Today, we take you into the complexities of the current financial landscape, emphasizing the crucial theme of positioning in an environment marked by rising interest rates and shifting market dynamics. We explore how recent structured product issuance is significantly impacting market structure, particularly in the U.S., where the volume of callable bonds and equity-linked products has surged. They highlight the risks associated with reliance on historical correlations, which may not hold in times of market stress, and the implications for investors navigating these turbulent waters. The conversation also touches on the potential for a significant monetary regime shift, akin to what was seen in the late '90s, driven by geopolitical tensions and domestic economic policies. You will gain valuable insights into how to recognize and adapt to these evolving risks, to become well prepared for the challenges ahead.
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Episode TimeStamps:
01:34 - A quick catch up since last conversation
02:13 - Dredge's key takeaways from 2024
08:58 - When did things really start to move for Dredge?
15:41 - Cem's analysis of the recent global macro environment
22:51 - What has driven the S&P volatility?
24:44 - Positioning is all that matters
29:31 - "Correlation is a bitch"
33:31 - Portfolio Manager in legal trouble for following an ESG strategy
37:57 - The difference between credit and vol investors
42:07 - The good outcome is a recession
45:36 - All the things that you are not worried about is driving your performance
48:49 - The state of interest rates and FX trading
57:24 - Is the Fed losing its grip on the economy?
01:03:46 - The outlook of markets - where are we heading?
01:09:18 - Risk is on your balance sheet, not in the future
01:16:14 - Dredge's perspective on structural products issuance
01:27:22 - The recession might come sooner than we think
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The good outcome is a recession because then people will buy the bonds. But if you keep trying to avoid the recession, you know, and you cut interest rates too early, people won't buy the bonds because the guys who bought them all, when the price was wrong, bought them because they were regulated to do so with an incentive to pay themselves for annual accrued income while they destroyed capital generation for somebody else's money. And those guys are full. They're full. They're not buying.
Intro:Imagine spending an hour with the world's greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.
Before we begin today's conversation, remember to keep two things in mind. All the discussion we'll have about investment performance is about the past. And past performance does not guarantee or even infer anything about future performance. Also understand that there's a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.
Here's your host, veteran hedge fund manager Niels Kaastrup-Larsen.
Niels: sing what lies ahead of us in: Dave:Great, busy, did a little bit of traveling right after I saw you – literally, right after I saw you.
Niels:You did indeed.
Dave:Worked through the holidays as my partners went off on some holidays with their families, and just been working ever since and, you know, a pretty active start to the year. So, it' good.
Niels:And what about you, Cem? How's Chicago this morning?
Cem:Cold. That's all I got, in a word.
Niels:Fair enough. Well, I think we're going to get our voices warmed up because it has, as Dave rightly suggested, been a pretty busy year already. And these conversations, always great to have in the beginning of a new year, as we normally do, so that we can kind of lay out our vision, so to speak, for the coming 12 months and hopefully create some value for our listeners.
Now before we jump into what lies ahead of us, I wanted to ask both of you, actually, kind of what your main takeaway was from last year. I know we, we talked about, we warned that maybe Japan, BOJ, would be a key thing to keep an eye on, and so on, and so forth. But there may have been another main event for both of you. So, Dave, I'm going to let you jump in first. What's, what's your kind of key takeaway from last year?
Dave:Thanks, Niels. I think, in terms of the stuff we talked about, Japan obviously, you know, super slow motion, but did end up playing a key role with the hikes they finally got to, you know, the first hikes in decades in July triggered a little bit of the yen carry trade unwind, Jackson Hole pivot from Jerome Powell on rate cuts are to come, more yen carry unwind triggers a shock across a number of things.
me what was relevant to us in: And now we'll see if:I think that's probably the main thing that's been keeping our attention now. If the election, the transition, very much a known known, turned out to not be a huge event, created some opportunities. I know you and Cem have talked about this over the months about the skew dynamic that that's caused and resulted in S&P vol and the proliferation of call selling. Whether that's call selling to fund puts or just covered call writing, and what's that has done to skew and done to spot vol correlation was something that even we got interested in and have been involved in.
And now, you know, you've got the bull in the china shop, so to speak, as the Trump administration comes in with very different (at least indicated) very different ideas around global trading policy, global monetary systems. I'm sure you guys are aware I've written a lot over the last few years about the fragility of the global monetary system, the US reserve currency role and, in particular, the relationship with China.
I feel at the moment for the: The exception to that rule is:So, that's my takeaway from last year. Lots going on and, and lots to think about. And I think a very key year.
Niels:Yeah, absolutely, and we'll dig into lots of that and it's great that you've already laid out some seeds for what's going to come up. But before we do that, love to hear your takeaways mainly as well, Cem, just to keep it even here.
Cem:Yeah, mine will be a little more to the point. What a call by Dave. Right? On how Japan and the yen and that whole space was, which at the time was very placid, was the next coming crisis, or next coming vol event I guess I should say. And I mean, he laid it out there well in advance.
I think the important part, and what I kind of learned from Dave, is the patience - just this willingness to say, you know, it's about time.
Cem:It's about thinking about, okay, this may not happen today. It may take six months, it may take nine months, but it's just way too cheap. And you put it away, you stock it away, you add to it, you kind of build a position. And not a lot of people have that, particularly in the vol space, I will say. And I think that was just an incredible call and I just want to highlight that in its fullest.
And he has a history of doing this, and that's because he is thoughtful, patient, looks at the big picture, and really is willing to go and do things other people might not be willing to do.
Niels:Yeah, absolutely, super.
Niels:All right, now, Cem, you have quite a lot of things that you wanted to bring up. So, I thought today we'll do it a little bit differently in a sense that I'll let you guide the conversation through the topics that you wanted to bring up. Then I'll let Dave bring up some of the new stuff that's coming out in the new Note, Déjà vu, that is about to be published, I think maybe tomorrow. And then I have some other things, if we have time, that I'd love to hear both of your thoughts on. So why don't you kick it off?
Cem:Yeah, let's kick back right where I just left off there. And I'd love to, I think it'd be fun for the listeners, it'd be fun for me to walk through August, for you, to really hear what it was like on the other side of the ocean, kind of with the positions you had. What were the counter players, different players doing? And how did you see this play out as it happened on your end?
And then, you know, I'd love to kind of feedback on my end what we were seeing and how it was different, maybe in some ways. Not that you don't look at this side of the pond as well, but I think we’d have some interesting notes to compare.
Dave:Yeah.
Cem:Take me back to when you first started really seeing things move. And what were the first trades that kind of set off the dynamic, I guess, on your end? What did you see when it started playing out, I guess? And then how did it play out as you saw it?
Dave: ity vol of vol terms, back in: that repricing took place in:Nikkei index stuff hasn't really paid, other than owning calls, in the last couple of years. But, that day, gamma paid. In fact, I've dubbed what happened that first week of August as Gammageddon because it wasn’t really a vega event even in Nikkei, even with the 12% one day down move. You know, one year vega hardly budged. One year vega and dollar/yen didn't even make a new high for the year in the event. But that single day gamma was really, really big and had a really, really large payout.
