The Beauty of Lyrics

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Each Sunday morning for over a decade, One River’s CIO, Eric Peters, has published “Wknd Notes.” It is an unorthodox take on markets, politics, and policy that’s widely read across our industry and within global policy/political circles. Eric has written for as long as he has traded and the discipline is part of his investment process. Drawing on wide-ranging, multi-disciplinary research, historical study, and discussions with interesting characters throughout the world, Eric collects those things he finds most thought-provoking each week and distills them into a concise letter. At times the ideas and views are consistent with his own, but just as often, they challenge his positions and it is this openness to opposing views that helps him maintain a flexible mind in the search for emerging opportunities and risks. His writing is a reflection of how he thinks, and as such it is as focused on identifying the right questions to ask as it is on seeking answers. The publication of this work is Eric’s way of exchanging ideas/information and developing dialogue with a network grown over his thirty-one-year career.

The Beauty of Lyrics

“Tell the ones you love, you love them / Teach only what you know / And oh, you better know it well.” Charlie and I driving, analyzing music, the beauty of lyrics. Silver Linings by Mt. Joy is my latest favorite. A song about overcoming addiction, owning our failings, turning them to strengths, swinging hard at life, unafraid. We listened over and over, as we always do, line by line, OCD, exploring layers of meaning, inspiration. “Let’s listen to David Bowie’s Space Oddity and Ashes to Ashes,” I said, “We’ll follow the journey of Major Tom through both songs, his rise, fall, addiction. Bowie uses Major Tom to explore our need for heroes, how we tear them down, our highs, lows.” Charlie played the two songs. “So did you listen to Bowie back when you were in your prime Dad?” he asked, matter-of-factly, age twelve.

One River Digital announced the creation of ONE Digital SMA, powered by Coinbase Prime technology. It provides an early glimpse of the future of how asset management products and services will be delivered as finance transitions to blockchain-based infrastructure [here].

One River Asset Management won an HFM US Quant Performance Award for our Systematic Alternative Market Trend Strategy [here].

Overall: “Biden Warns Putin of ‘Swift and Severe Costs’ of Invading Ukraine,” ran the WSJ headline. The situation sounds horrible. European stocks jumped 1.6% on the week, the euro fell less than 1%. Oil crept 0.9% higher -- nothing really. “Inflation, Ukraine Stoke Outlook for More Stock Volatility,” ran another headline. The VIX index rose +4.14 to +27.36, unable to break 30 on the eve of military conflict. “Elon Musk warns America is operating on borrowed time as national debt soars,” ran Fox. The benchmark for US solvency – 30yr treasury bond yields - inched up 2bps on the week to 2.25%. “Rapid Inflation Stokes Unease from Wall Street to Washington,” wrote the NYT, after the CPI jumped +7.5%, exceeding forecasts and broadening. Markets priced faster rate hikes, with 2yr treasury yields leaping 19bps to 1.51%. 5-year/5-year inflation swaps rose a barely noticeable 2bps to 2.41%. “As Protest Paralyzes Canada’s Capital, Far-Right Activists Abroad Embrace It,” wrote some paper, as Trudeau warned US Republicans to stay out of Canadian politics. The Canadian dollar rose 0.2%. “Trump’s Missing Call Logs Present a Challenge for Jan. 6 Investigators,” ran a headline, as the November 2024 political collision steadily approaches. “U.S. trade deficit soared to a record last year,” wrote every paper. Naturally, Biden’s approval rating extended its inexorable decline. Rumors swirled that Hillary would run again. And yet, for all the carnage strewn across newspapers, the S&P 500 ended the week -1.8% (4% above the Jan 24 low and 8.3% below all-time highs). Strip out the emotion and markets digested the awful news rather well. The S&P 500 is simply where it was 7mths ago. But 10yr yields at 1.94% are now where they were in July 2019, when the S&P 500 was 32% lower than today (Nasdaq was 44% lower). And we are left to wonder at what level rising bond yields will matter?

