after Powell’s recent speech, it’s not difficult to engender a bounce in the equity market. And
maybe we’ll get more of a one this weekend if we manage to pull off some sort of cease-fire
with the Chinese over trade. But it’s going to be a lot more difficult in the next area of the
economy, and that’s on Slide 6.

 As we look at this
out-performance of the Nasdaq, it seems to me you could make an argument, hey, something is
extraordinary there. Or you could say, well, wait a minute, tech stocks tend to be more volatile
anyway. And so I wonder, if we were to look at other periods of performance going back in the
‘90s, I would guess the Nasdaq when things were all going up dramatically outperformed.
To what extent is it just a more volatile index versus to what extent is it a unique phenomenon
to this period?

Julian: I think it definitively is a more volatile index. But there are some – you would think
something like the KOSPI, which is career, it’s highly export-orientated – should also do well. I
haven’t put it in here, Erik, but there’s actually a chart – if you take the S&P growth index
against the S&P value index, within the S&P identically calculated indexes, what you’ll find is the
ratio of those two indexes actually, to the tick, topped where we were in March of 2000, back in
September.

So, within the growth value space, within the US markets, which is really what the Nasdaq is all
about, we push that ratio right back to the dot com bubble high. I’m pretty clear – and I’ll show
you in a chart in a second – that I think, within that space – and if you follow me on Twitter
you’ll have seen this – there are definitive what I would call classic bubbles in a whole slew of
names in the US equity market. So I do think this is very excessive.

The risk with an excessive market like this is when you create excesses in the system, as you try
and normalize policy, things can become quite unstable. And I think, unfortunately, that’s
where we’re finding ourselves.

Now, as I just said, I think it’s quite easy to reverse or at least boost a highly volatile equity
market. The biggest excess that I think we’ve reflated, actually, you’ll see on Slide 6. And that’s
in housing.

This one really worries me. Now the first thing I will say is, when you look at new median house
prices, you have to be a little bit careful. I’m not saying that we’ve pushed them so far below
‘06–’07 highs.

What we’ve done, though, is we’ve changed the mix of housing that we build. So there are no
more two-bedroom affordable apartments that have been built in the last few years. Everything
is luxury two-bedroom with all the bells and whistles. So the underlying median cost is
definitionally higher. But the point is, even if you take existing homes, we have pushed prices
back up above ‘06–’07 or at least to ‘06–’07 highs.

That’s atrocious. So, not only have we arguably created some of the excesses of the dot com
space, we’ve actually arguably created some of the price excesses and also credit excesses of
the pre-GFC housing bubble.

Now, this is a lot harder to solve, Erik. As I said, you can tweak 5% on the Nasdaq. But how do
you solve for this? How do you solve for affordability in housing?

Well, one of the ways that you solve is that you see a collapse in activity. Back in the spring, we
wrote to our clients and said – we actually wrote this piece on housing one step back. We said,
as rates rise, they are going to prick what is arguably a price bubble in US housing, and the end
result is going to be a collapse in activity. We showed them this particular model. And,
obviously, since the spring it’s become front page headlines in the United States.

But this is definitively a big, big deal. This model is showing absolutely no signs whatsoever of
basing at this point. And it is, arguably, below ‘06–’07 levels of activity. I’m not saying that the
credit excesses are there. We don’t have Ninja loans and all those sort of things. But solving for
housing affordability, outside seeing a massive rise in incomes or a huge drop in bond yields and
hence mortgage rates, is going to be very, very hard outside seeing a drop in house prices and a
drop in housing activity. And both of those will have consequences.

Now, the other area that we think is – and this brings us back to that Treasury market – is we
think a lot of the soft data has been highly exaggerated.

If you look at Slide 8, you’ll see ISM here against 10-year Treasury yields.

Now, we’ve been sitting around 60 in ISM. That’s an incredible number.

That is an absolutely stonkingly incredible number. 60 is actually about as high as that ever gets.

And it’s historically – if you go back and look at periods where we’ve been printing 60, we’d
been printing 4% year-over-year GDP growth. Not the odd little quarter. Sustained 4% GDP
growth year over year.

