Today Alan and Mark step back from the noise to examine a market environment that feels subtly but meaningfully different. From AI euphoria giving way to harder questions, to gold’s steady rise and a surprising divergence between US and emerging market inflation, the conversation centers on rotation, uncertainty, and shifting assumptions about safety. They explore whether Treasuries still anchor portfolios the way they once did, how fiscal pressures could reshape monetary policy, and why regime thinking matters for systematic investors. Beneath it all is a reminder that correlations change, narratives evolve, and adaptability remains the most durable edge in uncertain markets.

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Episode TimeStamps:

00:00 – Introduction & market check-in

02:52 – February performance: CTAs, trend following & commodities

04:53 – Peak bubble? AI, metals & speculative excess

07:10 – Gold demand, central banks & safe-haven flows

10:40 – The AI narrative shift & tech repricing

13:22 – Global rotation: US vs Europe & emerging markets

15:22 – EM inflation now lower than US — why it matters

21:48 – Why macro still matters (regime thinking vs stock picking)

31:49 – Fiscal vs monetary dominance explained

41:59 – $700B in Treasury issuance — scale of the debt machine

44:51 – Inflation, asset bubbles & fiscal theory

56:45 – Machine learning, regime shifts & why trend following survives

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You're about to join Niels Kaastrup-Larsen on a raw and honest journey into the world of systematic investing and learn about the most dependable and consistent yet often overlooked investment strategy. Welcome to the Systematic Investor series.

Welcome back to the latest edition of Top Traders Unplugged where each week we take the pulse of the markets from the perspective of a rules-based investor. It's Alan Dunne here sitting in for Niels, joined by Mark this week. Mark, how are you?

Not too bad. I was just in Chicago the last couple of days in 60 degrees Fahrenheit which for Chicago, in February, is quite unusual.

Very nice. Well, I'm in Dublin. It's been raining nonstop for, I don't know, at least two months it feels like. So, I'm off to Miami next week. Niels is already out there. Obviously we've got a big iConnections hedge fund conference, so, a lot of people will be out there. So, if you're there, say hello. Looking forward to that. And obviously, yeah, hopefully we'll see… No doubt, we'll see some sunshine in Miami, you would expect at this time of year.

I'm going to say that there's so many hedge fund managers in Miami, Florida this time of year, it's almost as though, who's minding to shop if everybody's down in Florida?

That's right. Well, yeah, hopefully it'll be a good week. I'm sure it will. Lots of meetings and it'll be very busy.

We always start off with what's on your radar. Anything out of the ordinary catching your attention at the moment?

Well, everything seems to be out of the ordinary in the last month, since the beginning of the year, between all of the bubbles we've had the craziness in geopolitics. So where do we begin? Hard to say.

Fair enough. Well, we'll get to all of that in a minute. I think it makes sense to cover on performance, before we get into the main topics. So, on the month, trend following and managed futures continuing its recent good streak of performance. Month to date, the SocGen CTA index up 1.1%. And the SocGen Trend index slightly better at 1.15%, and then year to date pretty much neck and neck, both the SocGen CTA index and the SocGen Trend index up 5.9% on the year. So, it's obviously been a good period this month.

Obviously, we've seen a bit of a dip down in equities but continue to see some decent moves on the commodities side, I would say. Obviously gold is higher on the month, and that's been a big trend in the softs. The likes of cocoa and coffee trending to the downside. Energy markets starting to move up. And then elsewhere, obviously currencies probably a bit more choppy and US bonds obviously moving up, trending in the last while. But obviously it's been a good period, not just this month, last month, but for a few months.

Mark, any thoughts on how performance has evolved more recently in the last few months?

Well, what’s interesting is that, I like to say, after January we may have hit, at least in the metals and maybe some of the other markets, what I'll call peak bubble. And when you think about it, we had the spike in gold and silver. We've had a little bit of reversal.

What's really crazy is, if you look at some of the softs, if you look at what happened to cocoa in the last year or so, we've gone from a 12 handle down to 4, which is the same with coffee. It's just been a tremendous move. And this is what we see repeatedly with a lot of bubbles. You could have a blow off top that might have some correction and then sometimes they'll just slowly grind lower. And this is where a lot of trend followers can make money on both sides of the market.

Market goes higher, you take on a little of that speculative fever on the upside, then, if you can learn to get out at near the tops, then you can also play it on the other side.

I mean, coming into here and over the last few months, there's been a lot of talk about bubbles in the market and tech stock, etc. And obviously a lot of the momentum has already come out of that. So, is this a pause, do you think, or are we in the midst of the initial deflating, do you think?

Well, it's hard to say because you have to go back to what causes bubbles in the first place. So, you're going to need the fuel, which is excess money, which I think we still have. But you also need a narrative and a story associated with a bubble.

