211 Systematic Investor Series ft. Mark Rzepczynski – September 25th, 2022

[00:00:00] Intro

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.

[00:00:16] Niels

Welcome, and welcome back to this week’s edition of the Systematic Investor Series with Mark Rzepczinsky and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global markets through the lens of a rules based investor. Now, for those of you who are regular listeners, this podcast series is all about voicing our differences on the one topic that brings us together, namely, systematic investing, using the often overlooked, but very robust strategy of trend following.

We hope that today’s episode will trigger your curiosity to learn more by diving into the back catalog of all the episodes that you may have missed, like last week’s episode with Rob, where we answered a lot of great questions from our community that had come in during Rob’s vacation. You don’t want to miss that episode.

Also I would encourage you to listen to the Wednesday episode where this week we spoke to Michael Howell about how liquidity drives financial markets based on his book, Capital Wars: The Rise of Global Liquidity, which is very relevant at this point in time. If you missed any of these conversations, I would really encourage you to go back and listen to them as soon as you finished listening to Mark and I today.

Mark, as ever, it’s great to have you back this week. Another crazy, busy week if you follow central banks or any kind of financial or commodity market. How are you doing? How have you been doing since we last spoke? 

[00:01:41] Mark

I’m glad it’s Saturday, just in terms of, not from what I may have made or not made in the markets, but just because of all of the swirling around of information around central banks. I talked to some clients who said that this was “central bank week” and everybody was posting new information. I think we got a lot of clarity on where liquidity is, going forward in the world, and it’s not good. 

[00:02:13] Niels

It’s not good. You know the saying of course, “Thank God it’s Friday,” but I don’t think anyone yesterday felt that way, frankly, with what happened I must say in the markets.

But anyways as expected, the Fed did raise the overnight lending rate by 75 basis points from 3 to 3.25. In the hawkish post-meeting press conference, the chairman signaled that they are not yet close to a peak in that rate. It was communicated that Fed funds would likely end the year at 4.25.

The news rocked the treasury market with the two year note closing the week 32 basis points higher at 4.19%, just off the intra week high at 4.25. The yield curve inverted further, closing at minus 57 basis points, not far off the minus 75 basis points seen in May of 2000. Equity investors were equally dismayed by the news, the S&P 500 closed the week down approximately 5%, and now stands about 1% above the low that was hit in June, with last week’s Fed news continuing to reverberate through the market. 

In addition to the Fed raising interest rates, the Swiss National Bank also hiked, eliminating the last negative interest rate in Europe. Traders had been looking for a 1% move, greater than the 75 basis points that the S&P actually delivered. Both the BOE and the ECB continue to strike a hawkish stance, but investors are doubtful that they will follow through with the same determination as the Fed. 

Evidence can be found in the currency markets. We saw weakness in those two currencies versus the dollar, the pound closed near 5% lower; the Euro, near 3% lower compared to last week’s close. The fall in the pound, intensified by the news that the UK intends to cut taxes in an effort to combat what was labeled as an ongoing recession and hit a fresh 37 year low at 109, and also the 10 year gilt yields ripped to 3.83%, up from 3.5% – the largest one-day rise since at least 1989. 

On the other side of the globe, the Bank of Japan continues to be dovish, on the other hand, reaffirming their commitment to holding interest rates at artificially low levels. That policy has caused a nearly 20% devaluation of the yen versus the dollar. In an attempt to stem the decline, the BOJ intervened buying yen for the first time in over two decades.

Of course, many other central banks raised their benchmark rates this week. As we close out the week, the markets don’t feel anywhere near equilibrium. With that investors should expect volatility to continue into the quarter and next week, and most likely for a lot longer. 

Mark, let me bring you back here just for you to talk a little bit about one of the things that you’ve been noticing in the last few weeks since we last spoke, both either from markets or from your kind of trend following lens.

[00:05:12] Mark

The thing that really strikes me is the moves in the currency markets. We now have what I call currency vigilantes. It used to be that we talked about bond vigilantes, that they would slap reality in the face of policy makers.

Now we have the currency vigilantes that are telling you that some central banks are still behind the curve and some other banks are obviously going to continue their hawkish policies. When you look at the dollar as an index, it’s up close to 17%, closing in on 20% gains for this year.

You look at the yen, it’s well into bear territory. If you look closely, the BOJ has not changed its policies, but they’re so worried about what’s happening, now, with the yen, now that they intervened. Intervention has always been thought of as a failed policy. There’s been a lot of research in that area that was much more actively used in the ‘80s. Then they stopped doing it because they said it just doesn’t work. 