Week-in-Review (expressed in YoY terms): Mon: ECB’s Knot expects hikes as early as October / expects infl to stay above 4% for much of 2022, Lagarde reiterates calls for gradual policy adjustment, Australia to reopen borders to vaccinated 2/21, Biden says if Russia invades Ukraine there will be no Nord Stream 2 pipeline, Australia ret sales 8.2% QoQ (7.8%e), China Caixin serv PMI 51.4 (50.5e) / comp PMI 50.1 (53p), Japan leading index 104.3 (103.7e), German IP -4.1% (-3.6%e), EU investor conf 16.6 (15.2e), US cons credit $18.898b ($21.9b exp), S&P -0.4% Tue: Macron suggests Putin assured him that Russia will NOT invade Ukraine / Kremlin quickly denied that such assurances were given during 5+ hr meeting, Poland CB hikes 50bps as exp, US authorities seized $3.6b worth of BTC, HK announced strict lockdown measures after covid surge, ECB’s Villeroy suggests mkt reaction to ECB meeting were perhaps too high, US NFIB small business 97.1 (97.5e), S&P +0.8%; Wed: Pelosi endorses banning stock trading by lawmakers, Fed’s Daly talks down the possibility of 50bp hikes, BoJ continued bond buying program to keep 10y below 0.25% / Nakamura noted as long as USDJPY is 103-115 then the economy should be fine (rare for CBers to comment on specific ranges), UK to alleviate covid restrictions 2/21 – 1m early, Thailand CB unch ¬as exp, Fed’s Mester supports active MBS sales as part of BS unwind / suggests the Fed may have to hike rates above neutral (2.5%), Boston Fed named Susan Collins its next president, Poland CB gov Glapinski signaled the central bank would actively try to strengthen the ccy, Japan M3 3.3% as exp, German exports 0.9% MoM (-0.5%e) / impts 4.7% (-2.1%e), Italy IP 4.4% (4.6%e), S. Africa bus conf 94.1 (92.5e), Poland unemp 6.3% (6.1%p), Mexico CPI 7.07% (7.01%e), Brazil IPCA infl 10.38% (10.39%e) / ret sales -2.9% (-3.2%e), Russia ret sales 5.4% (3.5%e) / unemp 4.3% as exp / CPI 8.73% (8.86%e), S&P +1.5%; Thu: US CPI 7.5% (7.3%e) / Core CPI 6% (5.9%e) – highest since 1982, Fed’s Bullard calls 100bp of hikes by 7/1 and that the Fed should be open to intermeeting hikes, Mexico CB hikes 50bps as exp, Riksbank maintained its dovish stance after leaving policy/QE unch, India CB repo rate unch as exp / decision to keep rev repo rate unchanged was dovish surprise (20bp hike exp), Indonesia CB unch as exp, BOJ gov Kuroda said no chance policy easing will be reduced / BOJ announces unlimited purchases of JGB 10y at 0.25%, Macron announces plans to build 6 nuclear reactors over next 10y, Russia and Belarus begin military drills (original rationale for the troop buildup along Ukrainian border), carmakers forced to shut factories in Canada as the Truck convoy (protesting vaccine requirements) continues to block key supply bridge, Japan PPI 8.6% (8.2%e), Sweden unemp unch at 3.5%, Norway CPI 3.2% (4.2%e), Turkey unemp 11.2% (11.3%p), S. Africa mining production -1.1% (4.9%e), China new loans 3.98T RMB (3.7T exp), Poland CPI unch at 3.4%, US init claims 223k (230k exp), S&P -1.8%; Fri: Rumors that Biden expects Russia to invade as soon as next week were denied but got markets spooked late on a Friday / US sends add’l 3k troops to Poland, Fed’s Barkin open to 50bp but needs to be convinced / market prices 50% prob of intermeeting hike, ECB Lagarde says hiking rates would not solve current problems, Russia CB hiked 100bps as exp / governor says the board continued 150bp hike, Peru hiked 50bps as exp, RBA gov Lowe will tolerate inflation above 3% for a period, Goldman raises forecast to 7 hikes in 2022 (from 5) / Citi now expects 50bp in March, Canadian judge allowed police to use force to remove protestors blocking a bridge to the US, Turkey IP 14.4% (10.9%e), Turkey 12m exp infl 24.83% (25.37%p), UK 4Q GDP 6.5% (6.4%e), German CPI 5.1% as exp, UK IP 0.4% (0.6%e), Swiss CPI 1.4% (1.2%e), US UofM 61.7 (67e) / 1y infl exp 5% as exp / 5-10y infl exp unch at 3.1%, S&P -1.9%