What we find with a lot of bubbles is that it's for those assets that are very hard to value. Because if they're hard to value then you could be able to get stories or narratives that lead to extreme price moves. Now, an interesting piece of research, studying, it was talked about the retail habitat. So, analysts have looked at retail investors and sort of said what seems to be their characteristics?

One of their characteristics is that they actually gravitate to hard-to-value stocks. So, stocks and other assets that are hard to value, if they have an optimistic narrative, they could lead to sort of extremes. So, that's what we sort of see with a lot of tech stocks. If you don't know how to discount the future cash flows from these firms, then it's harder to value. You could be extremely optimistic and that leads to bubbles.

In the commodities markets I think we are in a different situation. People sometimes forget that with a lot of commodities, especially if it's not an annual crop, there supply constraints; mining for example - supply constraints. So, if you have some optimistic euphoria, whether it be in silver or gold, where are you going to get the supply? The supply is constrained, so, you could have these demand shocks.

And that's what we've seen with the gold market and the silver market is that we're not going to see new supply. In fact, we'll sort of say that some of the discount in gold, from the high, is just related to the fact that there are fewer retail investors right now because of the Chinese lunar New Year.

Well, the central bank issue is very central to gold markets. We'll talk about this a little bit later when we talk about the US dollar, and US assets as a safe asset. Those countries that feel as though there might be a potential risk of sanctions have been bigger buyers. Their central banks have been bigger buyers than other central banks.

So, we'll say, China has been a big central bank buyer as well as some of the other countries, that we know, that are worried about sanctions from the US, have been bigger central bank buyers. Some are on the periphery of where there could be war; like Poland has been a big buyer of gold.

And so, we'll sort of see that this is serving as a quasi-safe asset. So, if you have foreign reserves or you have your excess reserves, if you're a central bank says, like, well if I don't want to put it in dollars, where else can I put my money? And they say, well, if I diversify, I should put some in gold. This is what we've seen has changed.

Yeah, for sure. And you're right, I mean the data I looked at, I think it had the National Bank of Poland that was the largest buyer in that period, and also a lot of the former Soviet countries ending in ‘stan’. Places that are hard to pronounce, not just Uzbekistan but other places like that. So, that's certainly consistent with what you're saying.

Now, interestingly you touched on narrative there, which I think is quite interesting and obviously something that we're seeing in markets at the moment is a shift in the narrative around AI. If we went back 12 months, maybe, AI was seen as a positive influence, it was going to change the world. It was all positive.

More spending was a good thing, it was going to benefit the likes of Nvidia, and all of those chips and infrastructure providers. Obviously, that's shifted as we've come into this year. We've had the SaaS apocalypse (I struggled to get that one out), the software sell-off, and, I suppose, more generally, that shift in the narrative that clearly there will be winners and losers from this AI revolution, that's one thing. And then secondly, obviously, in terms of market reaction to earnings numbers and you know, the releases about the amount of Capex spending around AI.

So, just curious, your take on that shifting narrative. I mean, what does that suggest to you, in terms of… Is that symptomatic more of the end of this move or just a different transition, a different phase of the move?

Well, let's talk about what I mean by the word narrative. So, when we say the word narrative, oftentimes we say, well we think of it as a story, which is true. But I think that narrative is the use of storytelling when we don't have what we'll call countable risk. So, let's say that there's a difference between risk and uncertainty. So, a risk is something that's measurable. I can count it. So that would be our volatility.

So, if you say, well, what's the volatility market? You say, let's look at the VIX, okay, it's something that's countable even though that's a market expectation from the options market. But then there's uncertainty or that which is not countable because I don't have any past events I could look to.

So, when I think of AI and the AI revolution, since this is new technology, I don't have a way to actually measure the countable risk. So, therefore I'm in the realm of uncountable, which is uncertainty. And therefore, I have to use narrative.

And then when I use the narrative, I have to come up with a metaphor or story for what I think might happen in the future. And in this particular case they, say, will I have to discount or sort of say the potential use of AI in the future. And we'll sort of say that AI is revolutionizing a lot of our behavior. It's going to revolutionize a lot of businesses. It's going to increase productivity. But is the growth going to be what is embedded right now in expectations? Is it going to be a little bit lower? Is it going to be a little bit higher?

And because we can't sort of count that, that's where the narrative issue comes in, you could have a very optimistic narrative and then discount the price with those values or it may be something in between a failure and these overly optimistic forecasts.

We’ve kind of fallen into more of rangy markets, particularly with respect to equities in the last while. I mean, if you look at performance, say, over the last four weeks or so, bonds have actually gone up, equities have come down a little bit. You had the kind of the escalation of the run up in metals and then a correction. Currencies have been ranging, so nothing… I suppose, underneath, maybe the big theme has been the rotation in markets. Is that probably fair to say?

