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- [00:00]
A
On this episode of Full Signal, I sat down with Michael Gyad of the Lead Lag Report and we talked about the Japanese carry trade, why it's the biggest risk, that no one is talking about, how investors can position their portfolios for it and what this ties into with the AI trade, small caps, large caps and much more. This is a fantastic conversation. Michael raises some excellent points that no one has brought up on this show before. I think you're going to love it. Michael, it is so good to see you. And the first thing we have to get into. You've been pounding the table on Japan carry trade for several years now. You were early on it and you've talked about it more than most people I know. Walk us through what's going on here.
- [00:40]
B
I've been obnoxious about it is what you're trying to say. It's like an Egyptian talking about Japan. Who would have thought so? So let me take a step back. So in 2023, after I argued the market had bottomed in towards the end of 2022, I argued that you'd have a melt up in equities, but that towards the tail end of the year you would have a credit event which a lot of people associate that term credit event also to me because I was very adamant about that in media and social media when you talk about credit event, my reasoning for that was we just went through the fastest rate hike cycle in history and I didn't believe that you go through the fastest rate hike cycle in history smoothly, that it would because of lags, there would be some kind of tail. Eventually the question then becomes, well, what's the catalyst? I was thinking about it and it dawned on me that Japan probably is going to be the catalyst for some kind of disruption in markets. If my thesis that towards the end of 2023 a credit event were to take place, Japan would be the reason. Now the carry trade is something that's been out there for a very long time, but it's not really, I think, fully understood by people, which in many ways convinced me that it probably would take place. Because if something is hard to understand, it probably means money is not prepared for it. So there's an aspect of sort of, I think a catalyst almost needs complexity in its narrative for it to play out. So I had this thesis that there would be a credit event, that Japan would be the catalyst. And I said repeatedly since then that number of things. I said, Japan will panic and we'll talk about what I mean by that. I said repeatedly that it's only a matter of time until the yen does surge and that the real catalyst for a disruption would be oil. Why? Because Japan imports all of its oil. Oil is denominated in dollars. If the yen weakens and the oil strengthens, that makes oil priced in yen even more expensive, which then means they have to save the yen, which then reverses all the leverage that has come out from Japan. And that causes a cascading margin call effectively. Now you saw glimpses of that August 3rd, August 5th in 2024 on X. I organically on my lead lag report handle had 15 million impressions that one day when the markets collapsed. I remember I was doing a space with Weston Nakamura across the spread who's in Japan and has also been talking about this and we had like 30,000 people paying attention, right. So but only lasted two days. And then on that Monday I said markets would bottom and you know, they rally back. But I still think that the risk is very real, that there is some kind of tail event out there that Japan is going to be the source of. I tell people all the time I'm not bearish on stocks. I'm just bullish on a tail event. I think there is a dislocation coming. I think it's going to last longer than two days.
- [03:27]
A
The dislocation will come out of Japan, right?
- [03:30]
B
Because no country has enabled leverage more than Japan has. Japan has had zero to negative rates for the longest time. They have the last to raise rates post Covid and had the most debt in the system. So effectively what's happened for a number of years, decades, is money, rather than borrowing at US rates, money goes or investors or borrowers go to Japan at zero to negative rates, they take that money, they convert it to yen, they convert them back to their currency and they deploy that leverage elsewhere. People forget that money can be deployed any which way, but also can be borrowed any which way from anywhere. So if you really want cheap capital, you go to Japan. Okay? Now if you're borrowing money from Japan, you're borrowing it in their currency. The yen drops. That means that whatever you borrowed from Japan as the yen is dropping. You're actually when you need to repay it, paying back less because you're doing it from your stronger currency. So you as the borrower love a week yen. It makes the payback actually less on the currency conversion. The opposite also holds true if the yen appreciates now that debt load is actually higher because you need more of your currency to pay it off because your currency is weak relative to the yen. Right. So you need to have the yen strengthen aggressively to cause that panic of, oh my God, this leverage that I took from Japan is now so much more expensive. I got to pay it back. Well, how do I pay it back? I got to sell that borrowed money that I put into Nvidia, that I put into Treasuries, that I put into all these other parts of the marketplace. With that borrowed money, I got to sell that collateral to pay back the loan. Well, then what happens to the prices of all that collateral? That's the, that's the cascading margin call.