If you intervene and don’t change your underlying monetary policy, you’re not going to have any effect and, as a central bank, you’re going to lose money on those trades. That’s the environment that we’re in.

But you just look at the pound, you look at Euros, you look at all of the currencies, they’re clearly telling you that the rest of the central banks around the world are behind what the Fed is doing, and they have inflation that’s just as high as in the US, or somewhat higher.

So, in some sense, a lot of the trends that we’re seeing are going to continue. Some people have started to talk about how we’re oversold to some degree. Can’t be oversold if the fundamentals are still in one direction. In fact, that’s why I focus in and look at fundamentals, because if you look at technical graphs, you could say that these markets look like they’re overextended. But then you look at what’s going on the policy side and you say, “This could continue on for quite a while.” 

[00:07:32] Niels

Yeah. You know what? It’s interesting when you were talking about that and obviously with the pound hitting $1.09 this week, it reminded me that I think that in September, I think we’re exactly 30 years since the pound was forced out of the EMS (as it was called back then) on that, I guess, George Sorros breaking the the pound or whatever the story was.

That’s an interesting coincidence that we are now back to really extreme low levels now. But also I think that what you’re saying about the currencies, I think people have somewhat forgotten what happens when you really get these big, massive forces out. What I mean by that is that in the last 20 years or so, between central banks, policy has been quite coordinated because they’ve been more or less in the same situation from an economic point of view.

That means that there hasn’t really been lots of things going on in the currencies for trend followers. I don’t think we have, as an industry, made much money, from anything in the currency sector, up until this year – for at least 10, 15 years. But these big forces, especially when it happens and it manifests itself in currencies, actually have a ripple effect into many other things.

What I worry about, a little bit, is that there are so many people sitting in a portfolio management role today (even at big pension funds), and they have no experience with inflation. They have no experience with these kinds of moves in general, let alone big currency moves. Many of these “experts,” all they’ve been doing is calling for some kind of Fed pivot so that things could get back to normal, and we would get back to our 2% inflation target, and so on and so forth, and everything would be fine.

So, my worry is that there’s going to be some fallout from this lack of experience so to speak. Maybe this is really just the beginning of that. 

It was interesting to me, if we just stay with the trend following theme, this week, of course, it’s been a solid week (I imagine) for the trend following industry. That’s certainly what the indices suggest. Of course, once again, it’s been the fixed income markets and, to some extent, the currency markets that have been leading the charge, so to speak, maybe with a few other sectors. But frankly, I think most of the risk budgets are being focused in these two “trends.”

Interestingly enough, again we heard, and you and I think spoke about it a little while ago with JP Morgan and Nomura, coming out at the end of July saying, “Oh but trend followers have gone out of their short fixed income trades and now they’re positioning in for something else and what have you.

I think we have all agreed that no, no, no, if we look at our positions, there’s no nothing to suggest that we have any long signals coming in the near future in these sectors. I think that’s another thing why people should be very careful what they read in the mainstream media about what trend followers are doing.

We’re going to actually talk about that a little bit later with some other research that has come out in that direction, so to speak. But anyways, these are definitely interesting times. Unfortunately, these are also very painful times for many traditional investors, but at least for those who did make the jump into trend following there has been some good news, this year so far at least. 

My own trend barometer finished at 55, Friday. So again, confirming a positive month so far, at least for trend followers. If I, just briefly, before I bring you back Mark, talk through where we are in the indices. The BTOP50 index (and that is as of Thursday), I think Friday was a good day. I certainly expect that to be a good day, but even as of Thursday we’re up 2.3% for the month, up 17.3% for the year. SocGen CTA also up 2.3% for the month, and 24% for the year. The Trend Index up 3.5%, almost up 32.6% for the year. And the Short Term Traders Index up 75 basis points and up 11.93% so far this year.

Contrasting that, we have the traditional markets. The MSCI World Index down 7.19% so far in September, down 24.5% for the year. The World Government Bond Index down 2.62% for the month up, sorry, down 12.58% for the year. The S&P 500 down 6.62% for the month, down 22.5% for the year – well back in the bear market territory. Just a little bit of insight from the trend following world. 