Now, when we say out of bonds we want to be precise. There's been a lot of buying of US bonds, even by foreign investors. But, at this particular time, a lot of them are now hedging those bonds as opposed to unhedged. And we see US pension funds flows moving from the US and to outside the United States. And so that's where the rotation comes in.

And I mean, one of the interesting features has been, if you look at it from more of a sectoral perspective, you know, you've seen maybe industrials and materials (which would be kind of typically seen as cyclical sectors) doing well, and at the same time consumer staples doing well (which would be typically more kind of defensive stock). So, I mean, from that lens, a bit of an inconsistency, I guess we are seeing a rotation out of growth into value.

But I mean, is there, I suppose, a coherent story around that narrative apart from… Okay, I hear what you're saying about add a view, as it were, which is underpinned by a fairly obvious kind of story. But the other rotations, what's driving those do you think?

Well, let's go back to some of the facts that we sort of see. One (and I'll be leading the witness) is, what do you think of the US Inflation relative to emerging market inflation? Which do you think is higher or lower right now?

Well, you wouldn't guess US, but I'm guessing this is a trick question.

It's sort of a trick question, but I found this very amazing that if you look at a basket of EM countries and then you look at their inflation, it's actually lower than US Inflation, even now. So, obviously US Inflation was peaking after the pandemic. But we'll sort of say that, even now, US inflation is at around 3%. Our core inflation is higher than what we're seeing in emerging market countries.

So, this is a really big theme because what that means is that EM is much more attractive than the US just from the inflation story. So, that's going to cause rotation.

So, if you see that kind of behavior going on, then you have to say, well, what's really going on? And I think that the major theme, that I see, is two factors. We have this K shaped economy where we have real differences between the real economy and then the asset economy, in the US, and that's being played out in the behavior of assets such as stocks and bonds around the world.

And, I mean, you touch on the EM inflation versus US inflation. And I guess one of the upshots of that is that real yields, in EM, are higher and more attractive than in the US. I mean, I suppose, linked to this is, I suppose, historically the EM had a premium because policy was less credible, central banks were less independent, etc. They weren't as rigidly pursuing inflation targeting.

But now everything is shifting. They're kind of more adhering to those inflation targets, whereas credibility is maybe diminishing in the US. So, I suppose is that relative attractiveness of the US versus EM shifting?

Yes, I think the attractiveness is shifting. And we'll just say that part of this has to do with the major story of uncertainty. Now, I follow, pretty closely, the trade uncertainty indices; geopolitical uncertainty, monetary uncertainty. Some of those have peaked in the fall and some of them have come down. But let's say, trade uncertainty is still at very high levels. Overall uncertainty is high, although, again, it's come off its peak.

But when there's more uncertainty in, let's say, a G7 country or, in particular, the US, that's going to have an impact on whether foreign investors or even US investors look at US as a safe asset. So, that's on one level.

And also, if there's more uncertainty, well, I'm going to need a premium to hold a risky asset in a highly uncertain country versus a less uncertain country. And so, we're also seeing sort of flows going out there because you say, well, maybe I could discount those cash flows better in other countries than the US right now.

Just on this EM issue, I mean, is this a structural change, do you think, or we just had a point in time where this is a sweet spot for EM? I'm kind of thinking in terms of the overall regime that we're in at the moment.

Well, I'm spending more time thinking about the concept of a safe asset as a relative concept as opposed to an absolute concept. I think a lot of people, when they think about a safe asset, well they, they've always viewed it as the US dollar or treasuries as a safe asset, and it was as absolute.

And I think now we have to think of safety as a relative concept. You could still be a safe asset for US treasury, but it might be less safe than it was a year ago or two years ago. So consequently, your relative safety has gone down even though, on an absolute basis, you're safe. That means that people are going to diversify more of their asset flows.

Have we seen a fundamental shift in EM? That's probably not my area of expertise and I think that those are longer-term structural changes. But we do see a situation in that relative safety, or the view of the relative safety of US assets has fallen.

Yeah, fair enough. I mean it is something I've been thinking about. I mean, you do hear this comment, sometimes, that bonds are not going to diversify equities anymore, look at the bond equity correlation. But it's very definitive when you say it like that, whereas I don't think that's the case. I mean, you can certainly envisage certain scenarios where we have crises, the Fed cuts rate aggressively, and bonds rally, while equities go down, and bonds do diversify. So, you know, I would think in more, as you say, like kind of less safe or less reliable as a diversifier, but it’s not yes or no. It's more, less so than in the past.

