The refined oil product market is global

The big issue in US energy markets is the high price of diesel fuel, which raises shipping costs. The diesel-gasoline spread in NY Harbor is at a high for the year. Some of this is seasonal. More gasoline is refined during the summer driving season, but the US is a net exporter of diesel, and this has increased with shortages in Europe. What some will think is a local market for a product is actually a global market.

Regardless of crude price, there is no simple switch that can increase diesel fuel without changing the quantity of other products. If firms are allowed to export, the product will move to the location with the greatest demand; so if Russian refined product cannot reach Europe and Arab refining is limited because of the Strait of Hormuz closure, the product will come from the US and affect local prices. 

Partial knowledge versus full knowledge and storytelling

Partial knowledge is more often victorious than full knowledge; it conceives things simpler than they are and therefore makes its opinion easier to grasp and more persuasive. - Nietzsche 

Information overload exists. We don't want too much information because it gets in the way of the facts needed for a good story. Hence, there is an optimal amount of information: discard facts that aren't needed to tell a coherent story; yet if we have too few facts, we may miss what's critical. 

Good decisions always start with: Do I have the right information? Do I have enough information? What will I do with the extra information? Am I being too simplistic? Am I making the problem too complex? 

Back to basics on efficient frontier- it is not stable

 

The efficient frontier should be a well-defined curve when we have uncorrelated or negatively correlated assets such as stocks and bonds for the period 1986-2020. Yet, in the more recent post-pandemic period, it looks almost like a straight line. Investors have less risk as you move away from 100% stocks, but it is at the expense of return. You give up return by giving up risk in a nice, linear fashion. Bonds have not been a good investment, and the spread between stocks and bonds is at an all-time high. One could argue that this is not the time to increase stock exposure, but it is clear that those who followed the simple stock-bond allocation mix would have been disadvantaged.

The textbook trade-offs that we would like to see do not usually exist over short but meaningful time periods.

Saying good-bye to Treasury as a safe asset

Treasuries have been a safe asset, but it’s unclear whether they still are. A safe asset means investors will pay a premium to hold it, so a convenience yield exists between it and the next safest asset. Treasuries will trade at a lower yield than AAA-rated bonds. This convenience yield is time-varying. It will change with the business cycle and market fragility. A crisis or recession will raise convenience yields. Similarly, if safe-asset supply increases relative to demand, the convenience yield will decline. Ultimately, perceptions of safety matter. Treasuries are safe because they are viewed as safe relative to other alternatives. The structure and liquidity of the safe asset affect this perception.

Unfortunately, convenience yields have collapsed and are showing no safety premium. This is consistent with a positive stock-bond correlation. Safety from Treasuries relative to the risky asset is limited, given they are moving in the same direction. This is more than a correlation story, so investors should take note of the fall in convenience yield.

 

So what about bond risk - MOVE index has moved lower

A news report creates market buzz, but it is important to look at the numbers: the MOVE index for bond market volatility is still in a longer-term downtrend and is off the high from earlier in the year. The buyback announcements have caught the bond market's attention, but that has not translated into higher volatility. 

Our second graph shows the percentile level over the last ten years as a time series. We are significantly off the high of the high-inflation period. Rates have increased, but this has not translated into market highs in volatility. 

 

More on Treasury buyback operations

 

hat tip Kevin Coldiron - the ideas lab for graphic 

The Treasury buyback program has received considerable attention, but some key foundational information is missing. The current buyback program has been in place since 2024 and can be broken into two parts: the cash management portion is conducted when seasonal tax receipts come due or when the TGA has excess cash to time debt retirement with cash available, and liquidity support buybacks that are tied to specific bonds to ensure that the Treasuries outstanding have added liquidity. We will see both cash management operations and liquidity support increasing, so there will be a larger active player in the bond market.

The amount of debt does not change. Additional bill issuance is used to retire old, less-liquid coupon debt in equivalent size. Yes, there may be more T-bills outstanding to stabilize trading in less-liquid coupons. It can be viewed as refinancing/composition operations. In some sense, buybacks are like the Operation Twist (2011-12) from the Fed because the supply of bills will increase while supply out the curve will decline.

The Fed has stopped its balance sheet runoff but still buys bills to provide ample reserves. The Treasury will issue more bills, so the Fed will buy some of those bills, which will ensure reserves do not change. In the short run, the Treasury may issue more bills, but it can also issue more on-the-run Treasuries to fund buybacks when it makes regular issuances.

Whether you like it or not, the Fed and Treasury will coordinate more. To some degree, these two will coordinate their actions. 