[00:12:33] Mark

It really is, I don’t want to use the word scary, but unusual. For a lot of markets, I’ll run a short, medium, and long-term trend following indicator just to give me a flash look at what the markets are doing. So, a little dashboard that’s telling me exactly what’s going on.

You have everything in the equity markets, in equity indices in the US and countries, in sectors – they’re all short. You look at everything in fixed income, it’s all short. You look at everything in currency markets, (there are a few emerging market currencies that are maybe in long-term trends that haven’t moved through), but everything on the G7, it’s all short. You look at fixed income across the US and it’s short. In energy markets, you’re short across the board at all different timeframes. It is a little scary when you see everything positioned all in one direction, all following a single narrative.

It worries you because then you say is this crowded? Okay, we could talk about crowded a little bit later, but it also tells me that if there’s some information that changes expectations from this negative viewpoint, it could be painful if you’re trend following right now. It’s seldom that you see the situation where you’re going to be so sharpe short and in a lot of major markets.

[00:14:14] Niels

Yeah. It’s interesting you bring that up. It leads us into one of your first topics, but we have a question that came in that I need to ask you beforehand, but just as a little brief comment on that. I think a lot of people who are doing models like that will get exactly the result that you have.

All I want to say is that, from a practitioner’s point of view, that is not what our portfolio looks like. We are not short across everything. Frankly we have very little exposure in things like equities, because it’s actually a little bit of a mixed bag et cetera, et cetera. 

This is where, I guess, we all do trend following a little bit differently, and so we end up with different positions. I agree that if this continues, probably at some point, most trend followers will end up having a very short exposure across the board, just like we had earlier on this year. I guess if you say we were long the dollar, we would have had a very long exposure (with the exception of fixed income, perhaps) early in the year because all the commodities were going up at that time.

It has been an interesting year and there have been a couple of transitions, of course, but they have been dampened by the strong trends in a couple of the sectors. 

[00:15:27] Mark

Now, when I use this dashboard, that’s not accounting for volatility, that’s not accounting for portfolio structuring. It’s just let’s look at some simple trend indicators and look at what’s going on. That’s what you really pay for when you buy a manager because you say, “Okay, I see a lot of these indicators, but now how do I account for volatility? How do I account for the fact that I have diversification within my portfolio? Then I also have to account for, how I manage that risk in terms of stop losses or other mechanisms to reduce my exposure when everything looks like it’s all pointed or leaning in one direction?

[00:16:24] Niels

Now, you are not familiar with this question, but it just came in from Matthew. I just want to quickly ask you about this, because it is relevant when you think about the times we are going through right now. Matthew writes in, “I have a question, which may or may not be worthy of the weekly Systematic Investor podcast.” (Of course, Matthew, all questions are worthy.) He writes, “I was wondering about the risk of trend funds in the event of some kind of global financial reset event since the fundamental deal in the futures. Is there any risk that these contracts may not be honored at such time?”

So what you’re talking about here, Matthew, is the systemic risks in the clearing broker community – futures exchange community. 

What are your thoughts? We’ve obviously seen some firms, over the years, MF Global to name one, go under. What are your thoughts on these things, Mark? 

[00:17:27] Mark

I was around for MF Global. I was around for the ’87 crash. I was working for the Mercantile Exchange at the time. Just a sort of a side story is that behind the Board of Trade there used to be some pawn shops because it was a little bit of a seedy area underneath the subway system there. The night of the crash they had policemen on horses working with the mob of people outside the pawn shops that were trying to pawn off their watches to make margin calls. That always vividly stuck in my mind as I was walking through the area. That’s what you call a liquidity event.

Since we’ve had these crises, I think we’ve done a much better job of thinking about systemic risk, managing systemic risk, and trying to plug holes within the system where there could be leakages from failure. I think, as a brokerage community, we’ve done a better job. We’ll say the risk management at the exchange level is much better.

At the same time, as the quality of our risk management has improved, we’ve taken a strategic view (and this is policy makers around the world), that we want to place more and more risk on exchanges so that we can actually be able to monitor or see it. We could then have the clearing house be able to control that risk and control the margin process.

That’s a good thing. But at the same time we’ve taken a lot of little risks, which may have had a higher probability of something blowing up. We said that we’re all going to put it into one place. If you do it right, that should reduce all the risk. At the same time you have more risk concentrated, but that’s more theoretical; there’s some possibility that can occur.

In general the futures exchanges, the markets (in general) have done a better job of managing risk over the last 10, 15 years than I would’ve imagined. The risk that there would be a systemic failure is less. At the same time, for a given institution, could there be failures?