Well, this is the key overall theme. You know, obviously, I'm a trend follower, a strong believer in trend follower, but also a global macro guy. And the reason why I am a global macro person is because I think we go through regime changes, or there are different regimes that we might be in where relationships change through time. By being aware of (we'll call it) the regime changes, or how all of our analysis is conditional, then you might be able to get an edge on how you should form your portfolios or where you think the opportunities might exist.

Now, I was going to start with a quote earlier in our podcast. That was from Peter Lynch from Fidelity, and he has worked for Fidelity for a number of years. I don't believe this quote, but I thought it was a great one. He said, ‘if you spend 14 minutes on macro then that's 12 minutes too long’.

So, I don't know if I will actually believe that. I think you should use the whole 14 minutes, or maybe more, to spend time on macro. But I think that there is this view that you don't need to know what's going on in the global macro economy. And I'll take the opposite point of view in that we do need to do this. That has a big impact on all types of assets because most of our asset price relationships are conditional in the environment we live in.

Let's give a simple example. There is an interesting paper I was looking at, talking about stock beta. And if you just look at what the beta is for an individual stock or what the beta is for a given asset, and once you break it down into different regimes, whether we're in crisis, non-crisis, recession, non-recession, the concept of a beta for an individual stock is a fairly fluid one.

I remember one discussion I was having when I was at John Henry, he said like what's the beta for the stock? And I said, well, it's this, but if we measure it differently, we'll get a different beta. He goes, well what do you mean there's a different beta? He said there should be one. What is the beta? And I said, well, there isn't a beta, there are many betas. His hands were thrown up in frustration and he said, I ask you a simple question, can't you give me a simple answer? And the answer is no, there are no simple answers.

Now that could just be because I'm an economist and there is always, ‘on the other hand’. In some sense, a lot of our relationships that we see are conditional and that's why we have to spend a lot of time looking at different regimes, looking at different environments because that's how we create an edge.

Yeah, fair enough. Well, I agree with you. I mean Peter Lynch was a bottom-up stock picker. So, I mean in terms of how he ran money, obviously hugely successfully, he wasn't a macro oriented investor. But I think for the rest of us, if we're thinking about portfolio construction, it’s certainly good to be cognizant of the macro picture and the regime changes.

Now. you could look at the equity market and you wouldn't really see much evidence of a regime shift. It went up back then, it's still going up now. So, nothing there. But it is curious to think about what are the elements where we're seeing that change in the regime.

And maybe gold is the flip side of that. Historically you would have explained it in terms of real yields and the dollar, but obviously it's been accelerating in the last one to two years independent of those factors driven by central bank buying, ETF buying, etc. Anything else you look at or any other signs that you see, that point to, that that are evidence of, that regime change, do you think?

Well, we can think of regime change on a number of different levels. So, you can think of regime changes and use sort of techniques called, like, hidden Markov processes to just sort of say like well, are we in a high vol / low vol regime, or risk-on / risk-off regime? And I'm not saying that those are easier to forecast, but we could sort of say that's very data dependent.

So, we do find, for example, if we're in a higher risk regime or a higher risk environment, that the behavior difference, strategies, and tactics, are different than if you're in a low volatility regime. And in particular, let's look at the VIX. What you find is that the VIX is a very skewed distribution. We do find that, once it gets above like 25 and it's moving higher (so it's above a certain threshold level and moving higher), it's bad news for a lot of assets.

So then if it gets to above you know, around 40 whatever, then we know it's sort of peaking, and then we know it's going to come back the other way, and that's good news to get back in. So, there's a nice nonlinear relationship, and we could use sort of like techniques to look at high versus low vol environments. So, we could do that.

There are also regimes when we think about the environment, you know, what type of monetary environment we are in and what type of fiscal environment we’re in. We could think about, you know, the view of geopolitical, if there's high level of uncertainty, that's going to change the demand for safe assets. So, there's, we'll call it the price driven regimes. There are policy structural regimes. There are sentiment regimes.

So, we could decompose these different types of impacts. And so, in a simple podcast we can be flip with our definitions but when you look underneath the surface, you have to decompose this into a lot of different types of regimes and this is where you could be able to create your edge - so, by sort of decomposing the kind of regimes that you're in.

Now we do know, for example, the stock equity correlation regime, which is usually negative, inflation goes up, usually then that stock/bond correlation is also going to go higher. So, it's inflation dependent. So, you can use sort of third factors to give us some indication of what kind of environment we're in.

And why do we want to look at that? Because if, let's say, that the stock/bond correlation changes, well that has a big impact on what type of alternatives you want to buy. If the stock/bond correlation is negative, and highly negative, and rates are reasonably high… Let me put this way, I don't really need to buy alternative strategies. But when that correlation starts to go positive and rates are lower, they say, well, that's a great time to own a lot of hedge fund strategies or other types of strategies. So, that's a perfect example where we could use sort of regime analysis to help us build portfolios, how we look at them.