Weekly Close: S&P 500 -1.8% and VIX +4.14 at +27.36. Nikkei +0.9%, Shanghai +3.0%, Euro Stoxx +1.6%, Bovespa +1.2%, MSCI World -0.7%, and MSCI Emerging +1.6%. USD rose +2.0% vs Sweden, +1.8% vs Russia, +0.9% vs India, +0.9% vs Euro, and +0.1% vs Yen. USD fell -10.3% vs Bitcoin, -7.4% vs Ethereum, -2.3% vs Chile, -1.6% vs South Africa, -1.4% vs Brazil, -0.9% vs Australia, -0.7% vs Mexico, -0.4% vs Turkey, -0.2% vs Sterling, -0.2% vs Indonesia, -0.2% vs Canada, and -0.1% vs China. Gold +1.9%, Silver +4.0%, Oil +0.9%, Copper +0.5%, Iron Ore +5.1%, Corn +4.6%. 5y5y inflation swaps (EU +1bp at 1.75%, US +2bps at 2.41%, JP +1bp at 0.67%, and UK +3bps at 3.98%). 2yr Notes +19bps at 1.51% and 10yr Notes +3bps at 1.94%.

YTD Equity Indexes (high-to-low): Brazil +16% priced in US dollars (+8.3% priced in reais), Chile +14.2% priced in US dollars (+8% in pesos), Singapore +10.1% in US dollars (+9.8% in Sing dollars), South Africa +9.8% in dollars (+3.9% in rand), Colombia +9.7% (+5.8%), Saudi Arabia +8.9% (+8.7%), Greece +8.8% (+8.7%), Turkey +8.4% (+10.4%), Hungary +8.1% (+2.8%), HK +6.4% (+6.4%), UAE +6% (+6%), Czech Republic +5.7% (+3%), Austria +4.8% (+4%), Thailand +4.6% (+2.5%), UK +4.2% (+3.7%), Indonesia +3.3% (+3.6%), Argentina +2.2% (+5.6%), Norway +2.1% (+2.1%), Philippines +1.7% (+2.1%), Spain +1.7% (+1%), Canada +1.4% (+1.5%), Ireland +0.8% (+0.7%), Mexico +0.3% (-0.1%), Malaysia 0% (+0.7%), Taiwan -0.1% (+0.5%), Poland -0.4% (-2.4%), Italy -0.7% (-1.4%), India -1% (+0.1%), France -1.9% (-2%), Germany -2.2% (-2.9%), Israel -2.2% (+1.3%), Euro Stoxx 50 -3.2% (-3.3%), Australia -4.3% (-3.1%), Netherlands -4.5% (-4.6%), Japan -4.5% (-3.8%), China -4.8% (-4.9%), Finland -5% (-5.6%), Belgium -5.2% (-5.3%), MSCI World -6% (-6%), Venezuela -6% (-7.2%), Switzerland -6.2% (-5%), S&P 500 -7.3%, Sweden -7.3% (-5.2%), Portugal -7.5% (-7.6%), Korea -8% (-7.7%), Russia -8.5% (-6.4%), New Zealand -8.9% (-6.6%), Russell -9.6%, Denmark -11.1% (-11.7%), NASDAQ -11.8%.