Absolutely. The one area that we want to try to highlight is trade financing and financing of commodity houses, especially in the energy market. When energy was getting up to well over a hundred dollars a barrel, you think of the same cargo of oil and that it was significantly larger, in terms of dollar value. The risks that you have to put up for margin for insurance are greater. The amount of money that energy companies that are hedging or have to post for margin is greater. There could be a liquidity failure event for commodity firms, given the fact that they have to post a liquid margin with sometimes illiquid assets.

[00:20:58] Niels

Yeah, absolutely. I also think, and obviously have no way of knowing this, but I have a feeling that if there was a major exchange having an issue (a futures exchange), I would’ve thought that they are regarded as systemically important, just like a JP Morgan or whatever. I would’ve thought that there would be some efforts to make sure that didn’t actually play out. Because that would not just be a Lehman moment, that would be like a Lehman moment times to thousand. 

I think what’s interesting is that, with the futures markets, they have proven (historically, at least) to be incredibly good at upholding liquidity during all of these crises, much better than even foreign exchange markets that claim to be the most liquid markets in the world.

They certainly weren’t liquid during some of the crises that I think I remember from ’08, but also remember some of the days during the COVID crisis where futures were ( wouldn’t say unaffected), certainly liquid enough for people like CTAs to do their business, that’s for sure.

[00:22:09] Mark

Now, the real issue, when we look at what we’ve learned from the pandemic in March 2020, is liquidity. Liquidity is like the canary in the coal mine for a margin crisis or a failure crisis. We did have liquidity problems in the treasury market, in the cash market, which then spilled over to the futures markets.

People weren’t able to put on hedges. They weren’t able to find the collateral that they needed, and this is where they really have a problem. Now, I think that the Fed and other central banks are aware of liquidity issues. They know that they have to provide liquidity as the lender of last resort.

When you look at the problem of what is the amount of inventory that dealers hold relative to the size of the market and the size of trading, we just don’t have a lot of market makers in cash markets, and we don’t have a lot of market makers in general to provide liquidity to markets. That means that we could have large moves, that maybe started from an information event or some event, but will be extended for the simple reason that we don’t have liquidity providers on the other side of trades. Liquidity is a problem. 

[00:23:39] Niels

Yeah, which actually was very interesting because earlier this week, we published this episode with Michael Howell which is all about liquidity, and also capital wars in general. So it was very apropo at this time. If people haven’t listened to it, they really should go back and hear what he had to say.

[00:23:56] Mark

I love the work that he does. But there are two levels of liquidity. There’s the liquidity that’s provided by banks from credit, which is the flows of capital across the world.

We have potential problems in liquidity on capital flows and money needed to, let’s say, hedge dollar exposure. We’ll call that macro liquidity. Then there’s also micro liquidity. The micro liquidity is that when I want to trade an instrument, do I get the fair price at that time?

The reason why treasuries are considered a safe asset is because you will get (when you won’t go to the market), you’ll get the fair value price when you look for a price of immediacy. If you can’t get a fair price immediately, when you want to buy or sell, then you have gridlock – you have potential for failure. So, it’s the micro liquidity that we’re worried about.

Your last week’s call was about macro liquidity.

[00:25:16] Niels

All right, let’s move on from the question to your topics that you brought along, which look very interesting. The first one is a research paper that I’ve not come across before, I have to say. It’s from the Swiss Bank (UBS), it’s title CTAs: How the $375 billion Influences Global Assets.

Yeah, very interesting. I read it a couple of weeks ago and I wasn’t actually expecting you to bring it up today, so I’m glad you did. I’m curious to hear what you take away from this research. A lot of people worked on it, it seems. Maybe it’s something they’re going to continue to publish. I have a feeling it is, but, admittedly, it’s the first time I’ve come across it. What are your takeaways from this quant piece or CTA focus piece from UBS? 

[00:26:18] Mark

This is from their Q series, which is from their quant group. It’s a 57 page report. It’s first talking about CTAs in general and then about how to extract signals. The reason why you listen to podcasts is so you don’t have to read the 57 page report.

Hopefully we could boil it down to something reasonable. I had a client friend that I had been working with. He said, “Oh, have you seen this UBS piece?” He said, “No, I haven’t.” He says, “Oh, you gotta read it. It’s really interesting.” Now, he’s an equity guy. He’s not a trend follower. He’s not focused on these kinds of markets. He said, ” I read this. It’s really, really important, I think.” 