We aren’t printing that. Today we had a revision to the growth numbers and it was 3%. So how
come ISM is at 60 and yet – which really should be commensurate, let’s say 52 on ISM – and
we’ve been sitting at 60. How is that possible?

Well, really, we think it’s to do with the equity market. We think a lot of the reason why there is
this fluff in some of this soft data is because, when these executives fill out these surveys,
they’re really reflecting their confidence is partly to do with how well their stock options are
doing. And they’ve been doing bloody well.

And, as this thing naturally starts to roll over – because it doesn’t sit here, generally speaking. As
you can see, it’s a big, broad sine wave. That would say that it’s tough in that environment to be
short Treasuries.

Now, I have quite a lot of sympathy with that yellow box period. If you look at 2004–2005,
typically we’ve seen Treasury yields fall. And I’m not dismissing that. But, basically, at this point,
if you’re making that bet, you’re betting on a very, very weak equity market. And my suggestion
would be, if you want to do that, just short the equity market rather than try to buy the
Treasury market.

The point is, it’s not a great environment, I don’t think, to be particularly short Treasuries
anymore. And, actually, to our professional clients, we’ve recommended to get out.

So, ladies and gents, if we’re saying now that it’s tough to be short Treasuries, it raises the
natural question: Should you be buying Treasuries? Now, I’ve still got some reservations about
the broad market. And let me explain.

If you look on Slide 10, let me show you the slide that you’ve seen before, which is this chart of
30-year Treasuries going all the way back into the ‘80s. What you can see here is that, despite
the weakness that we’ve been seeing in equities, 30-year Treasuries have really not performed
at all. We are still sitting well above that 100-month moving average. And we’re even still sitting
above the neckline of the inverse head and shoulders.

So, if you do want to buy, certainly you wouldn’t be proposing to buy in the 30-year sector. Not
yet, at least.

Now it could be a false break. But, as I said, if you really want to bet on Treasury – a lot lower
Treasury yields at this point – you’re making a bet on the equity market. And my suggestion is
you just go and make that bet on the equity market. You’re really betting that that thing is going
to drop hard. So go and buy some puts. Don’t start doing a proxy in the Treasury market,
certainly not at the long end.

Another reason why I’m actually very nervous is Slide 11. I’m sure, if you’re on Twitter or you
read some publications from brokers, you’ll have seen – and this was back when yields were
around 3% on 10-years – a lot of people sent around this chart saying, oh my God, look at the
shorts in the futures market in the Treasury pit. And they were extreme. What no one showed
you was this chart. And this chart tracks positioning of Treasury primary dealers.

Now, these are the guys who get all sorts of benefits for standing up and, if necessary, taking
down auctions and helping to support the Treasuries’ issuance. What I think you can see here
pretty clearly is that, since QT, those positions have risen to historic highs. The holding of the
inventory of those primary dealers is sitting at absolute highs.

Here’s the thing: In the old days, it didn’t used to cost a primary dealer – which is mostly a bank
– any money to hold those Treasuries on the books. Zero risk weighting. They could be netted
down to zero. It cost you nothing.

Since the Global Financial Crisis and all the reforms around Dodd-Frank and the Basel III
legislation, it’s become exceedingly expensive to hold Treasuries on the books. So I can assure
you that primary dealers don’t want to be holding this degree of inventory. This is involuntary
inventory build. And, as any one of you who studies economics will know, that’s bad.

What seems to have happened is, since QT, no one has shown up to replace the Fed’s
purchases. And what it’s left is the primary dealers holding those positions. This is not a bullish
sign for the long end of the market.

Now, this makes it quite complicated. So we’ve got macro, which is arguing for you to
potentially be long Treasuries. But we’ve got structural and inventory issues and technical issues
which suggest that now is not a great time to be long. So the way that we’ve combined it, at
least to our professional accounts, is we’ve suggested that they switch to curve steepeners.

Now, this is basically where you’d look for an out-performance of the short end – in this case,
2-years versus 10-years – so you’d expect two-year yields to outperform on the way down,
relative to 10-year yields.

That can happen in one of two ways. You can get what they call a bull steepener, where you get
2-year yields drop very, very sharply. Let’s say the equity market implodes. That’s what you’d
expect to get as those rate hikes that are priced into the front end of the curve just get priced
out. That gets you bull steepener.