Super Bowl LVI: Slipped out to LA for a little football. Got caught short time to finish up this week. Marcel wrote the following note on The Great Financial Inflation, the decade of financial repression we now face, and One River’s new strategy to mitigate its impact on portfolios. It’s an example of how traditional and digital investing will increasingly merge. Back next Sunday with full weekend notes:

By Marcel Kasumovich -- One River, Head of Research

The Great Financial Inflation has compelled investors into passive portfolios in our view. Bonds are no longer assets to balance portfolio risk, as seen so far this year. Not surprisingly, investors are searching for replacements to bond holdings. To that end, we launched One River Digital Income last week – a low-risk instrument to generate yield in the digital ecosystem.

1/ Portfolios, we have a problem. U.S. household financial assets have risen to nearly 5-times nominal GDP in the Great Financial Inflation. So great is the financial inflation, households find themselves (perhaps unintentionally) with a whopping 49.2% allocation to cash, cash-equivalent assets, and bonds (Figure 1). This comes at a time when macro policies are resolutely committed to multi-generational financial repression. For all the hawkish hype, bond markets are convinced that the next easing cycle will come in 2023 and that long-term policy rates will remain well below inflation. This is strongly counter to Fed guidance. We see no historical precedent.

2/ So, financial markets are telling us that nearly 50% of household assets are expected to lose money in real terms in the decades ahead. It is not just a U.S.-asset problem – shorter-term real yields are a global phenomenon (Figure 2). The Great Financial Inflation has masked the misallocation – long gone are the days of diversification. A 60-40% equity-bond portfolio returned 15% last year with a coincident rise in equity and bond valuations. Bonds have taken on equity-like return characteristics – the 60-40% portfolio is unbalanced. No doubt, the drawdown in 60-40% portfolios to start this year was on par with crisis periods – we were only missing the crisis – with equities and bonds both sharply retracing in January.

3/ Are digital assets a potential solution to balance portfolio risk? Yes. But the solution has a more subtle first step: yield. Directional exposure to bitcoin and the One River Digital Core Index seeks to offer diversification properties over the course of market cycle. However, shorter-term cyclical correlations are still quite high. Daily bitcoin returns year-to-date have a 53% correlation to US equity returns and a 36% correlation to US fixed income. Not all investors are searching for more risk, slowing the institutional adoption to directional digital asset exposure. Ethereum’s migration to proof of stake will mark a milestone, transforming ether into a bond-like asset. But even then, the yield from staking is low relative to the ether’s volatility.

4/ A more natural first step for some investors is to focus on yield derived from the digital ecosystem. Ideally, a yield investment would avoid any directional exposure and offer an income-like cashflow that is familiar to institutional investors. It would bring digital assets to investment committees in a low-risk manner, a more natural fit for their mandates (What’s Taking So Long? (here). It was missing – an uncorrelated, low-risk, liquid yield fund without direct digital asset exposure. So, we built it: the One River Digital Income Fund. The objective was clear – deliver a low-risk yield solution in the digital ecosystem. The lowest end of the risk spectrum is the natural starting point – risk can be added alongside the evolution of investor appetites easily enough.

5/ Digital Income is a short-term yield fund. The Fund seeks to generate yield by providing a U.S. dollar loan to high quality borrowers in the digital ecosystem. The loan’s safety is achieved by over-collateralizing the loan through high-quality liquid digital assets, initially only bitcoin. The Fund does not take possession of the bitcoin and thus is not a money transmitter, an important consideration in the context of future regulation. Instead, the liquid collateral is held by a third party with conditions on when collateral can be liquidated (Figure 3). Our process selects known, researched, and regulated counterparties. Investors are granted the added security by over-collateralization of a liquid asset with 24-hour margining, 365 days a year.