I read it myself and I was disappointed because at this point in time, given all the podcasts we have, and you say this is a $375 billion market, right away UBS gets wrong the difference between a CTA and a trend follower. They said, “Let’s talk about CTAs,” and then what they do is they try to explain all the value of what trend following is. I think if there’s one thing that you get from this podcast it’s that trend followers are CTAs but not all CTAs are trend followers.

This is a mantra that you got to remember because people are still confusing the two. The second is that they talk about CTAs (meaning trend followers) as momentum traders. Again, trend following is not momentum. There is a difference between the two. Trend following is an absolute strategy.

So, where you’re looking at absolute returns and you’re extracting it from the behavior of prices. Momentum is a cross sectional, relative value strategy, in a traditional sense of how we think about momentum. What happens is that right away, if you’re an unaided reader, you’re confused about what exactly you’re talking about. When in reality what they’re saying is that trend following has value, but trend following is not momentum. It’s price based absolute strategies. 

What they do, which is really good, is that they walk through the battery of tests to show the value of CTAs (they call them CTAs), but trend follower – sharpe ratios are good over the long run, although there are periods that they’ll underperform (which we really already know).

Diversification from trend following is very strong. Correlation of equities is zero or slightly negative, with bonds positive. They could reduce drawdowns. They can provide tail hedging, or they could reduce exposure because they do very well. What they do is they look at it a different way. They look at the persistence when there’s an increase in real interest rates. I think their conclusion is that if you look at the six out of seven times when they indicate there’s a greater than a nine month increase in real rates you get positive returns from following trend followers.

It’s a slightly different take on how to cut the data to show that they still offer good value within a portfolio. Then they show exactly that if you add trend following to a 60/40 portfolio, or equity portfolio, you’ll get lower risk and lower drawdowns. Then what they do is that with their main part is they say look these are really important managers, these are important strategies. It’s a big market. What we’re going to do is we’re going to try to extract out what are the signals that come from CTAs. 

What they do is they actually say, ‘”We’re going to take some exponential moving averages and number of different timeframes. We’re going to look at some crossovers. We’re going to then be able to come up with signals for each market that they believe CTAs trade.”

Then what they’ll do is they’ll z score them. They’re going to weight them by volatility and convert them into signals between minus one and one. And from that, then they could be able to say using some liquidity and portfolio adjustments, “This is what we believe are the positions that CTAs currently hold in the market.”

Then they say, “We can extrapolate and say, This is what we believe that CTAs will be positioned like in the next two weeks.” What their objective is to say, “We can report and tell you what CTAs do. We can tell you what we think that they’re going to do in the future. We think that this does a better job than commitment of traders reports, which reports positions of large traders at US exchanges.”

In some sense, their overall objective is to say, “CTAs are really good. So, what we’re going to do is we’re going to replicate trend following strategies, generate signals, and then we’re going to provide a monthly report to tell you what those signals are and say, this is how they’re positioned, this is what they do, and you could do this too.” 

[00:32:15] Niels

Yeah, when I read the report a couple of weeks ago, I also got very excited, in the beginning, because I thought, this is great. Here’s yet another investment bank that is now clearly embracing trend following, telling all their clients how great trend following is and why they should have it in their portfolio.

Of course, these things happen often after a good period of performance, and then you hear nothing for a while. But we’ll take whatever we can get in terms of praise from these investment banks who clearly control a lot of client flows. That being said, I do not understand why there is this fascination of then trying to, just like Namura, just like JP Morgan (it’s not just UBS, let’s be clear) trying to… Although I will say, I’ve not heard the others talk about what CTAs would be positioned for in two weeks time. It’s this weird desire to almost front run CTAs. Okay, let’s agree it’s a great strategy. Why not just allocate money to the strategy or build your own trend following models and compete with us?

Why do you have to come out and say, “Oh, listen, we can predict now what they’re going to be positioned like in two weeks time. you can just follow that and position yourself like that.” How can you predict something that even we can’t predict? Unless you know what the markets are going to do specifically for the next two weeks, you have no idea what positions we’re going to have in two time.

It surprises me that there is this focus on that. I worry for people who may not be listening to us every week that they might eat it raw, because it comes from a big investment bank saying, “Oh, they must be right. Oh, they must be able to do this.” I would suggest that this is not a good way to look at trend following.