- [05:18]
A
So just so I understand, when we saw this in August 24, it was something like a flash crash. And it emerged as a very good dip buying opportunity. And I think that was, you know, led by retail, mostly. Retail has been right on a lot of things for the last few years. But is the next time this happens, could we point to that and just say, look, it'll be another flash crash by the dip.
- [05:42]
B
Maybe again, I go back to, it's ultimately going to be about oil. Because if oil continues to advance and spike, Japan then has to try to save the yen, which goes back to my Japan will panic. So the catalyst to all this is not about the yen, it's oil price in yen. Because Japan cannot control the price of oil. It can control the, the price of their currency. How do they do that? Well, they hold Treasuries. Okay, so the thesis always went that if oil priced in yen was spiking, then in response to that spiking oil price again, they strengthened the yen. To strengthen the yen, they have to sell dollars to buy yen. Okay, so how do they do that? They sell Treasuries. Now, if they sell Treasuries, what happens to our yields? They now rise precipitously because now you've got supply coming from Japan to try to counter the yen weakness, to try to counter oil price and yen from spiking.
- [06:39]
A
Right.
- [06:40]
B
I know it sounds complicated, which goes back to why I think it almost has to play out as that's the reason for the tail end. Because it is complicated.
- [06:46]
A
Right.
- [06:47]
B
But could it be a buy the dip opportunity? Yes. I do believe that the carry trade reversal of the carry trademark, it's probably going to come in pulses, meaning it's not just a one and done event, because every time it happens, there's going to be some intervention. And that you can argue is what partially happened also August 5th of 2024.
- [07:08]
A
So the carry trade, or let's say the risk of a carry trade, arguably is backstopped. Is that the right way to think about it?
- [07:16]
B
I think that policymakers are very creative at preventing creative destruction, so they will find a way. I think it was, what, two weeks ago, the Fed. I think it was the Fed or the Treasury. It basically said they're intervening in some way, shape or form with the yen. So the US is actually intervening on behalf of Japan because they're worried about Japan selling their Treasuries. Everything's interconnected. You're going to have a lot of these fits and starts. Again, it's not one of those things where it's like I'm arguing for a cataclysmic end of the world scenario, but it's a scenario, right? And then the question becomes, how do you position for it? And that's a whole different topic.
- [07:52]
A
Well, how should invest? Let's say, if you're a US investor, independent or retail investor, is there even a way to hedge against something like this?
- [08:01]
B
So hedge is the interesting word because it assumes that correlations stay constant. Treasuries used to be a hedge. I still think they're going to be a hedge. I keep saying on X, Treasuries will stand alone and I've been wrong for the last two years on that because gold has replaced Treasuries for a moment in time as a safe haven. But treasury is no longer hedged because the correlation with equities is so high. I'm biased in wanting to see Treasuries as a hedge because I have two funds, a mutual fund, ATACX, JoJo, my bond ETF, that are designed to play Treasuries as the risk off option. The last few years have been brutal, just from a cycle perspective. The challenge with the hedge is that it bleeds. When you think about options hedging, it bleeds so you're losing money. It's like you're paying for insurance. So you don't want to create a strategy which bleeds. If you're trying to, in quotes hedge, you ultimately still want to be able to participate in some movement but not have the convexity, the extreme movement which requires a bleeding option strategy to really kill it. I think if you're going to position for a reverse carry trade, it's an asset allocation question. Oil will be the play because again, that's a catalyst. Treasuries would be a play. Yes, Japan would sell Treasuries, but at some point the flight to safety goes back into Treasuries, meaning yields would spike and then come back in. I think under that scenario because credit spreads would widen, gold would be part of that. And then of course, long the yen and maybe some individual stocks along the way, or maybe some crypto. You know, I've talked about XRP as maybe a beneficiary of a reverse carry trade. I will say that on a side note, I think what's happening right now in the crypto space is a canary. I think I always go back to this point that every crash is preceded by leverage and there is still a lot of leverage in the crypto space. And the fact that you're seeing a questioning of Bitcoin as a store of value narrative, the fact that you're seeing a lot of these people that were very bullish on crypto now suddenly changing the tune, I just worry that you have another tail event also from the crypto side that could spill over into equities.