Here are the four most common questions on Digital Income:

6/ First, what are the risks to the structure? The short answer – negligible. Digital Income builds layers of protection. The over-collateralization means that a default scenario is recognized well before collateral values breach the par value of a loan. This negates counterparty risk. Digital Income also allows for U.S. dollar collateral, which can be used to buffer a cascading decline in the price of bitcoin. Further, the loan has recourse beyond the collateral. These measures are designed to add safety. Not surprisingly, our estimates of the “risk premium” needed to compensate for collateral risk is comfortably less than ten basis points. The yield is not compensating lenders for a known risk premium. Instead, Digital Income will seek to provide income to lenders for intermediating activity in the digital ecosystem. And we believe there is a shortage of high-quality lenders doing so.

7/ Second, where does the yield come from? Demand for capital in the digital ecosystem is robust, alongside high expected asset returns. This is the natural flipside of high asset volatility. In the early phase of lending growth, retail capital, such as yield-bearing digital deposits, were sufficient. However, as the system has matured, growth in loan demand has increased through digital banking partners, high net worth individuals, corporations, hedge funds and family offices. Active loans for Genesis Global Trading, for instance, are approaching $10 billion, an increase from less than $1 billion at the start of last year (Figure 4). Rapid and broadening growth in digital assets will require substantial debt capital, including attractive, low-risk rates for institutional investors.

8/ What is the right benchmark to compare Digital Income? Digital Income is a quarterly fund and will be compared to cash-equivalents such as the Bloomberg 1-to-3-month U.S. Treasury bill total return index. We anticipate Digital Income yields to be in the 4-12% range, varying pro-cyclically with the demand for capital. A rise in digital asset prices raises expected returns and the interest rates paid by the borrower, even with collateralization. Rates are driven by demand. However, it is important to value Digital Income relative to other benchmarks. One way is to infer unsecured funding rates from publicly traded digital asset companies. Five-year unsecured financing, inferred from one convertible bond, is running at ~4%, the low end of our expected range. Digital Income is secured and can still offer an attractive premium.

9/ How does Digital Income fit into a portfolio? This is a subtle benefit. Typically, credit and risk assets co-move. As equity asset prices decline, credit spreads widen. This is a mathematical truism of credit spreads– it is equivalent to being long a risk-free asset and short an equity put. But this is not how yields in digital assets behave. Figure 5 illustrates the implied yield in bitcoin futures against high-yield corporate borrowing costs. Most of the time, there is no correlation. However, digital asset yields decline alongside the fall in the demand for borrowing in sell-off periods for risk assets and widening in credit spreads. Digital Income spreads are counter-cyclical, narrowing as asset prices decline. This behavior is more like a Treasury bill than credit.

10/ The beginning is a good place to start. That is precisely what we are doing with Digital Income – we are defining the lowest risk point of the digital asset yield curve. Doug Wilson, the portfolio manager, executed our first loans this week with research and operational tools in place. We believe that this will be a comfortable step into the digital ecosystem for institutional investors. And it will also be a natural point from which to migrate out the risk spectrum, lowering collateralization rates to enhance yields and moving into credit provision through bitcoin bond-like structures. Bonds are a problem, and we believe Digital Income is a solution.

Figure 1: Great Financial Inflation: Large Bond Holdings

Source: Federal Reserve Board. St. Louis Federal Reserve. One River Digital Calculations. Provided for illustrative purposes only. See important disclosures at the end of this article.

Figure 2: Problem: Low Short-Term Yields, Inflation Taxing Bond Portfolios

Source: Bloomberg. One River Digital Calculations as of February 9, 2022. MKT L-T FED DOT is the 5y5y OIS forward to imply the long-term Federal funds policy rate. L-T inflation is 5y5y forward inflation.

Figure 3: Solution: Digital Income, Low Risk Strategy in the Digital Ecosystem

Source: One River Digital. This chart is provided for informational purposes only and represents a simplified description. The above investment strategy may differ from what is stated above at One River's discretion. See important disclosures at the end of this article

Figure 4: Market Demand, Shortage of High-Quality Lenders

Source: Genesis Global Trading as of September 2021.

Figure 5: How Do Spreads Behave? Opposite of Credit!