It had nothing to do with foresight, just with pricing. Cem knows this, Niels. Yeah, given what we do, we're not huge fans of gamma because it's too much work and too little asymmetry. Most of our activity revolves around vol of vol, 3rd, 4th moment stuff. But the one place we owned gamma, because it was really attractively price, was Nikkei. So, that turned out to be quite a good place to have almost all of your gamma allocation.
We did have some gamma, Niels and Cem, in S&P, which didn't really pay off per se, relatively speaking. We had gamma, but some skew related stuff that didn't work particularly well in S&P but worked extraordinarily well in Nikkei.
FX stuff, you know, we owned a lot of long dated vega there, long dated vol there. So, it did okay but it didn't have a blowout performance. The relationship to some other markets, Nasdaq, the growth versus value thing was something that we had to look into that was an early trigger.
Cem, you'll know better than me. The week before there was a really outsized move in a reversal of what had been the long-term trend in growth versus value. Nasdaq and Russell had a massive reversal which was very clearly driven by pod shop multi strats deleveraging and that deleveraging getting triggered, I would argue, by yen carry unwinds triggering correlation into Nasdaq triggering correlation into growth versus value leverage structures.
I don't think it's a coincidence that sort of the peaks of many of those markets that had performed so well, dollar/yen, Nikkei Nasdaq, coincided shortly after the launch of one of the biggest multi strat launches ever in history in early July. And the unwind in August correlated with them unwinding a lot of the initial risk that they put on chasing everything to the top. That correlation that their competitors had benefited from, from January through July, they got in at the very tail end of it and that correlation turned around and slapped them in the face. And that risk unwind triggers the next round of risk unwinds for the next guy.
And I suspect, Niels and I were talking earlier, that this correlation issue likely continues to jump up and bite people and, I think, is a big part of the themes for next year. But the Japan thing isn't over yet.
Yesterday, after Deputy Governor Himino's speech most people were assuming they weren't going to hike next week at their meeting. But today Ueda San gave a speech and everybody's assuming they are going to hike next week. I think most importantly, and people should go look this up, Hamino San's speech from yesterday, he said something that I've been saying a lot. You guys may have heard me say this before, and he said it in a public speech and I know it's something that's been discussed privately particularly with the governor Ueda San.
He said that if the deflation and growth risks are behind us, negative real rates aren't appropriate. And so, Ueda San has sort of indicated the neutral real rate potential growth achieved inflation target isn't a negative number. If it is, you've got something structurally wrong with the economy that you should be fixing.
And so, the concept that they're going to try to get from what are almost the most negative real rates ever right now, in 40 years, to something that's zero real, means that there's many, many more hikes to come. But of course, it's bank of Japan so the pace is really hard to call.
Cem:So much to dive into there. So fun to listen, for me in particular. And there are so many… You can't see me on video right now, but I was nodding my head violently throughout the whole conversation.
I think one of the more interesting things, as somebody here who tends to be more US and Europe focused, is to hear how well the gamma performed over there in Japanese stocks. As you mentioned, the S&P and local gamma had an historically bad performance relative to vega. I mean, we had a 3, 4 standard deviation difference in performance in correlation between the vega and gamma moves. Not because gamma was so bad but because vega dramatically outperformed.
That was really a function of September through December vol, and particularly skew, being dramatically under supplied. The world being really short of all of that but having an overwhelming amount of August skew in vol against it across the market. And that was just summer vol, again. Nobody was expecting something to happen there in August.
And partially because of the supply of gamma skew being so high, reflexively people also assumed well it can't happen now. So, it did. And when it did, you know, obviously you had a historic kind of 3, 4 sigma move in that relationship.
Why, in my opinion, did it bottom so quickly? Why we ‘V’ed was because everybody was long of gamma and protection into that decline. It was a vega event.
And part of why you saw some of the stress, in my opinion, the continued stress and long dated skew in the S&P is a relation of that. We're still seeing echoes of that. It's interesting if you look up throughout history when you get those events and people get really hurt.
There's still a lot of residual positioning that people had to push further out to fund the trades to get back September, October, November skew in vol. And there's a lot more short skew in vol sitting out there at the back end of the curve. Never mind, you know, models are now set to account for that.
There's less supply because people are less likely to sell it because it just happened. But also, I guess, maybe most importantly, you know, those things can lead reflexively to bigger more structural declines. And we've seen that throughout history once that long dated skew pops and doesn't come back in. I think long term capital management, that's a very specific example.
But there are a million examples where that skew in vol goes higher, everybody's short of it and it's a mark to market issue. And until people get it back, it will not come down. And that means, in the case of a decline that is meaningful, there is blood out there in the back of the curve. So, just know that's still there since August, and I find that really interesting. The skew swap in the indexes is incredibly bid to long dated puts, and short dated puts are historically very low.
It's not just on a relative value. On a relative that the front is very low, and the back is very high and that that makes for a really interesting dynamic that people should be watching, I think.
So, in reference to your kind of pod rotation and the blowouts that happened in that space in August, I think the most pain, as you mentioned, in general was in relative value, relative value skew, a beta value versus growth, as you mentioned. That that was a really interesting dynamic. It really started in July - in mid-July. And I think that fed very much into the decline that eventually happened. I think that paired with the stuff that you were looking at in Japan and overseas, broadly in Asia, were really able to take down the S&P and the Behemoth, despite everything else, basically.
And so, it was really fascinating. This part is why I want to talk about across-ocean. There was a very different dynamic going on over here. This was very much focused over there, and paired with kind of the stress from the millennium pods and other pods that we know about, and multi strats at that launch.
Why did that happen? It started mid-July with, well, first, from a positioning perspective, obviously everybody had been playing long calls in Nvidia and all these other tech names, and in short of Russell. Then we had a couple really big players, really starting in June, make incredibly historic call bets in the Russell that really loosened up the value upside call liquidity across the board and the value space. And as that happened, Nvidia had a couple pieces of news (we won't go through all of it) that really slowed things down.
And then that Wednesday expiration, in July, Trump came out and said hey Taiwan, we're not defending you guys. If you want us to defend you, pay us, basically. And that really was fed into, it was a catalyst to what was already a weakening, a slowing price action in Nvidia and in the AI space writ large. That created vanna and charm flows that were negative and really were pushing down on that, and that eventually led to a decline in that space.
And then obviously, with vol offered in the S&P, as I just mentioned, the vol was really offered in July and August in those names, and the skew was offered. That led to a massive dispersion that also pushed on that. So, it forced the two in opposite directions.
We saw that, we were talking about it in real time as it was happening. But that really led to some serious stress in a space that was very crowded and led to a pretty convex rotation there over the course several weeks, and led to some initial pain which wasn't direct to market direction, but you know how these things work. Once there's pain that leads to deleveraging across all assets. And that was very much the case there.