- [10:09]
A
That's interesting. There's definitely been a pretty, I would say for me, a surprising fall off in the crypto market to start the year. Just to follow up on the Japan trade. Oil has been going down largely for the last year since President Trump came into office. Is that a trend you see switching this year and therefore catalyzing some risks in Japan?
- [10:37]
B
I think it depends on war. It's like Iran is obviously the big thing. And admittedly it's true that the oil decline and the tremendous amount of supply that's coming from the US you can argue has delayed that scenario. And that's something I myself admittedly missed. I go back to that was the catalyst, but so I thought it would happen sooner. But oil has got the secular supply glut, then it's hard for that to be a catalyst unless you do have some kind of geopolitical dynamic, right? So if you were to have some kind of super spike in oil, that's a deflationary event, right? Because it's not about the level of oil that makes inflationary, it's the speed of it, which again I think would unwind a bunch of dynamics in terms of leverage. But you need to have a catalyst for that too.
- [11:27]
A
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- [12:39]
B
In some ways, yes. I think that's a good way to summarize it. Right. Exactly right. What benefits from an oil spike?
- [12:44]
A
Wow. See, this is something I don't see a lot of people talking about. I almost never see anyone talking about. Here's what to do in your portfolio against rising crude. That's not a headline, it's not a conversation.
- [12:57]
B
Because it's a foregone conclusion that crude is going to stay low, which again, makes sense. And the odds favor it. Sure. But on the off chance that that low probability event in the small sample plays out, you might want to have some protection against them.
- [13:13]
A
Is there anything that would make you optimistic on suddenly, okay, maybe this won't happen. Maybe I've been, you know, the macro in some way has changed. This tail risk is no longer on my radar.
- [13:28]
B
If the inflationary pressure drops in Japan and they actually take on some fiscal discipline, then yes, good luck with that. We're now seeing that they're talking about fighting inflation with more spending, which increases yields even more, which makes the yen even weaker, which makes it even more inflationary. It's like, I keep joking. It's like, I got to go to Japan and talk to the boj. I mean, it's like clearly they're not seeing this sort of issue, which is that they let inflation get out of control because they were so stuck on deflation for so long. And I don't know if people really understand this. It's like during the regional bank crisis in 2023, that momentary blip, why did a lot of these regional banks have trouble? Because their underlying collateral is the safe collateral that they're lending against its Treasuries. After the fastest rate hike cycle in history. Okay, fastest rate hike cycle in history means the collateral drops in value. Here we are with Japan having all this debt. You're going to tell me that Japan's solvent, that the collateral that the banks are using, which is JGBs, that that hasn't collapsed in value. Just because you don't see it doesn't mean it's not there.
- [14:39]
A
Wait, explain this a bit more. You mean, are you suggesting Japan's insolvent?
- [14:44]
B
Yeah, of course. How could it not be? With the sheer amount of debt they have and the fact that yields have to keep on rising to fight inflation, which again makes the collateral value of those bonds, the value of those bonds drop. And again, that is what is the safe collateral that they're lending against the banks. It's like, of course that's the case. Now I will say that people say, okay, you say all this, Michael, but Japan's equity markets have been on fire. It's like they must be aware that this is a dynamic. But Japan's equity markets have been on fire. They've been on fire for a different reason, which is that there's been a lot of reform on the corporate side that's been in the works for pretty much a decade. A lot of deregulation, a lot of things which have made Japanese equities in general more investor friendly for stock investors. So there's a distinction that has to be made between short term tail risks, this dynamic, this condition, and then longer term structural dynamics. The deregulation part of Japan has been a big driver of the equity bull market in Japanese stocks. I think that by the way, when it comes to the US is also a big driver of our US Stock market. Deregulation is unequivocally a major driver of profit margins of speed to market. I have a fund that's designed to play deregulation fmkt, the free markets etf. But again, I'm not bearish on stocks. I'm just bullish on this tail event. I don't know when it's gonna happen. I did not know August 3rd, August 5th was gonna take place then. Of course not, how could I? But it's like, I don't know. I don't need to know the mile marker that my car might crash. I just need to slow down and prepare for it. I don't need to know exactly when something happens. I just need to have the be prepared for it just in case it happens tomorrow.