And then from a, we'll say, more micro basis, we know that when we build portfolios, even based on trends, the correlation relationships may have a big impact on the kind of risk exposures we have. So, knowing the regime that we're in could help us, on the margin, change our tilts and our exposures to make sure that we're not overexposed to one sector versus another.

One of the topics you touched on there was the kind of the monetary regime, and I think you might have mentioned the fiscal regime. But certainly, we're into an era now where there is a lot more talk of possible fiscal dominance. I mean, people have been drawn around the term fiscal dominance for a while now as if we're here already.

I don't think we are quite there yet, but it is obviously a risk because fiscal dominance is when the debt and deficit levels are so great that they are dictating monetary policy. I know the pressure is on monetary policy at the moment, but we're not quite there yet. But taking that angle, that lens, what would you say about the regime now versus where we were from a kind of a fiscal and monetary dominance perspective?

Right. Well, I think that this issue, or at least trying to frame a lot of the discussion about Fed independence. Frame who is going to be the chairman of the Fed. Frame how, so the tussle between, let's say the current US administration and the central bank has to be looked at through the idea of fiscal versus monetary dominance.

And so, of course there's a political agenda going on here, but I think sometimes we have to take ourselves away from the politics and look at the economics and try to say, what causes the tension between the Fed and the Treasury Department. So, we'll try to take out the administration. We'll call it Fed versus Treasury. And this is the issue of fiscal versus monetary dominance.

In a monetary dominant environment, we'll say the Fed could focus on, or the central bank can focus on inflation, employment, regulation, and the fiscal focus is just on financing - where can I minimize the cost of my debt? That's all I have to worry about.

The Fed could do whatever they want. In fact, the fiscal side or the treasury could say, yeah, you could follow whatever you're doing because your objective is full employment. We're just going to then try to pick on the curve where we want to issue our debt and we're going to finance our deficits, which we don't think are going to be persistent, and everybody's happy.

Okay. If we have to go into a fiscal dominant situation, well then, you know, the government and even the central bank, even if they're appointed for a long period of time, they're still authorized or there's oversight by Congress. Fiscal dominance says that debt is so high, we're going to put pressure on the central bank to use its powers to control interest rates and then buy up excess debt. So, like, well, is this abnormal? Should this be shocking?

Well, look at World War II. The whole idea is that the Fed kept interest rates low because we're financing huge deficits to pay for the war. And then they are actively buying treasuries. So, this is what happened in World War II, post World War II. And then we had the Treasury Fed Accord.

The Treasury Fed Accord said that, well, now that we're going to split the Fed and Treasury working in tandem to lower the cost of financing because, in the effect of doing that, you raised inflation. Now we're going to allow them to sort of move in different directions.

Now, what's important here is there had been another recent paper about debt. And then they talked about debt as a safe asset. Well, that's true except if we're having a war. If you buy debt, and if you're in a war scenario, because there's a lot of financing of wars and then there's usually inflation because of, perhaps, pent up demand after the war ends, you don't want to be a debt holder.

And what these authors actually said is that the pandemic had all the characteristics of a war. We had constrained demand, we had excess monetary policy, we sort of drove down interest rates, we had excess fiscal policy. It sort of offset the war on the pandemic.

So what happens when we came out of that, that's why we had a sort of inflation burst because of the excesses of fiscal policy. So, when you think about it, the excesses from that pandemic war is, now, we're still having that issue today because, in some sense, that we should have said, well, all of that spending was temporary, so we should have seen a big budget deficit increase. Now that the pandemic is over, we should have reversed all of that.

If you don't reverse that, well then you have a problem. And this is where now you have the tussle between the monetary and the fiscal side.

A lot to get into there. Yes, as you say, you've got this tussle and as you rightly say, I mean Covid was treated just like a war. That was the kind of narrative at the time. And I think, in the UK, there was actually direct buying from the bank of England of bonds issued by the treasury, whereas in the US it wasn't direct buying, but in May, I mean, the treasury issued more debt and the Fed did more QE. And so, they didn't finance it directly, but effectively they did.

And then ultimately in that scenario, the Fed did flex its muscles again and demand its independence back. And that's why you had this kind of standoff between the Fed and the Treasury, which ultimately resulted in the Fed Treasury Accord, and the Fed got its independence back.

So, this is all relevant in the current context because people are now saying you've got Kevin Warsh and you've got Scott Bessent, both linked via Stanley Druckenmiller, interestingly enough. But they obviously already have spoken about a possible new accord. But I mean, they’ve spoken about it in some kind of positive light. But I mean, you know, should we interpret that as more financial repression or what do you think that might look like?

