The Mechanics of Deleveragings - And Where the Current One Fits In | Andy Constan

Episode Summary

Executive Summary: Andy Constan argued the recent market drop was a classic deleveraging, not a mysterious one-off, driven by falling asset prices, leverage, and positioning rather than just the yen carry trade. He said the economy is slowing, inflation may not be dead, and markets are pricing too much recession and too many Fed cuts. He favors being short stocks and short 2-year Treasuries.

Main Topics: Market Selloff as Deleveraging (Priority: 5/5): Constan framed the recent decline as a broad, classic deleveraging event caused by leverage in the system and falling asset prices, not a single catalyst. Yen Carry Trade and Its Role (Priority: 4/5): He explained how yen-funded carry trades work and why they can amplify unwinds, but argued the Japanese carry trade was not the main driver of Monday’s move. VIX Spike and Market Liquidity (Priority: 4/5): Constan said the VIX move above 60 was largely a calculation artifact from bad option pricing, while stressing that real liquidity is always poor when everyone rushes for the exit. Economic Slowdown and Fed Outlook (Priority: 5/5): He said incoming data point to weaker growth and a likely landing of some kind, with the market pricing a recession and many Fed cuts, possibly too aggressively. Inflation “Script” and Policy Transmission (Priority: 5/5): Constan revisited his framework that inflation is killed by tighter financial conditions and falling asset prices, but said the process was interrupted by policy pivots. Long-Term Inflation Drivers and AI (Priority: 3/5): He discussed supply, demand, and monetary sources of inflation, noting AI could be disinflationary over time but is inflationary today through capital spending and wages. Historical Analogs and 1998 Comparison (Priority: 3/5): He used 1998 to illustrate how history can build frameworks, but warned against overrelying on analogs as predictive tools.

Key Arguments: The recent selloff looks like a broad deleveraging because multiple indicators moved together: risky assets fell, short-term rates rose, the yen strengthened, volatility rose, and credit spreads widened. Leverage usually unwinds when asset prices fall and lenders demand more collateral; rate hikes alone are typically too slow to force an immediate unwind. The yen carry trade matters as an amplifier, but the larger issue is leveraged positioning across assets and investors, not just speculative yen borrowing. The VIX spike above 60 was not a clean market signal because it was driven by a mispriced option in a non-tradable calculation; VIX futures were more informative and did not show an equivalent spike. True liquidity risk is not everyday retail trading costs; the real problem is being forced to sell into stress when large players are all trying to exit simultaneously. The economy appears to be weakening, but the bond market may be overpricing recession and Fed easing while equities still imply a soft landing. Inflation may not be fully defeated; if it reaccelerates, that would pressure bonds and support a tighter-for-longer view. The Fed should pay more attention to long-term rates and might use balance-sheet operations or a “twist” to influence the curve without cutting reserves. History is useful for constructing frameworks, not for assuming exact repetition; 1998 looks different from today because current stress is broader and less concentrated. AI is potentially disinflationary over time, but near-term it is causing inflationary capex and wage spending without yet delivering broad productivity gains.

Data Points: Central bank response after COVID: 120 days - Constan said markets fell for about a month in 2020 and returned to all-time highs about 120 days later because of the strong policy response. BTFP outstanding: $106 billion - He referenced the Fed’s Bank Term Funding Program as still outstanding from the SVB episode. Japanese overseas portfolio value: $3.5 trillion - He cited Japanese holdings of rest-of-world assets as a large structural source of cross-border investment and lending. Market cut pricing: 50% chance of a 50 bps cut in September - He described market expectations after weak labor data. 2024 Fed cuts priced by market: 125 basis points - He said markets were pricing substantially more easing than the Fed had projected in June. Fed June projection: 1 cut - He contrasted market pricing with the Fed’s data-based view from June. 10-year Treasury yield: below 4% - He noted the 10-year had fallen back below 4% after being near 5% in the fall. 10-year Treasury yield in late fall: 5% - He said 10-year yields had reached 5% around Halloween before rallying. Mortgage rate threshold: below 6% - He said some mortgage rates had broken below 6%, which could support housing activity. Policy cuts in 1987 and LTCM crisis: 75 basis points total - He used these episodes to argue that even major market events sometimes brought only limited Fed easing. Typical yen carry change example: 10 bps to 25 bps - He illustrated how small floating-rate increases are often too slow to force carry trade unwinds. Collateral example: 100 cents on the dollar to 70 cents margin - He used a leverage/margin illustration to explain how falling asset prices trigger margin calls.

Pivotal Quotes: "Monday was just an outcome of what had been set up." — Andy Constan: He used this to frame the selloff as the result of pre-existing leverage and positioning rather than a single shock. "There never is [enough liquidity] when everyone wants to go out the door." — Andy Constan: He answered concerns about market liquidity during stress and argued that exits become difficult whenever everyone tries to sell at once. "The market has headed to recession island." — Andy Constan: He described the shift in market pricing toward recession and aggressive Fed easing.

Implications: Investors should focus less on headlines and more on leverage, positioning, and policy response. Constan sees better risk/reward in being short stocks and 2-year notes, while warning that inflation may not be finished and markets may be overpricing a soft landing.