But I do agree, by the way, and I think it is important that we distinguish this point about that not all CTAs are trend followers, but trend followers are CTAs. I think that is a very important point. 

[00:34:30] Mark

Now, given a $375 billion market, Wall Street and the London City are always going to behave as if there’s a big pot of money there. How are we able to extract some of that for ourselves? Now, banks are already competing against trend followers, as a business, because they already offer (we’ll call it) trend following surrogates in the alternative risk premium swap business. 

You can go to a bank and they will give you a set of rules of a trend following model, and they would say, put it into a swap form and then we won’t charge you any incentive fees. What we’ll do is we’ll just charge you a fee on the swap, and then you will be able to notionally fund this and be able to put this in the portfolio. They’re already generating swap business and there’s some French banks that have sizable (in terms of billions of) trend following swap products available.

They’re also competing by saying, “Look, we can tell you what the signals are. If you like the strategy, we’ll give you the signals.” It’s important then to say what is the distinctive value of having a money manager or a firm manage your assets versus doing a swap? A swap is, in some sense, a passive investment. It follows the rules and, no matter what happens, it is not going to change unless you sell the swap back. 

What you’re looking for, when you buy into a firm, is the fact that they can do ongoing research. They could be able to adjust models. They can get execution value so they could be able to add or subtract markets based on whether they think that there’s a need for more diversification, or they feel that some markets don’t work for trend following.

There’s a whole set of dynamic behavior that you get from a firm that you don’t get with, let’s say, passive trend following and investing. Others could say, “No, I want that passive index because I know exactly what I’m getting.” I think one of the things that I take away from listening to the podcast, and from my own view of the markets, is that markets are dynamic. They constantly are changing, and the structure of markets are changing. So, it always requires ongoing research to try to say, how are you able to enhance or further develop your edge in the marketplace? 

[00:37:27] Niels

Yeah. The other point (and then we’ll move on to the next topic you brought along with you), the other point I wanted to mention is that a lot of the CTAs are clients (are good clients) of these investment banks. Why is it you have parts of your bank trying to compete, even trying to take business away from your own clients? Why don’t you instead have a business model where you actually try to help your clients by finding investors for these funds that are paying you well every year for doing business with you? It just strikes me as a very weird policy, but of course, I’m biased in this case. 

[00:38:13] Mark

The main thing though is, if you read this paper, it has some good takeaways on just how trend following can add value. I think that even in the nineties, and even the eighties, banks were constantly trying to reverse engineer trend following signals so they could be able to look into what CTAs were doing and see, and if that could give them an edge as market makers.

In some senses, if I’m a market maker, I would want to know what CTAs are doing for the simple reason that if someone calls me up and says, “Okay, I want you to be able to execute this amount of trade.” I would want to know, is that all of the trade? Are they trading full or are there a lot more orders behind that? Am I going to get steamrolled if, let’s say I am a market maker and I take the other side of that trade? 

There is a gaming strategy between broker market makers and money managers, where you’re always trying to say, “Can I anticipate what the CTA or trend following is doing so I can be able to position myself to either reduce my losses as a market maker, or potentially increase my profits?” There is a gaming aspect of all of Wall Street, with every strategy, where someone’s trying to reverse engineer your strategy to be able to figure out how I can be able to profit from that flow. 

[00:39:51] Niels

Yeah. All right, speaking of flows, you brought another topic that you wanted to talk about, which is the global fixed income markets and what’s been happening at the moment in the last couple of months, but certainly intensified this week with the coordinated central bank policy, and now even some other actions from at least one of the central banks. Take us into that topic and let’s see where we go with that. 

[00:40:19] Mark

I think that the important point here, and which we’ve already touched on, is that there’s a tremendous amount of coordination of central banks. All of them are behind on inflation. All of them are following the same strategies, so that when you move from (and I think a recurring theme into the way I view markets is that) what are the underlying macro trends? How are those displayed in prices? We have a clear market trend of coordinated central bank behavior. 

We know that they’re behind the curve relative to inflation right now. We should expect that there will be price trends that will be coordinated around the world. They’re going to be correlated. Correlated trends will happen. You should expect that the bund market, the gilt market, the treasury market, up along the curve, are all going to be in the same positioning.

We’ll say that the narrative leads to a sort of correlation in trends, and that’s what we’re seeing in the marketplace. That’s what we’re seeing, especially this week, with all the central banks. What you find out is that when the Fed raises rates, they’re attempting to actually (in some sense) export inflation to other countries.