Source: Bloomberg. One River Digital Calculations. 2018 to 2021. The above graph demonstrates implied yield in bitcoin futures against high-yield corporate borrowing costs, both in percent. The bitcoin futures’ yield is a five-day rolling average of the daily annualized yield implied by the ratio of the one-month rolling bitcoin future to the spot bitcoin price.

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

Important Disclosures

This document (the "Paper") has been furnished to you for informational purposes only and is not, and may not be relied on in any manner as, legal, tax or investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any investment vehicle managed by One River Asset Management, LLC or its affiliates ("One River"). Any offer to buy interests in any investment vehicle will be made pursuant to the current Confidential Private Placement Memorandum (or similar document) and other applicable governing documents (the "Fund Documents"), which will be furnished to qualified investors only. The information contained herein is not complete, may change and is subject to, and qualified in its entirely by, the more complete disclosures, risk factors and other information contained in the Fund Documents.

One River is not acting as an investment adviser to you. This document has not been prepared for, and should not be construed as, providing investment advice or recommendations to any recipient. Clicking on a link containing this Paper or receiving this Paper through a distribution does not create a client relationship between you and One River. Such a relationship would only be established pursuant to relevant agreements. Before making any investment, One River strongly suggests that you obtain independent advice in relation to any investment, and with respect to any financial, legal, tax, accounting or regulatory issues resulting from such an investment. In addition, because this Paper is only a high-level summary; it does not contain all material terms pertinent to an investment decision. This Paper should not form the basis for any investment decision.

Information contained in this document has been obtained from sources that One River believes to be reliable, however One River makes no assurance or guarantee that such information is true and/or accurate, and One River expressly disclaims liability arising from the use of information contained herein.

This Paper contains statements of opinion. These statements of opinion include, but are not limited to, One River's analysis and views with respect to: digital assets, projected inflation, macroeconomic policy, the market adoption of digital assets, and the market in general. Statements of opinion herein have been formulated using One River's experience, research, and/or analysis, however, such statements also contain elements of subjectivity and are often subjective in nature. In addition, when conducting the analyses on which it bases statements of opinion, One River has incorporated assumptions, which in some cases may prove to be inaccurate in the future, including in certain material respects. The analysis and opinions contained herein may be based on assumptions that if altered can change the analyses or opinions expressed. Nothing in this Paper represents a guarantee of any future outcome, or any representation or warranty as to future performance of any financial instrument, credit, currency rate, digital currency or other market or economic measure. Information provided reflects One River's views as of the date of this document and are subject to change without notice. One River is under no obligation to update this document, notify any recipients, or re-publish the content contained herein to reflect information that subsequently becomes available, or circumstances existing or changes occurring after the date hereof.

Certain information contained in this Paper constitutes "forward-looking statements," which can be identified by the use of forward-looking terminology such as "may", "will", "should", "expect", "anticipate", "target", "project", "estimate", "intend", "continue" or "believe" or the negatives thereof or other variations thereon or comparable terminology.

The target returns referenced herein are neither guarantees nor predictions of future performance, and there can be no assurance that the investment objectives of each investment strategy will be achieved or that investors will receive a return of their investment. The target returns are based on the One River Digital surveys of borrowers over the past year and their relationship to bitcoin futures’ yields. Actual realized returns will depend on, among other factors, the demand for borrowing against bitcoin collateral which can differ from the underlying assumptions on which the target returns data is based.

Forward-looking statements made in this Paper are based on current expectations, speak only as of the date above, as the case may be, and are susceptible to a number of risks, uncertainties and other factors. Assumptions relating to the foregoing involve judgments with respect to, among other things, projected inflation, the regulation of digital assets and macroeconomic policy, all of which are difficult or impossible to predict accurately and many of which are beyond our control.

Although we believe that the assumptions underlying the projected results, target returns, and forward-looking statements are reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurance that the forward-looking statements included in this Paper will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation to future results or that the objectives and plans expressed or implied by such forward-looking statements will be achieved.