The heat at Jackson Hole Fed meeting - not innovation but inflation

 

The Jackson Hole economic summit has an agenda set in advance, though it is released at the beginning of the conference. The conference agenda focuses on innovation and features some top-flight speakers. The agenda will be interesting, but the real talks will be in private or in the Q&A between the economists. Several Fed officials have spoken out on inflation; however, the audience will want to hear whether Chairman Warsh will clarify his policy thinking.

We will hear at 10 AM EST today.

The sobering math of the US bond deficit

 

The US deficit-bond math isn't very attractive. The primary deficit is improving strongly toward levels closer to the 2015-2019 period, but we are not seeing the same improvement in the total deficit, which is now persistently below 5%.

The fiscal primary deficit was 2.6% of GDP for FY2025, but the total deficit was 5.8%. We are away from the pandemic-era extreme deficits, but in a perfect world, some of those extremes should be reversed, not just reduced.  

Bond Vigilantes are Global

 

If the bond vigilantes are back, it is not just in the US. Rates in other G7 countries have been rising, and the US is not the only one. Global bond markets are repricing risk, and there seems to be a common concern about government budget deficits. The problem is that government deficits are high and generally getting higher. The exception is Japan. The problem is that deficits continue to rise because interest rates are also rising, so financing costs strongly drag on any improvement in the budget deficit.

One key reason the US wants to lower interest rates amid persistent inflation is that rising financing costs limit room for further spending increases without larger deficits or higher taxes.  

The bond investors are fully aware of the budget math and they want to be compensated for the added financing risk. 

Know your non-linear VIX behavior

 

This simple chart provides the rules of thumb when thinking about the VIX. The VIX and stock index returns aren’t linearly related, but they show clear non-linearities and breakpoints that investors should know. If the VIX is at extremely high levels, you should buy a return to normality. If the VIX is at extreme lows, it is time to cut positions.

One key issue is that the VIX is not normally distributed; it has a high positive skew. It is more likely that the VIX will stay below 20, with only a few large moves that push it above 40, so it is critical to be ready for extremes.

Druckenmiller - Vigilante or truth-sayer?

I have spent five decades trading on a simple premise: Markets aggregate information no committee possesses, and prices are how that information reaches decision-makers. The long-term Treasury yield is the most important price in the world. It is also the only fiscal disciplinarian the U.S. has left. 

Every basis point of artificial yield suppression is a subsidy to procrastination. Suppressed long rates sugarcoat the interest-cost projections, shrink the apparent urgency, and let incumbents assure voters the debt is someone else’s problem. 

Stan Druckenmiller WSJ opinion piece 

Stan Druckenmiller had a few choice words for Treasury Secretary Bessent's changing buyback plan. The objective of the Bessent plan is not just to provide liquidity to the long end of the yield curve, but to try to bend long-term yields back to lower levels through buybacks that support bond prices. This is an attempt to stop the flood with a bucket. The fundamental problem is the size of government debt, and there is no solution. 

The first quote is spoken like any true trend-followers: market prices aggregate and disseminate information. This is foundational to any market signaling, 

The second quote focuses on the problem: the government just wants to lower the cost of the problem.

Treasury buybacks - what does it mean?

 

Treasury Secretary Bessent announced a Treasury buyback program, an increase in an existing program, amid much market discussion about its objectives and what it means. Investors should note that this does not change the size of the deficit or the Treasuries outstanding. It may change the debt’s composition and will affect the spread between on-the-run and off-the-run bonds. For the Treasury market to function well, off-the-run bonds need strong liquidity, and this should be the main focus of this program.

We are concerned with the plumbing of the Treasury market. Primary dealer capital is constrained under current bank regulation, so dealer capital is out of balance relative to trading and outstanding debt. Dealers must maintain high leverage, and if capital is insufficient, their ability to maintain orderly markets is compromised. 

The unstated and overlooked issue is the potential problems in the plumbing of the Treasury market. Actions are being taken to constrain the potential for a liquidity crisis. The chief bond salesman - the Treasury secretary - is not going to talk about this issue.

Treasury buybacks - A history

The Treasury announced an increase in its Treasury buyback program from $2 to $4 billion per operation. This is not the first time buybacks have been used to support the Treasury market, yet this action suggests plumbing problems in the Treasury market. Past buybacks have focused on ensuring more Treasury market liquidity. We expect the same for this program, but it also means the Treasury will be an active liquidity provider in the Treasury market. 

Short-term trend trading and liquidity - stay away from small tick contracts

 

The paper, “Is Trend Still Your Friend: A microstructural account of the demise of short-term trend-following”, is important research on why trend-following may not work over short horizons. While trend-following seems to span time, there are exceptions. Since 2009, there has been no profit to be had from short-term trend trading. This paper documents the break in short-term trend trading and finds a reasonable explanation. 