Well, the situation we're in right now, we'll sort of say that the current Treasury Department would love for the Fed to lower interest rates because that lowers the cost of debt and you could use that. Instead of paying off interest you can use that money for other purposes. It could be used for other expenditures.

So you have the desire to do that and you sort of say, well, if you can't default on your debt, what's the easiest way to reduce the value of your nominal debt if you have inflation? So, you have a Treasury that would sort of say, I'd like to have lower interest rate to lower my financing costs. I really don't mind if, let's say there's a little bit higher inflation (even though they'll never say this because that reduces the real value of the debt).

And you have, we'll call it, K shaped economy. And if you look at some of the data on the employment side, you can sort of say that I may, as a current administration, I may want to run an economy hotter because I don't believe the data that I have. And a perfect example we just had in January, the revisions for employment.

The revision for employment said that there was probably a million fewer jobs created because we changed the benchmark. The year before we actually did a seasonal adjustment and we got like lower job production. So, if you said, look, we didn't create a million jobs in the last year or so. The economy may not be doing as well as we expect, on the one leg of the K. So, you may want to, say, run my economy hotter.

Now, you could also say that these benchmark revisions were caused by demographics. And so, let's say people are moving out of the United States (we'll call that euphemistically they're moving out of the United States), and you have less people in the workforce, well, then it may not matter as much. So, we don't see the unemployment number going higher. But you'd say there's this tussle between fiscal and monetary policy because we do have these competing interests.

Now the interesting part and the reason how we get back to this recurring theme of always uncertainty and is that worse, he said is that we never really liked QE in the excesses of what we had. So, in some sense, if he actually follows through on his behaviors, he's going to reduce the amount of treasuries on the Fed balance sheet. That's reducing the overall liquidity. That's going to cause a major deleveraging which should have an impact on asset markets.

At the same time, it's exactly what the Treasury does not want him to do. They like the fact that the Fed has a large balance sheet and we'll say like look at the size of the financing. And, again, Alan, I throw out these questions just to be provocative. You know, it's not the obvious answer. How much debt do you think the US actually issued, just last week? Just take a guess.

Half a trillion or something there.

So, you're close, but you're still off by about US$200 billion. In one week the treasury that we had sort of quarterly refinancing. Not all of this was new money. Some of this was rolled over. But, we did like a US$700 billion of treasuries being auctioned in one week. Now that was between bills, 2-years, 10-years. So, it was along the entire curve.

But that's a huge amount of money. Now, the world can absorb that kind of stuff. But if, let's say that there was a change in people's buying habits for treasuries, that's a big number. And so, when you think about, in one week you could do that, then you look at the size of the balance sheet. That's a pretty good portion of the entire Fed balance sheet.

Now, again, we have to look at what is the net new money and what is this total demand from a number of different sources. And you can cut sort of overnight repos. So, there's ways to do this, but that's a big number. And that should give people a sense of what we're dealing with in terms of the size of the issues.

Yeah, well, as you say, the demand is there for it at the moment. I mean, you'd have to look to see where it's coming from. Obviously, that's shifted over time. Maybe it's less foreign. And also, they've talked about changing the SLR to make it more attractive for banks to hold it. So, there are things.

I mean, coming back to Warsh, his idea is the smaller balance sheet but equally lower rates. And then, I guess, the upshot of all of that would be maybe more T-bill issuance to take advantage of lower short-term rates, if that's how it played out.

But one thing that we're missing in this… We're talking about fiscal dominance. Central banks are only targeting inflation. And now we're talking about adjusting rates to target, you know, to be cognizant of debt. But of course that forgets about asset prices.

So, if we had this scenario of the Fed being more cognizant of debt considerations and lowering rates for that reason as well, not only could it be inflationary, but presumably, as you say, it would run the economy hot and potentially fuel asset bubbles as well. Which is another part of the discussion from the ‘90s, that kind of is kind of getting lost in the current debate, I think.

Well, let's go back to what we started with. We always talk about regime changes. So, first this is that this could be a regime change if we get a new Fed chairman because he might have a different view.

Now let me put this way, there could be a regime change because he has the view that is consistent with what he said he is interested in, which means have a lower Fed balance sheet. We could also have a regime change where he's going to sort of follow more of what the Treasury Secretary would like and allow for fiscal dominance. That's a different regime change.

And the other third will sort of say that if we just continue to follow the path of these large deficits in the US, and probably the most interesting piece of research the last couple of years in the macro side, it hasn't got as much attention, is from John Cochrane from the University of Chicago, now at the Hoover Institute. So, he's written about the fiscal theory of the price level.