So, I think those are the interesting parts of that whole story that I thought I could add from our side of things and what we were watching. But yeah, wonderful to hear your take and what you're seeing on your side and to hear how different some of those aspects were and how they all work kind of together. It's an incredible little symphony when you start putting it together and start seeing why things happen.
So, I don't know if there's anything else you want to add to that, Dave.
Dave:I'll add one thing. We talked about it last year about how much of the structured product, Asia time zone activity was getting sucked away from the Asian markets now that S&P vol And VIX trades 24 hours out here. And I think that had an impact. You know, really the S&P and theoretical VIX moves were much bigger in Asia time. And in a sense, because there's so much S&P exposure now in Asia, when that Nikkei selloff, the whole thing took off on that Monday morning, you know, the extremes on S&P vol took place in Asia time. It already happened by the time US markets opened. And VIX had already, the theoretical levels of VIX had already corrected by that time.
So, I think it's interesting. That is a sort of the first episode where really S&P vol, in a shock event, was driven in the Asian time zone.
Cem:Yeah, I agree, that was fascinating. I think that's part of what caused it. It hasn't happened in so long, probably 30 years. Like you were mentioning, the ‘90s was the last time we saw Asia really take the reins. And so that was, I think that's part of why it took people by surprise.
People just assumed the vol was so well supplied, and skew was so well supplied, it couldn't happen. And that was a massive vega move relative to the market movement.
It was very short lived, and for a reason, because again, ultimately people were hedged on this side. But like, last thing is I would keep watching the the knock-on effects that are still out there from that.
So, the other thing I want to kind of reference, kind of in relation, as we move through the conversation is, relative to relative value, how well prediction and second order Greeks and effects are working. I think the structured product issuance, the size of vol markets, has gotten so big relative to underlying markets. I find it incredibly interesting how poorly relative value trading is working. It's actually, the opposite is working incredibly well, taking the other side of positioning, better than it's ever worked.
I mean, there are funds now. Capstone, I know, has one that's growing leaps and bounds that essentially just does that - takes the opposite side of every relativity trade, buys what's high and sells what's low. That's all they do. And it works incredibly well. It's incredibly counterintuitive to most people. But that's ultimately just betting against the positioning, knowing that if something is high, that ultimately the world, dealers are short, and if dealers are short it's going higher is essentially the way that works.
I just find that, you know, it's the exact opposite of when I started in the business. When the underlying markets were dominant and that you would see enough liquidity to push things backward, back and forward, and be able to capture a real edge on just essentially market making. You know, that doesn't really exist anymore. The edge of market making is informational and that information and the ability to predict that that drives is what is at an all-time best.
And those two things are incredibly connected and for good reason because if there's not enough liquidity to absorb the opposite. You know, in the options market the relative value trade, those trades that are high and low, they have to not make money. They stay in a relatively efficient market some way and that's through where the liquidity is, which is in the underlying market or in the vol itself directionally, or in the skew itself. So, this is why prediction tied to options markets works so well and why the relative value works.
Dave:I'm sure I've probably said this to you guys before. I'm the simplest guy in the world, positioning is the only thing that matters. You know, everything else is just gaming a flawed risk or prediction system. Positioning is all that matters. I know Niels will agree with me. It's just let the market tell you what's going on.
And then, you know, I've taken it to a new extreme in my constant tirade that, you know, lots of my friends, who were economists or forecasters or macro guys, who have been, based upon economic fundamentals, forecasting a recession for three years now, and the markets keep going up. So, I've taken it to a new idea.
I say, politics and geopolitics are downstream from economies and economies are downstream from markets. A recession is not going to cause a market crash, a market crash will cause a recession. And that positioning, and exactly to your point, Cem, it simply comes down to leverage. It's the leverage in the system that makes returns left tail skewed. And because of the impact on capital and the negative compound effect that, as leverage builds, the asymmetry goes the other way.
And back to my correlation conversation, probably the simplest, most neglected understanding of leverage is correlation, what's called diversification. So, everybody's taking more risk counting on their diversification benefit of some sort of constant steady correlation.
And then whenever correlation surprises them, they have to reduce risk because they have not enough capital for the risk they were taking because they assumed they were diversified. And then, in a sense, this is exactly what you're saying, Cem, that these correlations that people relied on and still are running models on and risk parity, et cetera, just keep breaking down, keep disappointing, keep disappointing. And every time it disappoints, somebody's got to go out and reduce something that ends up getting reduced in a left skewed dynamic.
That's what I think it is. I think that's really the theme for this year. Now that will be on my Note that's coming out tomorrow that, you know, that's a theme.
Niels:I thought that was very, very interesting what Dave just mentioned about the correlations and how people rely on that.
Do any of you know, to what extent are these correlations in terms of how, say, pension funds, insurance companies end up being positioned? How much is that down to “regulation”, like Basel, whatever, 1, 2, 3, 4, whatever number we're at now? So, even if they wanted to take a different route in terms of their portfolios and how they see correlation change, could they even do it?
Dave:Yeah, it's, I think it's a challenge because it's sort of hard coded, you know, from the academia of modern portfolio theory and capital asset pricing model down to risk and accounting regulation. So, Basel III and Banks and IAS 19 and Pension Funds, Insolvency II, and insurance companies. Obviously, the one that's back in the news again, these recent liability driven investment schemes that say it's risk reducing to lever gilts. Well, it's obviously not risk reducing to lever gilts, that's nonsense. But the regulation says it is because the academia says it is, and the far too short 20-year empirical back test said, well, it was for a little while. And yet it's obviously not, and this is a big problem.
And this, again, is why I've dubbed it The Coming Regime, correlation's a bitch. And that correlation, I mean, you look at the constant underperformance of risk parity type strategies over the last 5 years, 10 years, 15 years, and this drag, I think, is going to keep pressure on these correlation problems - exactly what Cem's talking about. Because their sort of principle has been lever diversification and low volatility to risk match your growth risky assets and sort of optimize around probabilistic short-term carry.
And probabilistic short-term carry has been a big loser. And exactly what Capstone is doing is saying we want to be on the other side of that because probabilistic short-term negative carry has been a big winner.
year, last year at the end of:It just keeps reminding me of how I felt in ‘95, ‘96, going into that and the pressure that was building on these ties to the global reserve currency and the imposition of inflation as the Fed behaved wrongly for parts of the world that were tied to them.
Now, so, that again gets back to… Sorry to jump ahead.
Niels:No, no, it's absolutely fine. Did any of you read the story that came out in the last couple of days where, I don't know if it was a pension fund CIO or someone with a portfolio responsibility who actually got somehow in trouble legally because he had followed an ESG strategy. So, essentially, they now say, well actually you should have focused on returns, not on ESG. And I know this is one example, we may see more of these, which is of course a complete U turn from where policymakers wanted us to go a few years ago.
And I'm just speculating here, if we could see the same when it comes to this model portfolio that suddenly it's a fiduciary responsibility to make sure you have vol and you have trend following because clearly they are risk reducing, but it's not risk reducing leveraging your bonds in an inflationary environment and having equities at peak prices.