Or you can get a bear steepener. Let’s say that, potentially, inflation breaks out and the Fed
decides not to do anything about it. And the long end, together with its lack of demand, just
gets eviscerated.

Now, that is quite complicated. Particularly the one at the top here, which is a forward
steepener. But I just want you to potentially keep an eye on this. Even if it’s hard for you to
trade, I would watch this. So this is 2-year swaps, 2- 10- swaps, two years forward.

Really, it’s a bit like playing 4-year or 5-year bonds. The reason why it’s interesting is this has
already started to turn up. And if you look below at the cash curve, you’ll see that generally –
and we call it the curve’s canary – generally this swaps curve starts to turn up first. This is
important because, once that curve starts to turn up, you’re already potentially moving into
bear market, and the equity market – a recessionary type economy.

This is definitively a bit of a warning sign. And this is how we, at the moment, have switched our
stance in the Treasury market.

Erik: Julian, before you move on, I see your next slide is labeled Timing. We are recording on
Wednesday, the 28th and, just in the last couple of hours before we recorded this interview, the
big news that everybody is freaking out over – and I stress freaking out – really is a fairly small
piece of news.

Jay Powell changed the word “long way from neutral” to “just below neutral.” That’s the full
extent of the actual news. The reaction to that news seems to be that the entire world has
changed dramatically in an instant. Everything is completely different. Throw out the previous
understanding.

So my first question is: Is the market overreacting just a wee bit here? And, irrespective of that,
I’m guessing that your Timing slide was prepared before this news came out. Does that change
any of what we’re about to get into with respect to timing of these markets?

Julian: The first thing, I think your interpretation is exactly right, Erik. It would appear that
we’ve just moved from night to day and the clouds are lifting and everything is glorious again. I
do think – look, I’ve spent years of mentally parsing the exact nuances of what the central bank
has said. And I think, to a certain extent I think Powell is trying to achieve something that’s very,
very hard to do.

And he’s trying to control and steer a very unstable ship which he inherited courtesy of Janet
Yellen’s excessively easy policies. So he’s had to deal with it.

Remember back in September, we had those comments that you just mentioned – a “long way
from neutral.” I think, in part, that was a reaction to FOMC minutes which the equity market took
as incredibly dovish. Now, if you remember, back then there were people saying, well, that’s it,
you know, deck and then they’re done. And that means we could rally stocks back to new highs.

I think, in part, is what appeared to be very hawkish comment was an attempt to back the
market back to a more realistic stance. Because part of the problem is slowing the economy
down entails not just hiking Fed funds. I mean, they don’t just hike Fed funds in isolation.

They’re trying to achieve a broad tightening of financial conditions within the broader economy.

And that means affecting credit. That means affecting bond markets. That means affecting
equity markets.

So if the equity market just runs all the way straight back – and this is part of the problem that
we’ve had in this tightening cycle, that the equity and credit markets have utterly ignored what
the Fed does. For the first time in modern history, we’ve actually seen the equity markets rally
and credit tighten as the Fed has been hiking. And that’s unprecedented. It really leaves you in a
very difficult situation.

So I think in September he was trying to be overly hawkish. I think this time he was trying to be
a little dovish. I do think they’ll have things that have quite dramatically changed in the last few
weeks. I’ve just highlighted some of the excesses that appear to be unwinding. And they have to
be very, very cognizant of that.

But I do think it’s interesting that you’ve got an equity market that is naturally - to some extent -
has latched onto the most dovish interpretation of his language. Because he said we are just
below the broad estimates.

So what does that mean? Well, I think, firstly it means 2.5 could be the bottom of those broad
estimates. So maybe we’re just going to go in deck, but that would be the most dovish
interpretation of that. Because the broad estimate, when I talk to friends of mine who are still in
that policy space, they would put the broad estimate on the FOMC of where neutral Fed funds
are. It’s probably somewhere between 2.5 and 3.5.

So who’s to say that we stop at 2.5? Maybe we go to 3.5. Maybe we just go to 3. I don’t really
think he’s actually changed much. But I do think he sets us up timing-wise to actually a really
interesting setup.