The paper tests four different explanations: 1. capacity constraints, 2. market electrification, 3. a change in CTA order flow interactions, and 4. microstructural changes. The authors find that the first three cannot explain the differences, but the volatility-normalized tick size can explain the change in profits. The trend profits fell on small-tick contracts but remain intact for large-tick contracts. Trend signals trigger directional trades. The market impact of these trades reinforces price movement. This feedback loop requires aggressive execution at reasonable costs, but it also causes market makers to withdraw from the trend, especially for small-tick contracts. Trend-following becomes unprofitable. Stick with the large ticks if you want to trade short-term. 

Japan and the big carry trade

 

The yen carry trade has existed for decades. Borrow in cheap Japanese funding markets, sell yen, and then buy the currency of a high-yielding market in some other currency. Of course, hedging and risk management add layers, but the overall strategy is straightforward. Everything works until it does not, because of two things: 1) rates in Japan increase relative to the rest of the world, the yield spread falls; and 2) the yen appreciates, which can wipe out the gains from the spread differential. Now the Bank of Japan is raising rates, and the Finance Ministry is intervening in the yen markets to stop the currency slide. The net effect. is that less money will flow into foreign-yielding markets versus Japan. This will mean global rates will adjust higher.

Global bond markets are changing, and old sources of funding will no longer be available to borrowers. We can expect higher equilibrium real rates. We cannot say what the new rates will be, but the old environment is not working. 

Hedge funds and Treasuries - An unholy alliance

 

This may seem obvious, but hedge funds dominate a significant portion of Treasury trading. Their exposure exceeds that of mutual funds, and their behavior strongly affects market direction. These are not the same bond vigilantes of long ago, but a breed of arbitrageurs and directional traders ready to go long or short based on small market deviations. They are both liquidity takers and makers. Their turnover is significant, and they use substantial financing.

You have to ask: what happens if they change their strategies, or if losses elsewhere in their portfolio lead to deleveraging? Treasury prices are unlikely to rise, and liquidity will decline. Regulators have little to do. Do you want hedge funds to leave the market? Data from Decomposing Hedge Funds’ U.S. Treasury Exposures.

Big losses - big mistakes in finance from leverage

 

There are some common themes when it comes to large losses in finance - leverage kills. We cannot say that it is always the case, but a review of the biggest trading losses seems linked to excess leverage. Too much risk with a surprise event, and you have a recipe for losses. This will happen with funds and financials, and if we dig into corporate losses, we will find a link to leverage. What is surprising is that we haven’t had more large losses, given the spike in rates after the long period of low rates. 

We need risk management to protect ourselves from our leveraged behavior. 

Fed balance sheet - More work to do

The issue that has been important to Fed Chairman Warsh has been the Fed balance sheet. There still isn't enough focus on the dynamics of changes in the balance sheet, inflation, and credit. Total Fed assets are still more than 6 times higher than before the Great Financial Crisis, which was well over 15 years ago. Now, Fed regulatory rules have changed, so the total assets may be much higher for a normal state, but what is the proper number is still. not clear. We do know that over $8 trillion is too high, and more than 25% of GDP is also too high; yet, given inflation is still above target, we should see the balance sheet reduced further. The RMP program is going to zero, which will take out the small blip in 2026, but there is more work. Mortgages will roll off slowly given the low prepayment rates, but that is only a small portion, and the Fed is currently buying bills with the cash flow. There is reluctance to sell Treasuries given the Treasury's strong financing needs. 

To solve the inflation issue, the Fed will need to further reduce its balance sheet.  

 

Peter Lynch on stop-loss

Selling your winners and holding your losers is like cutting the flowers and watering the weeds - Peter Lynch 

Peter Lynch was not a quant or a trend-follower, so it may seem odd that he is talking about trend-following fundamentals, yet the premise of Lynch's argument is clear even for fundamental investors. Hold your good companies and get rid of the bad ones. This does not always have to be based on price. It may just be related to the underlying firm characteristics. However, the thought is always the same. Rid yourself quickly of those weeds and tend to your flowers.

The types of trend-following systems - choose what fits

 

A recent paper tries to develop a unified theory of trend-following by classifying trend-following into three groups; see “The science and practice of trend-following systems”. 

The authors break trend-following into three types: European, American, and Time Series Momentum. 

European trend-following is based on continuous weights using an EWMA filter. In this system, position sizes are proportional to the signal strength, with the number of contracts changing day to day.

American trend-following uses channel or breakout systems with binary position sizes, so exposure is fully allocated when a signal is on. 

Time series momentum is based on the momentum of returns adjusted for volatility. 

There are parameter specifications that will deliver similar risk-adjusted returns close to the SG trend index. 