Dave:Yeah, it's explicit risk reduction and it's mathematically supported and empirically supported, whereas modern portfolio theory and everything that's inside Basel III has no empirical support and no mathematical logic to it. And of course, as I say all the time, the fundamental flaw, and Cem's heard me rant about this when there was beer involved, so it gets even livelier. The fundamental flaw is that there's no benchmark for geometric compounding and the objective for the end capital holder surely must be geometric compounding. But we've taken that away and so it distorts all the math. And we apply math, wrong math to wrong solution and so we end up getting precisely the wrong answers. But you know, the emphasis is on being precisely wrong.
And so, to your point, and then obviously I've been ranting and raving about this for 35 years in the regulatory community, which, you know, would put me out of business if they ever actually did it, but would make everybody have a much better retirement in some of this destruction of wealth that goes on. So, you know, I think people need to make noise about it. I think it's great that you raise it, Niels, in this sort of conversation and the benefits.
I listen to your guy’s group calls, two-part group calls and, you know, conversations about risk and uncertainty and the same stuff that I speak about all the time. And the fact that, you know, I think it was Andrew Beer who said, I go meeting after meeting and show people here's the solution and they say, oh, but that's not the way we look at it. Which is exactly what I go through every day. I'm sure Cem goes through it every day.
Cem:Yeah, I think, I think we're all preaching to the choir here. But maybe somebody's out there on the other end of the line, you know, listening.
I mean, to simplify it, I mentioned this on a recent conversation with Niels, but I was at a recent endowment conference, and the amount of groupthink, the amount of just unwillingness by a hundred seasoned, probably the average time that those people had been in that seat was 25 years. The ability to think outside of a stock and bond portfolio, it was almost zero. The amount of agreed equity exposure is going up. The portion of that going into private equity is dramatically increasing. Into venture is dramatically increasing. Everybody is increasing duration, decreasing liquidity, increasing leverage, and then increasing the beta at the same time.
And the answer, broadly, is because, well, venture and private equity have been a diversifier. Their alternatives to, it's literally called private equity. And people like somehow believe it's not equity. It's similar with private credit. It's like people just somehow believe it's not credit. It's somehow an alternative.
Niels:I think we should change the name to Private Long Vol and Private Trend Following, and we'll be very successful.
Cem:Yeah, we're going to take vol private. I like that. I think, you know, the funny part is that's what Dave does. You know, I think he takes this really long view and people, understandably, have better outcomes.
Niels:Anyway, back to your agenda, Cem.
Dave:I say that a lot of times people are like, I don't understand what you do. And I'm saying, you're a distressed credit investor, I'm a distressed vol investor. You buy a whole bunch of stuff, because nobody wants to own it, for 10 cents on the dollar and wait 10 years to see if it reliquefies. I'm just the exact same thing on the other side of the liquidity spectrum. I store a whole bunch of liquidity that everybody's happy to give away for pennies and try to hold it and maintain it over time until the market needs the liquidity back at highly convex asymmetrical returns.
Cem:You just need to make it not mark to market for 10 years and then deploy some more leverage.
Dave:Imagine if I could treat our option premiums that everybody looks at and says, oh, you're negative carry. If I could treat that as investment the way they account for private equity or private credit, I'd have this long-term investment portfolio of things that don't make any money. Just like your private equity doesn't make any money. You know, companies that have no income or even revenues.
And then when it pays off, 10 years down the road, you get the, you know, 50 bagger and off you go. You put the two together, on opposite ends of the liquidity cycle, and you’ve got absolute magic. Which is exactly the math that we go out and show people all the time.
Look at the math. You guys talked about it. I know Niels knows I've written about it. Even my friends out here, the big sovereign wealth funds, Singapore, and Australia, and New Zealand, have written papers about total portfolio approach. This is the new catchphrase, the next evolution beyond strategic asset allocation, total portfolio approach where they show that the only thing that adds value to the portfolio is negative correlation, negative correlating risk mitigation and that no other hedge fund strategy, no other diversifier, no bonds, anything adds value to the portfolio. Just pair growth assets with highly asymmetric negative correlation.
I'm not sure any of them are actually doing it but they've all written big research reports and go out and talk about it. Some of them, the future fund guys, give a fantastic presentation on it. I'm not going to say if I influenced it or not, but they give a fantastic presentation on it. So, again that brings me back to the same thing, and Niels is spot on. This correlation reliance has to unwind because the wealth destruction is just getting out of control. And you know, true risk is your divergence. I write about this a little bit in the Note that's coming out tomorrow.
True risk is your divergence from your compounding path. It's not annual volatility of returns, it's how far behind what people need me to make for their retirement in 30 years. And if you're well ahead of that path because you've had a well-constructed, positively convex portfolio, you have a lot less risk than the risk parity guy that's way behind that path. And then, you know, you do what Calpers does, they add leverage to the thing that's been failing for two decades. They add more leverage to it and that's supposed to make it up.
Cem:So yeah, I think that's the most interesting part, that recency bias, especially after 40 years of a very structural trend in interest rates and certain dynamics. I think it's far from a certainty, but if we are truly kind of in some type of decade plus long regime shift and it doesn't happen overnight… We're seeing though the tremors. We're seeing things that are clues that it is happening. And once those things accelerate, they can break in meaningful ways for a long time.
And there's so much positioning the other side because it's just the momentum of the trades and the positioning that it will become a self-fulfilling prophecy. It will continue to push on because of everybody positioning, everybody back to work a full circle, everybody ultimately will have to get out. And there's no liquidity on the other side.
Dave:Which is clearly is what's driving bond markets. And now, you guys know, I've been talking about this maybe longer than anybody. Who's going to own the 40, who's going to own the bonds now that the correlation and volatility benefit, that created them as risk mitigants in financial regulated institutions, is gone? These guys are so overloaded with bonds they bought with infinite leverage at ridiculous levels, and they don't mark to market.
So, they've got these ginormous unrealized losses and the supply keeps coming. And then, as we said a year ago, and I think I said a year before that, the good outcome is the recession because then people will buy the bonds.
But if you keep trying to avoid the recession and you cut interest rates too early, people won't buy the bonds because the guys who bought them all, when the price was wrong, bought them because they were regulated to do so with an incentive to pay themselves for annual accrued income while they destroyed capital generation for somebody else's money. And those guys are full, they're full, they're not buying.
Cem:So well said. I hope everybody heard that. I couldn't agree more. And I increasingly think, by the way, that they are going to cut the bonds. The rates too early because that's just what they've learned to do. And in an administration that's probably going to run things hot. In general, I think that adds to that.
I mean, I think right now, like let's come back and talk at our cadence but that's going to, I think, end up being very prescient.
Niels:Well on top of that, just before you… I just want to add to that because we were talking about bonds here. I mean, let's not forget that we have something like $10 trillion of refinancing coming in this year in the US given the infamous wisdom of funding themselves short when interest rates were practically at the lowest level ever. So, there's going to be a lot of bonds coming.