And so, he said, well, if we really want to look at this shock to inflation post pandemic, it's a fiscal theory of inflation. It's not a monetary theory.

Now, the two of them were working together, but his view is that you're going to get inflation because people are going to start to buy real assets as opposed to, you know, debt assets if there's the expectation of permanent large deficits or, we'll call it, negative surpluses on the fiscal side. So that's going to lead to inflation.

So what you’re going to do is that you're going to put your money into real assets, which we've seen in the gold. If, say, you're going to put it in other financial assets, we're calling this sometimes a bubble because if too much of it goes into one type of assets. But generally, financial assets are being bid up because people sort of feel as though they may have excess savings. They may not want to buy real assets or they purchase goods so they're bidding up financial assets.

And he had a definition for inflation of something like, inflation happens when the government spends too much and lives too well, or something like that, which is consistent with the Cochrane perspective.

This is consistent with this. So let me put this way. It's possible, if you get the Chairman Warsh, of his comments over the last 10 years, you know, we'll sort of say the current administration may have no idea what they're really getting. If he's the person that they choose and he follows through on what he says he's going to do, we're going to be in a very different monetary regime because we're going to be cutting back the balance sheet.

You could sort of say there's going to be a different view on how we're going to look at interest rates, and that that may not be inconsistent with what the Treasury Secretary would like. So, when we talk about uncertainty and then we talk about, okay, why might you want to be a trend follower? Why do you follow certain strategies? I don't think people fully appreciate the amount of uncertainty they could have. It's almost as though that, at different times, you see people in government and you say, I'm surprised by what he did. If you just read his speeches and read what he said, you might have a pretty good idea and you'd say like this is not what you were expecting.

Well, there are different views on this. There is the, as you say, that's a very literal reading of what he's saying. But he has also said that he believes in the disinflationary effects of AI, and he sees scope for lower interest rates. So, presumably, he was emphasizing those comments when he was doing his interviews at the White House.

If you’ve seen those charts that show whether he was dovish or hawkish, depending on whether it was Republicans or Democrats in power, there is a suspicion that he might be a bit more political than maybe other central bankers.

We'll say, Wall Street, and many voters, actually sort of project what they would like to see on a candidate or on someone as opposed to what they see as reality. And sometimes they actually then respond to what they think their constituents want. So, we'll just sort of say there is uncertainty here because we don't know what Warsh we're going to get.

Yes.

I think that you often see this with Supreme Court justices, not the current court, but if you look historically, there are a number of Supreme Court justices that are picked, and it is assumed that he was going to behave a certain way, and then after becoming the justice, his behavior seems to be significantly different than what they thought that they were getting. So, this is the kind of uncertainty we have. And so, what we're saying is be prepared for something that may be different than what you're reading about in the newspapers.

Yeah, I mean, that's fair enough. I mean, maybe moving it to more of a quant model trading perspective. Obviously, this is more qualitative, but obviously, as you say, when you do get a regime shift, you could get shifts in relationships that would be relevant. So, how do you think about… And obviously the Fed is at the heart of the financial system. So, if there was a change in how the Fed is operating, whether it's a shift in towards less balance sheet, more active on the interest rates, or if it's fiscal dominance, whatever it is, that could have pretty widespread implications. So how do you think about that when you're maybe building models?

Right. Well, one is that we've talked about that you want to try to pick up regime changes. So, we know we have the technology to do that. So, if we see that using, let's say, the hidden Markov processes, we can be able to say that if asset prices start to delink or have a change in behavior like a volatility, we can pick that up. And so, we can adjust for that.

We also know that there are breakpoints in data sets. So, we have technology to, what we call, change point detection, to sort of see if there's a change or break in a time series. So, now what we could have is, of course, you're never going to pick a peak or a trough in a break point because it has to break before you actually then pick it up in the data.

But that being said, if we're sort of aware that there's these structural changes, then we could be more sensitive to when we look at the data to see if there's a break point.

So, what does that mean? One of the things that I work with my friends, with a firm we're involved with is that we're looking at the connections across markets. We think of markets as a connected system. We think of it as a network. And so, what we're trying to look for is the causal relationships between markets, And then sort of say, like, how have network connections changed through time? And if we see that there are changes in network connections, and we are willing to accept or adapt to these changes, then it's more likely that we could get ahead of it.

Now, any type of trend following any type of quant model is always sort of looking into the past. Okay, so the question is how fast can we react to past data or how can we sort of react to these changes as they occur? One of the advantages of having a macro view is that when you start to see changes, or we expect changes, we could then be more sensitive to say, is there something going on in the data that we should be aware of and highlight?

Yeah. So, is it a case that you would see a shift that is consistent with what you're expecting from a macro perspective? Is that it?