Other countries (in some sense) stop inflation from occurring in their country, have to also raise rates. In some sense you have an arms race or a game going on that the Fed wants to export inflation, they raise their rates. They say “Oh, what do I have to do? I see that there’s depreciation in my currencies, which means that my imports are going to be more expensive, so now I’m going to have to raise my rates because I don’t want to take in this exported inflation. So, now I have to raise rates.” 

What happens is that you actually create the foundation for a global recession because we’re coordinating the behavior of central banks to all raise rates around the world. What may seem rational for one central bank, when done across the board, could lead us into a global recession.

We could say, we get the indications of that when we look at commodity markets. While we look at commodity trends, at the same time they’re giving a forward expectation of what might happen to markets. Look at oil markets. Oil markets are now under $80 a barrel.

If you would’ve said, we just had 300,000 Russian conscripts called up. The Ukraine war is still going on. You still have an energy problem in Germany and the rest of Europe. How are you going to heat your homes? If someone said given all that information, what do you think is happening to crude oil prices? You would not think they’re going to $78 a barrel after being at $110 to $120. We have a more than a20% decline in oil prices while we have a geopolitical crisis. This is clearly telling us that there’s a decrease in aggregate demand. Where people don’t need energy right now. Markets are forward looking. 

[00:44:05] Niels

Yeah, there’s a lot of stuff going on in the energy markets and commodities in general. Actually, I just want to sort of flag that, on Wednesday, we’re going to publish a follow up conversation with Adam Rozencwajg, which was one of the most popular conversations we had in the spring, where he went through the whole sort of commodity situation. We continue that conversation with the focus on energy, next week. We will do a further follow up with Adam a few weeks later because there are many other parts moving in that. Definitely stay tuned for that. 

We talked earlier about the trends in the same direction. I don’t know if you have any more things? I noticed that as one of the topics then, there’s also something that happened this week, which we haven’t seen for a long time. Which kind of links a little bit to the whole issue about central bank policy, but we did see the Bank of Japan intervene in the currency market this week, which is something we, at least those of us who have been around for the last 30, 40 years (it was pretty normal back in the day), haven’t seen for a while. It’s interesting that we are back to that instrument being used by central banks. 

[00:45:22] Mark

This is where the internal (we’ll call it) monetary policy, what you’d like to have is that you continue to have loose monetary policy because you want to try to get inflation higher. You want to try to get growth higher. At the same time it intersects with the fact that you’re not isolated. You’re part of a global economy. 

You see that the yen is in a tremendous bear market. It’s going to 146. How do we stop this? Maybe if we intervene in the market we could stop this speculative excess. It usually works in the short run – intervention. Most of the research, if we go back, it’s old because there just hasn’t been a lot of intervention. It shows us that you can dampen volatility, you’ll have a short-term impact, but usually then if you say that the underlying policy is still the same, then you’re going to go back to trends.

I think there was little strengthening of the yen, but you say if there’s no change in policy for the BOJ, and the rest of the world has higher interest rates and they’re having more hawkish policies, you can’t sustain that, not unless you’re going to start to use up all of your reserves to try to manage that currency. I don’t think that we’re ready for managed exchange rates just yet.

[00:46:59] Niels

No. I wonder if there’s a little bit of a link in some of the treasury sell-offs and the intervention, actually. If they’re buying yen, they’re probably selling dollars. They might have to sell treasuries to sell those dollars. I don’t know. I was just thinking about it while you were talking about the intervention. It has been quite a ferocious week for US treasuries as well. 

[00:47:27] Mark

Now, I would say that I was engaging in the cognitive dissidents of following the markets really closely, as a macro guy, when I should just be looking at trends. If you look at the Fed meeting, the Fed comes out 75 basis points up, the market sells off a little bit. Then Chairman Powell has his press hour, and he starts talking and the market starts rallying. It’s almost like , “Okay, I’m listening to the words and people are interpreting them completely different,” that he’s not as hawkish, and they’re saying, “Look, I think that there’s something positive here.”

Then they really had to say, ” Okay, let’s digest what we just heard and what we’ve seen from the dot plots or whatever.” That’s when the markets started to sell off hard. 

From a trend following perspective, and a macro perspective, you say, “Yes, we got the 75, it could have been a hundred. It fell within expectations, so there shouldn’t have been as much of a reaction because the market should have already discounted that.” But what they didn’t discount is the fact that we’re looking at well above 4%, 4.25% by year end; we’re going to go even higher in 2023.