Cem:Yeah, it's a function of supply and demand. I'll add to that commentary. I think the hard move has happened. What I mean by that is it was relatively easy to hedge your inflation risk and your duration risk last year, the year before. The curve was inverted and you got paid to do it. At this point it's a hard trade. I mean, it's a hard trade to hedge, which means it's a more likely trade. That means there's less supply on the other side.
And I just think, increasingly, people are now kind of stuck. Who didn't already do it? You know, there's a lot of people who didn't do it. I'd say the majority of people haven't because the wild thing is, the more I talk to people outside of our kind of vol space, or even the rate space, I increasingly hear, well, you know, the 10-year hasn't gone above 5%, 5.5% for 15, 20 years. It's not going to 6%. I literally just went out and said, I think the 10-year is going to six and a quarter, and people's minds exploded as if we didn't just move 100 basis points in three months. It's the most fascinating…
Dave:With rate cuts.
Cem:Yeah, with rate cuts. But the Fed's going to cut. Well, how well did that work out those last three months?
Niels:This was after it went from 50 basis points to 500 basis points in 18 months.
Cem:Correct.
Dave:As I always say, and I may have said this to you guys before, but when I'm at some sort of risk conference, risk institute, chief risk officers dinner, etc, and risk management, people forget portfolio managers, investment managers, but chief risk officers tell me about what they're worried about. They're worried about geopolitics here, or recession there, whatever. And then when they finish, I always ask the same question, okay, what are you doing about what you're not worried about? And then they say, well, what do you mean?
% up year in S&P in:But it strikes me that it's all the things you're not worried about that are driving your underperformance because you're wasting all your time trying to structure things to what you think's going to happen and allowing forever on both the good and bad sides of the distribution underperforming away from what you think is going to happen, which is always what drives your returns. And then you always go and explain, after the fact, well, of course we're driving slowly, we have no brakes on the car.
This year, Cem, more than any, this goes on every year for me. But more than ever at my sort of year end, approaching year end conversations with investors and people we talk to a lot that aren't maybe investors, the dichotomy between the guy who has really efficient, negatively correlating, high convexity protection and aggressively out taking risk. Like I said, we have just come through the second block of best five years ever and they're calm as they could be. They're going out for a Sunday drive. They're pointing at the most beautiful mountain covered in snow and saying, let's go drive up and over that. See what we could find.
When I'm talking with all the guys that we've been talking to forever, that are still running traditional correlation based diversified portfolios, heavy bond weightings, maybe levered bond weightings, all they want to talk about is what could go wrong, what could go wrong.
They're so anxious, they're so keen to collect up their bear porn trophies to take to the investment committee and justify why they're driving so slowly. They're out for a Sunday drive with no brakes on the car and they're absolutely terrified. And all they could talk about is, you know, what can go wrong and how prudent they're being.
You know, making mid-single digits in another year when equity markets are up 20%, and just falling away from their path because the opportunity cost of missing those opportunities, in this very noisy path of compounding, is every bit as bad as losing money. But nobody treats it that way. It drives me nuts.
Cem:Let's talk about those brakes, shall we? What are the best brakes right now?
Let's start in the bond market. I mean, if you had to put something out there in the bond market to really just get you convexity so you could not just sleep at night, but as you mentioned, really take risk in what is a world of opportunity right now. Are there certain, I don't want to tie you down to a specific strike, or expiration, or anything like that, but if you were to (as I know you are prone to) put something on in the rate space, in particular, what would you be looking at? And then feel free to bring in the FX space too. I know that's obviously a huge opportunity as well.
I'd love to just hear your thoughts.
Dave: edentedly cheap at the end of: interest rate vol since late:A retail guy, who owns municipal bonds, that doesn't realize that his call maturity isn't his actual maturity when interest rates go up. But the biggest buyers of those callable note structures were Taiwanese insurance companies, and German pension funds, and Danish pension funds, and Korean pension funds, and Japanese banks. And all this stuff is sitting there just trapped. And you use that word exactly - it's just trapped. It's stuck. The pipes are clogged. And that keeps this sensitivity to interest rate vol.
Now interest rate vol is noticeably cheap in general. But in the markets where there was the big destruction in interest rate moves, dollars and euro, the management of the vanna and the vega duration of those permutant structures meant that they had to desperately buy back all the front end vol that they had sold to the original call date on an assumption of 100% probability. Cobble bonds always get called because interest rates never go up. Eventually they and had to sell that vol out to the terminal date.
So back-end vol, you’ve got the most extreme inverted vol surfaces and interest rates you've ever seen. And so, the cost benefit of owning extreme long-dated, back-end interest rate vol makes it very attractive because the inversion of underlying term structure, and vol structure, and pricing, has made it carry neutral at worst, if not carry positive to be long.
And it sits there and has big potential payoffs. Should, as we keep talking about, anybody decided shit, I'm going to cut those positions. Taiwanese insurance company is going to come back and unwind those structures and buy back the vol. And if that happened, the system wouldn't know what to do with it. It would be a vol shock of epic proportion, particularly in the Euro.
On the other hand, the market that hasn't had the huge move in underlying interest rates that did have, as I talked about, a major repricing of vol but hasn't actually had the move of delta, is Japan. And so, the Japan yield curve has not inverted like the US and Euro yield curves did, and their interest rate hikes just started.
I would argue there's some volatility pricing around the assumption that there won't be a big move in Japan interest rates and that it will be gradual - this forever gradual step. So, in other words, Cem, skew out of the money vol, vol of vol, has come back to be reasonably attractive in front-end yen rates.
So, a lot of the repricing that took place was this adjustment in the 10-year and longer 10-years, and the JGB market, and the interest rate swap market, not in the front-end 10-years. And so, that's a place that we think is interesting and has some potential for doing the inversion that took place everywhere else as they're now steepening back to not being inverted anymore.
FX has been, by far, the biggest opportunity last year to own convexity, to own vol of vol. I stuck pictures, I think starting in April, in my monthly updates of the Euro 25 delta butterflies, and drew red circles around the lows that always seem to occur right before the reflexive unwinds, and drew a red circle around March. And that's an example of one that I don't mind sticking in a write-up because there's plenty of liquidity in Euro FX vol.
My deeds aren't going to impact that market. Nobody's going to chase that away. But there's a whole bunch of other markets that I wouldn't talk about or draw pictures of. But I can say that, particularly around Europe and Euro space, vol got very, very cheap; initially Euro versus dollar, Swissy versus dollar, then eventually the crosses Euro/Swissy, Euro/sterling (probably the one that was the last one to stay cheap and after this week is not cheap anymore).
And you know, this raises questions around if this current move triggers that reflexivity as we step out of all time extreme lows, well, extreme lows for vol, but for vol of vol and convexity pricing. So, that's one I think people should really keep an eye on right now because it just started to move last week.
And this gets back to what I wrote about two months ago, month before, about this possible Trump led rejiggling of the global monetary system, which was due for a rejiggling because imbalances have gotten pretty big. I write about it in this Deja Vu Note. That's one of my usual quotes. Pegs end badly. All pegs end and you've got a number of very notable pegs or quasi pegs or highly managed currencies. The two most prominent ones being the two, you know, the second and third largest economies in the world, China and Europe.