- [16:16]
A
That's a great analogy. I really like that. The Japanese stock market, I checked right before this 40% in the last 12 months. It's pretty insane. Is the risk of the carry trade, would that also have spillover effects in the Japanese market? And let's Say other international markets as well.
- [16:37]
B
Everything correlates to one in a tail vent. Except historically treasuries, which I go back to sort of a flight to safety dynamic. Now you can argue that maybe in that scenario gold benefits. It does not correlate to one. I'm not as convinced about that because I think this late in the trend, gold is not a safe haven trade, it's a momentum trade. And the price action we just saw last week I think confirms that the momentum crash that we saw. But yeah, in the same way that Japan's equities were down 10%, it was like 1987 move in Japan. It's like this is the fourth largest economy in the world. I mean, you can't argue that what's happening to Japan doesn't have impacts on global markets because again, everything's interconnected and leverage has a funny way of unwinding all at once.
- [17:24]
A
Well, you've obviously thought about this a great deal and I appreciate the nuance and how you're explaining it because myself, I'm definitely not a carry trade expert by any means, but I feel a lot smarter than a few minutes ago. So let, let me ask you about the AI trade here. We've had an unbelievable run last couple years. We're starting to see quite a divergence in let's say, hardware versus software. How are you thinking about this as we get into this new year?
- [17:55]
B
I put a post out on X the other day. I said AI went from the reason for the bull market to the reason for a bear market. So from bull to bear. Why? Because exactly to your point, what's happening with the software side is now letting investors or making investors realize AI is really going to replace whole industries. Unemployment is going to rise. I just saw this morning Washington Post is going to lay off a bunch of people. I'm sure it's because of AI. So it's bullish until it's not. Until it's the reason for companies no longer being around or people being laid off. Now for a number of years I've said or last two years also I've kept on saying small caps hold the key. Okay, so. And again, I'm very obnoxious on X. I'm very repetitive. I do it purposely. It's an act because the algorithm likes it. Right? It's like you can't argue with the success of the reach, at least. When I say small caps hold the key, what am I referring to? It's the idea that if AI is real and if it's really Going to be this tremendous boom for the economy. It should benefit small cap companies. Why? They're the users that get the productivity gains from all this AI tools that are out there. And yet the Ross 2000, it's still stuck. Everyone's talking about this rotation into small caps. Yeah, there's been some relative strength, but it's not really sticking. Still, it's like another false positive where small cap momentum looks like it's going to go and it doesn't. Yet fundamentally, if you're bullish on AI, you have to be bullish on small caps because smallcasts have been held back by financing costs, higher cost of capital, they have very leveraged. Okay, fine, but if AI makes these companies more productive, their margins should increase. They should be able to deal with at higher cost of capital, which means these zombie companies are no longer zombie companies. They might actually have a chance to survive. It's like a distressed asset that suddenly people realize it's no longer distressed. So how can you be bullish on AI and then not be bullish on small caps? So I keep saying small caps hold the key. So if small caps are still not able to get out of their own way and you still have all this AI integration, is AI really bullish or is there something else going on that people are not seeing in terms of the implication of what AI is doing to the system? And I think that's where it becomes the narrative flip.
- [20:13]
A
On a anecdotal basis, I hear what you're saying. I see massive productivity gains in my own life when I use these tools. A lot of my friends say the same thing. I know a lot of business owners, they've said the same thing. Does it seem like, like in the way you're laying it out, is it possible we're just not there yet where these productivity gains aren't showing up in the small caps? But maybe, you know, who knows where, six months away or three months, you know, whatever it might be.
