It’s easy for me to sit back and take pot shots at the hedge fund gurus calling for a repeat of the 2008 crash. Spouting words about markets never repeating the previous crisis is kind of cheap. If I am so sure history won’t repeat, why don’t I offer an alternative theory?
Well, at the risk of embarrassing myself, here it goes.
The biggest risk out there is not credit. It is not the monster short VIX speculative position. It is not CDX leverage.
The true DANGER AHEAD lies in the universal belief that treasuries (and other sovereign fixed income) offer a perfect hedge versus risk assets.
The other day I was listening to an interview with an insightful, smart, engaging value stock manager. He went through his stock selection process, named a few down and out value plays, and in the final moments of the interview, said something that nearly caused me to spit out my coffee. I am paraphrasing here, but the gist of his argument was that the only “free arbitrage” left in the markets was the near perfect negative correlation that US treasuries offered against a portfolio of risk assets. Buying a low yielding, highly leveraged sovereign bond is usually the anathema of value investors. And I don’t mean to pick on this manager as he is by no means alone. This belief is almost universally heralded as sacred.
And it’s easy to see why. Adding US treasuries to a portfolio has been an astounding diversifier, with zero cost as long-run volatility adjusted returns have been nothing short of incredible over the past couple of decades.
Here is the chart of the 10-year US t-note future continuously rolled. This chart represents the total return earned by going long 10-year note futures and diligently rolling them each quarter.
Talk ‘bout a bull market. No wonder guys like Alex Gurevich advocate going long fixed income and just continually earning the carry. The trade has been a stunner. Try to find a serious drawdown. It’s virtually impossible.
And here is the best part of the returns of this asset class. Not only is it a great risk adjusted long on its own, but since 1997 it has largely been negatively correlated to equities.
Risk parity managers like Ray Dalio made fortunes levering up bonds and adding them to a portfolio of risk assets, riding the wave higher in both equities and bonds, while enjoying less volatile returns through the diversification of two negatively correlated assets (see “Axe would hate risk parity”). And I am not dissing this trade. It’s been genius. But I wonder if Ray Dalio’s retirement was equally smart. Could he have timed it perfectly? Did he retire like Michael Jordon after sinking the jump shot in the dying seconds to win the series?