Now one is an external peg, one is an internal peg, but both of them have created unsustainable imbalances that maybe the Trump wagon is going to kick dirt on and see if he shakes him up. And obviously the market pricing for that, you know, has taken place again. And People’s Bank of China is back to trying to manage their fixing methodologies and keep the currency from weakening.
And obviously Euro FX vol had already gone up quite a bit and Swiss FX vol and now sterling and Euro sterling going in the last week or so quite aggressively. So those are kind of the main things we've been focused on.
Now as I said, we've looked at S&P vol more than we've looked at it, well, since before COVID, since about July. And on this skew dynamic, particularly as that sort of flows through to convexity space more so than vanilla vol space. But the top side convexity has been, since really July, super attractive in S&P, attractive enough for us to get interested in it.
Cem:You know, if you look at a big picture analysis, we've been hammering on this idea for years now that, well before FX and interest rate vol picked up, that those volatilities, for a decade (this is a secular opportunity in our view) should be dramatically higher. It's a function of rising interest rates, inflation, deglobalization, all the things that are tied up with this big populist protectionist wave we are in the midst.
And again, last time we saw this, in the late ‘60s through the ‘70s, these same effects, equity vol, ironically, dramatically underperformed. Things like commodity vol dramatically underperformed.
It's the FX, the precious metals, the bond and interest rate vol, those are the things that were dramatically higher. And so, I think that's going to continue to be a trend, the areas and the cross-country kind of flows and opportunities. I know you're likening it a lot to the late ‘90s and that is a possible path. I hear you on that. But I actually think it probably goes even further back to a period, and it's probably more dramatic than that, because the same pressures that drove the late ‘90s are at play in terms of driving, strong dollar kind of braking everything else globally. But this time we have a much bigger structural inflation issue, and that's different than the ‘90s.
And the Fed has much less control in this environment, which creates, actually, more volatility. And you have this analogy: you have a big guy that's four times bigger than everybody else, with 10 guns in his pocket. Everybody kind of sits very quietly in the room.
When everybody's about the same size, and everybody has one gun, and something bad happens it’s a little more chaotic. And I just think that we're going to the latter, not the former.
And I think the Fed is going to lose control of the long end of the curve and lose the ability to push people, and everything, the markets, around. And you haven't seen that for 40 years. I just think that's a wow, what an opportunity for convexity, and rates, and FX.
Dave: , I mean, it so reminds me of:It was so easy for these guys to fund themselves, to just endlessly, money is just pouring in. Every corporate, everybody issuing bonds, everybody levering up the FX benefit because of the peg currencies. And you could borrow in dollars and invest in Indonesia at 14%. And then, all of a sudden one day, it was this desperate competition for a diminishing supply of that liquidity. And all of a sudden nobody could borrow. And all of a sudden everybody's competing and everybody's trying to capture it.
And you know, you see this right now. And, of course, the biggest competitor has been Secretary Yellen. She's dominating the stakes here and she's issuing her bills at 5% and sucking up endless trillions as the rest of the world's like, oh, you know, see if I can get mine.
And, as that picks up, and this competition comes, and this strong dollar wrecking-ball that we've started the year with just coming, and just knocking over cabinets as it runs through the china shop, and rising interest rates everywhere, heedless of what your individual debt and deficit situation is. You've got your own inflation problems. You've got your competitiveness to maintain some sort of currency stability.
As US rates go higher, well, Aussie rates go higher with them. They're not going to just sit there and let that interest differential expand away. You've already got the Aussie dollar at longtime historical lows.
So, it's such an interesting environment right now. I did the recent conversation with Grant Williams, and of course Grant always loves to chat with me because everybody he talks to talks about VIX, as though volatility is VIX. Volatility is not VIX.
VIX is one very specific market, a very big, very efficient one with all kinds of RV market making components and trading the VIX against the S&P vol against the dispersion - all these different things, but it's not vol. It's just S&P vol.
And vol around all asset classes and around the world is so dynamic right now and so fascinating. I love my chair.
Cem:And counterintuitively, I know we talk about this a lot, but I really want to make this point to the listener because the focus is on the VIX, because that's how people tend to hedge, counterintuitively it creates, going back to the beginning of our conversation, the opposite effect. That volume actually tends to underperform relative to the places where people aren't hedging. That's another argument for FX, and interest rate vol, and some of these other places to look, other than the big macro picture.
The hedging is not one sided in a lot of these other markets, or to the extent they are, they're no longer compressed in a way and dominated in a way that maybe S&P vol is. And I think that's important.
,:Those are two very different outcomes for markets. But they both had, at the center of them, this very same pressure. And, and started the same.
Cem:I think the difference, and I'm just kind of spitballing as I go to talk through this, is really the Federal Reserve's ability to be dominant in the ‘90s, to be able to be a bully and to force its will. And that's what led to that blow-off kind of tech bubble. People talk about, ‘the euphoria on tech’. No, it was liquidity. It was the first time that bazooka of monetary policy was deployed.
Cem:Greenspan took that natural rate of inflation and lowered everything in unemployment and he really started what we have now seen for 25, 30 years. The question is, is the Federal Reserve still going to be able to do that this time?
Dave: that last came out in August:I think the other thing that will be discussed, I mean, I don't think they'll do anything about it, but I think at least somebody will raise it. I mean, obviously Claudio Borio just spoke about it in his farewell speech at the BIS, is QE might be a good emergency - in case of fire break glass. But it's not necessarily a good economic stimulus tool because the long-term side effects are painful, it's hard to get out of. So, it'll be interesting to see if they somehow redefined QE as an emergency crisis tool, not as a policy stimulus tool. And again, I also don't think they'll apologize for misusing it either, but we'll see.
Cem:So yeah, they definitely want to apologize. I think that's fair to say. I also am skeptical that they would, although academically I agree with you that they would let go of the reins of power that is QE, and hem themselves in in any way, much less admit that it doesn't work the way they fathomed.
Dave:So, I think that's interesting because, again, it gets to this, how are they going to respond to this environment? So, their response with interest rate cuts in ‘95 and’ 98 was in big part because they were tightening in ‘94.
basis point hikes, in a year:What else was unique about ‘95 to ‘99? Well, the US, courtesy of Bill Clinton and Newt Gingrich, reduced debt to GDP and ran a surplus. Imagine if DOGE reduces deficit, and that makes US bonds relatively more attractive in the world, and more money gets sucked out of the rest of the world and the dollar gets even stronger.
You mentioned the dollar went up 50%. DXY went from 80 to 120. We've only got up 10% since Trump won the election so far. Imagine if we went up 50%. It would absolutely tear the world apart.
And again, this gets back to the problem, and obviously I quoted a link to my friend Russell Napier's paper in the November Note, his conversation, on-going conversation about a new monetary system, the US/China. He refers to what we're currently in as a non-monetary system that was set by China in their deval in ‘94 and their decision to not join sort of the major economies in the world, and to manage their currency in their own way. And are we going to find an amicable way to reset that system or will it be unilateral, both trying to impose their will on the others? And then how do we correct the imbalances in that scenario?