- [20:41]
B
So I think this is, this has been nothing I've brought up and I do believe this deeply. The human mind is very bad at estimating time. It's like think about any construction project, it's always going to cost twice as much and take twice as long to get done. AI, I think the assumption is everyone assumes it's all going to suddenly, magically, tomorrow, just be integrated everywhere. But to your point, it takes longer. And because investment dollars are based on time frame, time value of money, I would argue that under that exact scenario, small caps are saying AI is going to take longer to benefit them. But then shouldn't that be a constant towards large caps? That all these expectations around these mega cap companies that are driving the AI push and all the hyperscalers and all the data centers, wouldn't that also then mean that that's going to take longer than people think to really play out? You can't have two different time frames for the integration of AI between small caps and large caps. Right. So which I think is an important nuance which would argue that large caps are overvalued relative to small caps. If small caps have the time frame aspect of AI integration. Correct. Right, again, nuanced. But I think it's, I think it's just going to take longer than people think and it's going to be much more complicated than people think there. It's going to be societal pushback, like it's going to take. It's not going to be a smooth road.
- [22:08]
A
I do think the social fabric question, that's going to be a big red flag, big problem. And even if Wall Street's convinced they have to spend a trillion dollars on this thing, you will start seeing probably something like protests, social unrest, distrust. That's going to have big ripple effects in the financial world.
- [22:29]
B
I would argue that if you want to win the midterms as a candidate, all you have to do is be anti AI.
- [22:35]
A
I'll explain that a little more.
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B
Well, because to your point, it's like you're going to see more headlines of unemployment, you're going to have more people being nervous about being replaced. There was this movement of the Luddites back centuries ago.
- [22:48]
A
Right?
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B
It's the anti tech movement back then. You're going to have that pushback. And I'd even argue that in an
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A
odd way,
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B
the political winds shifting towards more socialist aspects is a push towards more government to protect us from AI. Because government's got to pay us, got to give us ubi. If AI is going to replace my job, I need to get an income. It's like glitch is socialist socialism in practice. Right. So to your point, I think there's so many interesting butterfly effects that happen because of AI on the social fabric side that again would argue that this is going to take longer than people think. Which again goes back to has the time frame that large caps have discounted. Is that too short? If it is too short, then there should be a correction for that.
- [23:38]
A
Real quick, we'll get right back to the interview. Just wanted to pop in and say if you like this content, I read a Newsletter every single morning called Opening Bell Daily. I cover macro, the stock market, asset prices, why things are going up, why they're going down. And if you want to get that for free, you can sign up at the link in the description. Let's get back to the interview. Do you think that there's a risk of, let's say all these hyperscalers spending, you know, $500 billion this year? Like how, how do you see that number?
- [24:10]
B
So I have this other theory, I've got a lot of theories. I've also said, I say, I say things repeatedly because I believe in them. I've said that private credit is this cycle subprime. Okay, so let me unpack that in the context of the question. I do believe there's evidence that suggests that because there's been such a demand pull on the AI side that a lot of private capital has gone towards anything that says AI. Just like we saw a few years ago or year or two ago, anything that had blockchain, all the money went into blockchain private companies. Right? Okay, so all this private capital, let's say, has been favoring AI type companies. Okay, so what does that mean for all the other companies are not AI that are in the private credit space that need to roll over their debt. There's less liquidity, less funding because those dollars have been allocated towards the next hot thing, AI. Okay, if that's the case, given the sheer size of the private credit space, that would suggest that you're going to have some blow ups which by the way, you're starting to see in the private credit space. You can see that in some of the BDCs, you can see that some of these headlines. There's a lot of interesting dislocations that are happening on the private credit side, I think because these companies are star for capital that AI is taking from them. Right. So again I go back to I'm not bearish on stocks, I'm bullish on a tail event. Japan is one, private credit's another. All this stuff is ultimately interrelated because it's still ultimately about leverage.