One would hope that it's consistent with what we see in a macro perspective. But what we're finding, and this is one of the key issues that we're seeing in economics in general and especially in finance, is the issue of trying to identify causality. So, this is the number one issue in finance now.

And we'll sort of say that ADIA, their labs, had their causal discovery challenge where they sort of said you could use different machine learning to look at sort of finding causal relationships. The reason why this is so important is that, over the last couple of years, what we have is what we call the factor zoom. You look at enough data, everybody's finding all these new risk premiums or risk factors in the data.

And then what you find out is that you find them in the training set, or you find them in past history, then we look at them in the future and they no longer exist. So, there were sort of spurious causality, or we are trying to find something that we overfitted, or we found something that didn't really exist or it only existed temporarily in the disadvantage peers.

So, I said, well, look, if we're having this, we'll call it the factor zoo, we're finding also that, well, what we find in the data sometimes doesn't persist through time. Well, maybe we got to go back to square one and say, let's look for what are the important causal agents. Let's look for causal factors and then see if our models are consistent with the actual data, or can we find causal relationships that we need to rethink our models. This is going to improve the amount overall science for quant modeling.

Interesting. I mean, in the current context, where is that relevant, do you think? Or what are the ones… causality uncertain, would you say?

Well, say this is a work in progress because what we'll sort of say, when we've analyzed some of the interesting work in machine learning right now, they've done some testing, some research where they said like, well, is it the number of features we look at that gives us value added or is it the complexity of our model? So linear versus nonlinear?

And the machine learning world says that, well, you know, we want to add more complex sort of techniques to try to tease out relationships in data. And what some of the research is now telling us is that it's not the complexity of the technique that matters, it's the number of features that we have or it's the domain knowledge we have that actually adds more value. So, if it's an arms race choosing more complex machine learning techniques, we may not get as much value.

So, we talked about peak bubble. We'll sort of say that for different techniques there's a while that everyone thinks that this is going to be the new holy grail. And then, in reality, what we find out is that it's a lot tougher to come up with a new model solution than we thought.

Another thing we find with machine learning is, for example, is that machine learning is very good on stationary data. So, I'll use the analogy, if we're using machine learning to look at visual interpretations, can we find a picture of a dog? So, we show a hundred thousand pictures of dogs is, after a while, it learns how to find a picture of a dog in a photo. Okay, well, if the dog is changing through time, its characteristics are changing, like a market, that we find that it's a lot harder to do this.

And so, a lot of the techniques that have, in machine learning, been very promising in different areas of science, which has very stationary dictionary data, it's been very successful. When we apply these techniques when we're looking at time series data, that seems to more follow an adaptive markets hypothesis, which is what Andy Lo developed.

What we find is we find that agents behavior changes through time. We find machine learning is a lot harder to… increases predictive power. So, markets are complex, they're non stationary, they go through regime changes. Which means that the quest for finding the perfect model is ongoing and we still haven't solved it yet.

Very good. So, I mean it comes back to robustness, doesn't it? I mean, obviously what you're suggesting is you can't overly optimize given the complex adaptive nature of the system.

And when you think about, okay, for your listeners and for a lot of modelers, you say, well, should I tool up for machine learning? On the one hand, the answer is absolutely, you’ve got to know what's going on in AI, you have to know what's going on in machine learning. At the same time, your benchmark standards should be more simpler models. So, I don't want to sound like I'm talking out of both sides of my mouth.

I still believe in trend following. It still seems that it works, especially in uncertain regimes, especially when data is nonstationary. At the same time, how do I always try to try to improve on that? Because so many people are already trend followers, so many people are already using similar models. So, you're always trying to say, how can I look for some small improvements that are going to differentiate myself from everyone else and also give me a predictive edge. The problem comes in on margin, it's sometimes hard to do that.

Now, when we say it's hard to do, just when I think that you've solved it, come up with a better model, markets may change slightly and they go through periods of, you know, strong performance. Then you get fallen performance, and then it improves. And that's even finding for momentum and trend following.

There are periods that when it does really well, then there might be a period where it wanes in performance and it goes back, and this is what we've seen throughout history. So, right now we've had a good performance and trend following. Will that persist? Well, I could sort of say over the next five years, I could still be a believer in momentum and trend following. Over the next five months, that's a little bit harder to say.

Who knows?

Well, we'll be here, anyway, to evaluate that over the next five months. So, we shall see. Thanks very much for your thoughts, Mark. Great to catch up and get your perspective on all of that. I'll be back again, actually. Next week I'll be back from Miami in time to record with Cem. So if you've any questions, please get them in to us. But until then, from all of us here on Top Traders Unplugged, stay tuned and we'll be back again with more content.

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