Niels:And one thing that's very different, I mean, I hear you talk about what if that happens, say, to the dollar. But also, I mean, think about the time we're in right now. I mean back in ‘95, ‘96, ‘97, we didn't have 75% of the world equity valuations in one country, I mean, the concentration risk. And it kind of reminds me, sadly, it's reminded also of the tragic events that are happening in LA. But I think you've kind of written about this forest fire analogy where when the system is fragile. Maybe you can just…
Dave:Yeah, self-organized criticality. That's systems self-organize and become unstable. So, the sand pile theory, forest avalanches, you know, the risk isn't the lightning strike, the risk isn't the wind. The risk is the dry brush on the ground. In my race car analogy, you can't manage the unknowable future curves. All you can manage is your car.
You can put brakes on your car, you can put good tires on your car, you can put a good engine in your car, a good steering wheel in your car. Well, the same thing goes with managing a risk portfolio. I say this again all the time when I'm talking to banks. Risk isn't something that you think may or may not happen in the future. Risk is on your balance sheet. Everything you need to know is right there on your balance sheet. What makes you vulnerable?
I'm vulnerable because there's too much dry brush. We haven't cleansed the forest. We know there's going to be droughts. We know there's going to be winds. We know that there's going to be lightning. You get enough dry brush, it'll find a spark. But the risk isn't the spark, the risk is endogenous. It's how you prepare for the inevitable. There's going to be a sharp curve. So, better to have brakes on your car.
And so, I hate to even talk about it, but it is such an obvious analogy that all of the risk management should take place before the fire starts. You should have water reservoirs full, dry brush cleaned out, fire breaks cut, wood roofs replaced with plastic roofs, you know, brush cut back away from houses, all these things.
Risk is subjective. Risk is yours and it's not some sort of average of 200 parallel universes. It's not an ensemble average. It's a time average. It's a path through time and you need to avoid things that you can't recover from. So, if you don't want your house to burn down, you need to find ways to protect it.
Now you can buy insurance. If somebody's willing to sell you fire insurance in Los Angeles, in California, buy it because you'll find out, as apparently they found out, as you get approaching more and more fire risk, they'll stop selling insurance. And it's a great analogy.
Cem:It is the analogy. I mean, that's what options are. They're insurance.
Cem:It's more than an analogy. It is truth. It is reality. And I love how it's coming full circle on the positioning conversation. Positioning, like that dry brush, is positioning at the end of the day.
Cem:You know, if dealers are ultimately short something, it's more likely to happen if there's dry brush. It's more likely to happen that potential energy, that supply and weight, or demand and weight, and, like you said, it's the only thing that we know for fact. Everything else is relative to some random, all kinds of things could happen in this world and subject to variants.
But what the actual positioning, what the actual facts are on the ground, what things look like in terms of supply and demand and weight, essentially, those are true probabilities, those are true potential energy. And that's what you really need to be paying attention to at all times.
Dave:And in my market analogy to the fire, dry brush is leverage. You've got a whole bunch of trees that you think are independent of each other, but you let enough dry brush grow up in between them, you're going to find out that you got a huge correlation risk. It's not how the fire starts or the one tree that catches fire because of the lightning strike. It's how the fire spreads across your entire portfolio.
Everybody's risk is correlation. Correlation is the number one implicit leverage in the system because everyone's been taught that's what you do. You buy things that are positively correlated but low positively correlated. And then you act like the average is constant, but in reality, that correlation is always too low in good markets and too high in bad markets because you've optimized to something stupid like a Sharpe ratio that says driving slowly is your only form of risk management - forego the upside to protect the downside. Well, that's mathematically wrong. Protect the downside so you can go participate in the upside. That's obviously the right answer.
Cem:And when people, and we could say that generally for getting convexity, whatever, but I'd like to also take this a little step further. When people ask me and say, how do you bend the probabilities in your favor? How do you predict or at least have a better sense of certain probabilities than others? You know, this bends people's minds. It's that simple.
You look at the market structure, you look at what's likely and improbable based on how the world is positioned. And everything flows out of that. The opposite of that is the distribution of outcomes, not some long normal distribution. And I think that's really such a critical conversation to have.
Dave:That allows me to give away what we actually do, give away the secret, right? We're not trying to guess how the fire is going to start, or where the fire is going to start, or when the fire is going to start. We're just trying to recognize where the most dry brush is in the forest. And we can do that because defining that dry brush as leverage, it's indicated by the price for that leverage in the form of volatility supply.
So, we just need to go and find. Because regulations force people to price risk inversely to risk, we just have to go and find where the insurance is the cheapest because that's where the risk will be the biggest in a financial market because it's driven by this leverage implicit in vol selling.
Cem:And obviously this is a trading financial podcast, but this is true for life, it's true for policy, it's true for every aspect of life. And I think we'll be the first to tell you once you become a vol guy, everything in your life you think about in this way. But I think it's so great to bring in the fire analogy into that picture as a result.
Let's keep on this positioning idea. And I have like one big question in terms of positioning. You know, I think it's interesting ,sitting over in Asia, how familiar you are, especially given how long you've been doing this, to think about structured products and structured product issuance. Here in the US we're not as accustomed to, especially given the size of our market, to those effects becoming dominant, or at least, in some way, so meaningful that they bend those probabilities like we just talked about. They're increasingly bending those probabilities here. Structured product issuance in two years is twice now tied to the S&P 500. And in particular, here in the US, twice what it was just two years ago.
Global structured product issuance has also broadly doubled, but again much more focused here in the US. We're talking $500 billion of issuance per year two years ago, to a trillion. And those are some big numbers. And that doesn't include all of the ETFs and all of the other products, mutual funds that are, some are $40 billion, $50 billion each. The JPE structured hedged equity for example, is I think up $50 billion now. So, it's really something to behold. I would argue that it's not slowing down, it's accelerating for all kinds of reason.
And actually, it makes sense in a sense. We, you and I, were talking about alternatives right here. Like people need an alternative to data. They can't do private equity or private credit anymore. They need to find something different. And options and derivatives and optionality allow for a non -directional, a diversification of that risk. Whether you agree with these structured products or not, they are, in a sense, diversifying parts of the risk. Not all of the risk for sure. Especially given that a lot of them are vol selling.
But I just wanted to ask, given your experience, do you see if this continues to grow, particularly if we see the same trends, if equity. 60/40 doesn't work, if the equity part and the bond part of the portfolio, over the next decade, perform poorly (which I actually expect that it will), and structured product issuance just grows, and grows, and grows.
Are we going to turn into Japan or Korea from the ‘90s? Talk to me about your thoughts, how that played out, for people who don't understand kind of the structured product issuance and how that change market structure out there. I'd love to have just a little bit of a conversation about this.
