The Case for Tail Hedging

In this discussion, I make the case for tail hedging. I communicate two main ideas. First, I lay out the concept of the “fourth type of risk off”, an episode that features instability in the back end of the US bond market. As I’ve said, nothing can really work in markets if the Treasury market does not. Count me as worried that the US fiscal issues are incredibly difficult to solve – we wouldn’t be here otherwise – and that the timeline to address them has shortened.

Second, I argue that the US economy and market are far too exposed to the AI capex trade. There are various correlations that emerge, two of which are among the companies in the value chain and between the economy and the market. The AI buildout is demanding capital that is likely putting upward pressure on real rates. A prospective homebuyer may certainly find a 7% mortgage rate restrictive. A hyperscaler chasing AI gold may not find the current cost of debt capital restrictive at all. If getting inflation to target means slowing this capex materially, leading to a meaningful decline in the equity market, there could be substantial knock-on impacts via the wealth effect and an economy which has gathered so much beta to ongoing capex.

These concerns are set against some of the lowest prices for financial market insurance we have seen in a long time. I find tremendous value in long optionality. Buckle up. The midterms are coming, monetary policy is in flux, the back end of the yield curve is wobbling, the AI trade is way too concentrated, and implied volatility is quite low.

I wish you a wonderful holiday weekend and thank you for listening.