All of these trend-following systems are strongly correlated, yet there are differences in position-taking and signaling. The success of trend-following is based on the serial dependence of the underlying price series. Differences in performance will be related to differences in short- and long-term variance, and signals are related to an autocorrelation and drift term. Profits are related to an autocorrelation term even if drift is zero. 

A benign inflation number - now what?

Inflation numbers were within expectations, yet this is not something to celebrate. Core inflation is still above the 2% target, and headline inflation is still above 3%. Has the Fed been successful with its policy? The answer is no. However, the current inflation numbers suggest that no action will be taken at the September FOMC meeting. Policy changes are unlikely before an election, and that will take us to the end of the year to see any policy rate change. 

The important monetary policy information will come from the Jackson Hole conference and any headway from the five task forces reviewing policy. Chairman Warsh, if current behavior is a guide, is unlikely to tip his hand about policy at the Kansas City Fed confab, so the market will have to make decisions for itself on the direction of rates.

TIPS yields continue to move higher

 

It is not just nominal yields that are moving higher. Real yields have also been on a steep ascent, with levels at the highest in ten years. In fact, to get to these real yields, investors will have to look at data prior to the GFC. We are in a strong situation where real yields are telling investors that we have tight monetary conditions, yet inflation and nominal yields suggest that concerns about inflation are real. This places the Fed in a difficult policy environment and clearly is a reason for FOMC voting disagreement. 

Yen intervention can buy time not a solution

Always bet against intervention if there is no change in policy. Now, this does not mean you should fight a central bank in the short-term. It does mean that intervention has to continue if it is to work. Central banks are much savvier with their intervention. It will occur when there is limited liquidity. It may come through markets not expected, like EUR/JPY instead of USD/JPY. It will be followed by rhetoric to reinforce resolve. It will occur through selected banks to ensure not all are harmed. 

It can buy time but it cannot buy a solution.

AI investment follows other boom and bust cycles

Booms or bubbles are often associated with excessive investments. The euphoria associated with a new technology or meme leads to significant money flows. But there is a marginal return on the capital that falls as more investment dollars flow into the theme. The excess investment leads to a large capital stock in the new technology that may have significant positives for an economy, yet that does not make it a good investment, especially for those that come late to the investment cycle. Is new money late to the cycle? There is not a definitive answer, yet it is clear that all of the capital chasing returns will not be rewarded and likely will be a bust. 

Canals, railroads, new tech in the 20s, and the dotcom boom all saw significant capital investment, yet for many the rewards were limited.

 

Consumer sentiment not supporting market sentiment

 

University of Michigan Consumer Sentiment is now at the lowest level in 40 years. I could go back further. It is the lowest level ever recorded, as listed in the FRED database. Worse than the Volcker recession and the double-digit recession. Sentiment has fallen since the pandemic. The consumer confidence survey data, which goes back even further to 1959, shows the same pattern. There is a confidence problem in the US. 

The Conference Board numbers are better, yet the overall direction is the same. So, even if you choose the best survey, there is still a problem. This will carry over to economic behavior, yet it is not clear when or how, but the general trend is negative. Who or what is going to provide a jolt to sentiment? It does not seem to be on the horizon, and because of that, it is hard to see strong economic growth over the next year.

Yen intervention will not change fundamentals

 

The coordinated Yen intervention continues as we see the currency has continued to improve. Short-term intervention can reduce volatility, but this is not a volatility problem. This is a policy problem, and nothing has changed in policy. The Bank of Japan has moved its target rate to 1% and has provided forward guidance that it expects rates will continue to move higher. If this is the policy, then the yen carry trade will be reversed, and there will be further upward pressure on US Treasury rates.

The expectation is that short-term intervention will stop the yen slide and reduce pressure on global rates, but that is not how markets work in the longer run. There is no change in BOJ policy, no change in Fed policy, and no change in global imbalances. Hence, the markets will readjust their positions and currency rates will have to adjust. The process can be slowed but not reversed. 

What makes me worry about the markets - August 2026

 

The markets are connected, and the message is not good:

1. The Korean tech bubble is bursting, and some return to normality; however, it is not done yet. US retail investors are net sellers. We just saw a US fund blow-up with Situational Awareness. It is a one-off, but investors need to realize that investor euphoria led to the excessive money flows.  

2. Coordinated intervention in the yen market to stop a massive currency slide. Japan rates moving higher, so global fixed income is being reset. 

3. Long-term Treasuries at levels not seen since 2007. Real rates continue to move higher. Housing market declines will continue given high mortgage rates. Cost of borrowing for all AI projects is going higher. 

4. Consumer sentiment continues to move lower. 

5. Continued war in Ukraine and the Middle East, which impacts the oil market. Oil inventories are reaching low levels.