Dave:Yeah, it was really driven out here, from the financial repression imposed by currency policies, mercantilist policies, beginning with Japan and then Taiwan, Korea, Southeast Asia, China, everywhere, as interest rates were too low on the global savings side of the global balance sheet, and still continues to be much more prominent out here than it is even in the US and Europe with the growth you've had. I think I saw some, I think it was a Goldman Sachs note that you know, the growth in Asia last year was biggest, was bigger than Europe and the US, starting from an already higher base. Now, of course, out here in the US it's very dominated in the equity space out here it's across anything and everything.
did the first one in Korea in: irst one to really blow up in: ates were at all-time lows in:And so, you get these dynamics that interest us where you're implying that we stay at historical highs of correlation after a three standard deviation move. Well, that's obviously not possible. Just like you were implying that vol of vol would be zero after Euro interest rates went up 300 basis points. Well, obviously that's not going to happen. It's just not possible. You can't have the biggest move ever in vol of vol be zero. You can't have the biggest move ever and have the highest correlations ever, because it must have gone down because they moved relative to each other.
So, again, I think we talked about this last year. What was really this dynamic over time out here was the extension of duration, and that vol selling that all nibbled at the front end, and built, and built, and built over time as vols got lower and interest rates got lower. The structures became longer and longer and longer dated and you got the dynamics where you had inverted vol term structures and inverted skew term structures, in particular, out here in equity markets, up till COVID.
So, that dynamic we've not yet seen in the US. And however the deals are getting done, and the short-dated nature of it, they aren't doing stuff that is the real skew destroyers that eventually you got to out here. The accumulator type products, auto callable stuff that was really aggressive on skew, and aggressively became aggressively long dated that allowed for guys like me to do 3 year, 5 year variant swap type structures.
That isn't happening so much in the US although, again, this skew opportunity has triggered some interesting longer dated stuff that has been worthwhile.
Cem:Yeah, I think it's coming, I think it's a matter of years. It's not a short-term thing but I do think they’re continuing. Yeah, it's taken a while.
I do think this dichotomy, it’s between the opportunity in a world where liquidity is broadly coming out, we have much more volatility and less control from the Fed, and relative country asset class, et cetera, the dichotomy between that and then the structural vol selling that's then happening at the center of markets I find incredibly fascinating.
It's what's driven this dispersion which you and I have talked about at length. Not just in equity markets because you have all that vol selling at the index level but not in the opposite vol buying, directional betting involved buying, that's happening in the constituents that's really driving that market structure, that's creating historic dispersion.
Similar things are happening throughout the market in our vol space where, from one side you have this incredible amount of issuance that's, by the way, not concentrated, not leverage well distributed. So, it's consistent, it's not, it's not something that breaks. It just comes in, it spells. But then, at the same time, structurally having incredible realized volatility or impetus for it, at least, throughout systemic issues of the market.
So, actually, that is also one of the biggest reasons to think FX vol is going to continue to do incredibly well because it's not that vol center where it's being sold and monetized. Bond vol is somewhat, but not really, it's really that equity vol that continues to be compressed. I think equity vol, again, which is where everybody's going to try and go hedge the next 5, 10 years will likely underperform. While everything else will really have incredible opportunities.
It's really tied to this, the supply and demand issue that we've been talking about.
Dave:Yeah, I think that's exactly… Not that I advocate a particular view. I just say be convex, but the convexity that has worked, and looks like it continues to work, is owning something that has a decent weighting of US beta and owning opportunistic volatility and global multi asset class. And that has performed incredibly well for five years, six years, seven years, eight years.
These guys are all outperforming an equivalent benchmark of traditional portfolio managers - modern portfolio theory, Sharpe world guys, at a significant scale for a significant rundown. And again, the best period I've ever seen of that was ‘95 to ‘99.
And, of course, the big difference (and I was going to say this, Niels, to your point earlier), the big, big difference, and it's related to that inflation seems to be out of control now, is debt, is that you've now got every major country in this game through 100% of debt to GDP - most specifically, the keeper of the global reserve currency.
So, they're really putting pressure on breaking this thing down, and their main competitor China, in that game saying, I don't want any more part of this.
And so, the challenge is to get them to amicably come together and do a Plaza Louvre Accord, Shanghai Accord, and some sort of amicable arrangement, seems less and less likely. Which means the imbalances get torn apart in a far more abrupt conflict driven way.
Cem:Which, by the way, is what will ultimately force it to get done. I agree that it's got to be painful. You have to have that crisis right before people are forced to do something. And I do think that's probably coming. It's just going to be, before that comes, you're going to have the some pain.
I think this is, when I say big, I think Bretton Woods type big. I think we're going to have some really incredible... And this is not, we're not talking in 10 years, I'm talking in the next 2, 3 years. It’s going to come to a head much quicker than people realize because, like we were talking about on the bond side, once it gets started, that's when the speed accelerates. You get a first move where the vol is well supplied. That move breaks things a little bit, but vol was well supplied. The second move is the one that gets you. That's the one where, you know, there's no more vol available, it's too expensive to hedge.
And then, the next move is a five sigma, six sigma type event. So, I think when it comes to rates, you know, debt to GDP can't handle 7% to 10% yields. And I think we're going to 6.5% this year. So, you know, I think if we get to 7% to 10%, and I don't think it happens at a straight line, I think we'd go into recession before we got to that next level.
But I think if we start getting to those types of numbers, which people think is crazy for me to say, but people thought what I said five, two years ago, that that was crazy. And so, I just think that it's going to force some real, real big conversations.
I'm curious to see if the US does something as well, as really kind of like Japan did, it's going to be forced to at some point. Abandon QE, I don't think they have a choice. I think QE is their only out, essentially. Call it QE or call it just monetizing the debt. Debt to GDP may go to 220 from 130, or 120, where it is now, but we'll own all that debt and so it'll effectively be zero.
Interesting times ahead again. We could talk for three hours, we're at the hour and a half mark.
Niels:But it's a good time to, to wrap it up for this time.
I mean, speaking of big conversations, it's been big today. It'll be big the next time, and maybe it won't be a whole year before we do this because there is quite a lot to discuss. I think we did pretty well in getting to many of the sort of interesting topics that we are faced with right now.
Now, to all of you listening out there, if you also appreciate all of this information that Dave and Cem have provided, head over to your favorite podcast platform, leave a rating and review, make sure you follow both Dave and Cem, and make sure you read the new Deja Vu when it comes out tomorrow, hopefully, that Dave so graciously publishes on LinkedIn. At least that's where I get mine from.
And from Cem, Dave and me, thank you so much for listening. We look forward to being back with you as we continue our Global Macro series. And in the meantime, as usual, take care of yourself and take care of each other.
Ending:Thanks for listening to Top Traders Unplugged. If you feel you learned something of value from today's episode, the best way to stay updated is to go on over to iTunes and subscribe to the show so that you'll be sure to get all the new episodes as they're released. We have some amazing guests lined up for you and to ensure our show continues to grow, please leave us an honest rating and review in iTunes. It only takes a minute and it's the best way to show us you love the podcast. We'll see you next time on Top Traders Unplugged.