- [25:37]
A
Well, this is, you're giving me a lot to think about, I gotta say, because I, and I understand that you're not bearish on stocks, but you're raising risks and ideas and look,
- [25:56]
B
I'm right a lot and I'm wrong a lot. It's okay if you're wrong a lot, as long as when you're right, you're really, really right. It's like people will attack Michael Burry because he's been wrong. They show that tweet when he said sell and it was at the bottom. And meanwhile, then afterwards he said, I changed my mind on the regional bank. Right? And it's like nobody ever shows the next post or they just attack him. But it's like you get all these people that attack Michael Burry because he was right in quotes once, which is not true. The dude's richer than anybody. Why? Because he was right once. Right? So it's like, it's not about the frequency of being right or wrong, it's about the magnitude. So I'm right and wrong a lot. But I hope at least I get people to think differently. Right? It's like, I do think there's a hive mind aspect to our industry where everyone is saying the same thing and they're saying the same thing because it's safe, because nobody has any incentive to stick their neck out. I have an incentive to stick my neck out because I can't build businesses any other way. I have to stand out and be different. I have to communicate differently. I have to be able to express ideas in ways that nobody else is able to express and then hopefully have products to benefit from that.
- [27:02]
A
One thing I've observed this year, everyone I talk to, all the investors, retail and institutional, there's almost universal bullishness right now on AI, on asset prices, that seems to me like a risk, and I'm optimistic myself. But the fact that everyone's saying the same thing feels like a risk going into the year.
- [27:26]
B
Look, the crowd is right on average, but wrong at these streams. So the question ultimately becomes, is it an extreme? Now, I can argue that yes, it is. And it's gotten more extreme. You look at positioning, you look at sentiment, you look at everyone on the same side of the boat holding an anvil, you might be fine, right? But look what's happened the last several days. Even some questioning around Nvidia Investing in OpenAI has caused some ripples. It's just all you need to do is plant the seeds of some doubt. And at the margin, some people start selling and then that metastasizes to something bigger. So in the same way that gold and silver had that crash, because everyone was so bullish on them, you think it can't happen to stocks? Of course, again, it's like the commonality is overconfidence. Overconfidence leads to leverage, leverage leads to crashes. And if everybody believes in one thing, everyone's by definition then overconfident because they're all feeding off of each other's confirmation bias that yeah, AI is bullish. Well
- [28:25]
A
Michael, I can't tell you enough how much I've learned in this few minutes sitting down here. Where can people find you online?
- [28:32]
B
I appreciate it. Sod Laggerport's sort of the main way to do it on x, on Instagram, YouTube. I have my funds, my free market ETF deregulation fund which I'm very bullish on structurally.
- [28:44]
A
Give us the tickers for these.
- [28:46]
B
So Frank, Mary, Kellogg, Tom, I should really know the military side. I don't fmkt free markets of all my funds, I think my JoJo Bond ETF which I launched literally right into the bear market for bonds is probably going to benefit the most because the real contrarian trade here is what ultimately everything we're talking about, whether it's private credit, Japan, large, small, whatever it is, it all relates to one thing and one thing only. Credit spreads. Credit spreads, which is the differential between junk debt, poor quality debt and high quality debt is at pretty much all time tight levels. Historically credit spreads correlate to volatility. So if you get a VIX spike, credit spread should widen. Why? Because credit spreads are basically your tell on default risk perceptions in public bonds, if you have any doubt around private credit, it should at some point translate into doubt around junk debt, high yield debt. If you have any doubt around volatility staying low, it should translate into credit spreads which again goes back to Japan credit events as the catalyst. So I think the riskiest part of the marketplace by far from a risk adjusted perspective is junk debt, is high yield junk debt. Because all these tail events can suddenly unravel these incredibly tight levels where people think no companies can go default. But here we are with AI replacing companies. Well
- [30:11]
A
Michael, I really appreciate your time and we'll have to do this again soon.
- [30:15]
B
I appreciate it, thank you.