We might start to see rates fall in 2024. If the Fed, through their dot plots, is telling me that we’re going to have above 4.5% rates, and they’ve been still behind the curve, but that’s their best estimate. If I’m a fixed income guy, why the heck am I holding these bonds?

So, there’s this dot plot reaction, which is forward looking and, now, if I’m a bond trader, they’re like, “If that’s really what they think and I’ve got to act accordingly.” 

[00:49:27] Niels

I was reading one of the Danish newspapers a week or two ago, and the largest public pension plan in Denmark published their first half results. It was shockingly bad. I can’t remember specifically how many percent they had lost, but it was significant. I actually think, from memory, that there were some articles out towards the end of last year, early this year, where they had come out saying actually it’s so hard to get any real return, so we are going to take even more risk heading into 2022.

Which of course couldn’t have been worse in terms of timing. But it does, as I mentioned earlier, it does concern me that you may have a lot of these “long-only type investors” of real size, but also of real consequence. From a societal point of view, if their assets get shaved by 50%, because they weren’t just losing money in equities, they’re now also losing money in fixed income, and private equity, and what have you, everything is going the wrong way. Frankly, most of them don’t have much exposure in uncorrelated strategies like trend following or something else, of course. 

There’s going to be a fallout of what’s coming in. I think it could also exaggerate the moves. Listen, I saw a Bloomberg conversation this week with Jeremy Grantham, I think it was recorded, maybe late August (I don’t know I can’t remember), but anyways, he’s obviously bearish when talking about this bubble. Which, to his credit, they have forecasted the previous bubbles except for the fact that they’re always early and he admits them always being early, and sometimes it almost cost them a lot of clients because they’re too early. They were early this time as well because they started talking about this a year ago.

If he’s right, like he ended up being the last few times, what we are looking at right now, according to him, is only the beginning. The bubble has not even burst. There is one thing that is quite interesting that I’m noticing more and more of these people that I would consider as being, people that are worth listening to. A lot of them talk about how orderly it has been in the equity markets. There’s no sense of panic or anything like that even though we are in bear market territory. But it’s all been very orderly. Look at what volatility is doing. It’s not suggesting any panic either. Maybe there isn’t really any panic yet, and maybe the panic is all to come going forward at some point, like the ECBs Schnabel, was out saying that we are moving from the great moderation to the great volatility. This could be some interesting times and certainly for strategies that are directionally based and not predicting anything, it could be. 

That’s the other thing actually I wanted to say. I don’t know how you feel about this Mark, but of course CTAs get a lot of attention right now because returns have been so strong in the last 18, 24 months maybe even. Who’s to say that they can’t continue? I think, with the Fed pivot, some investors will sit back and feel maybe we missed the boat. We should have bought CTAs 12 months ago. We didn’t, so  it’s too late. Maybe this is just the beginning of some kind of long period of above average returns after a period of time where certainly from 2015 to 2019, including those years, returns were below average.

What are your thoughts on that? 

[00:53:28] Mark

I think that you have to look at the forecasts and recast your question. You look at the forecast, what we’re seeing is that the Fed actually thinks that we’re going to have 1.7% real GDP for 2023. We’re going to have unemployment, 4.1% to 4.5% in, PCE inflation at 2.8%.

So, they’re forecasting a Goldilocks economy. What you really have to say, “Is Goldilocks not going to occur? What happens if things are worse than what they expect?” So, let’s go back and say how good at forecasting has the Federal Reserve been with their SEP forecast? They’ve been horrible. This is it. If they were working at a Wall Street bank, they would be fired. 

The real question is, “Are we not cognizant of the fact that we’re hoping for a world that may not exist?” If the world that we would like is not the world that we see, then there’s going to be further adjustments. That means that trends could last a lot longer than expected. I think that’s a reality that we are going to face in 2023.

[00:54:59] Niels

Yeah. Now, just for time constraints a little bit on my side today, Mark of the last remaining topics, is there anything you want to sort of highlight you think is appropriate just to round things off?

[00:55:12] Mark

The one thing that I wanted to talk about (this could be a longer discussion and depending on what your listeners think) is that I’ve been reading some of the work of A W Kruglanski. He is a psychologist. He’s now working on radicalism and terrorism. He spent a lot of time looking at something on dealing with how people deal with certainty and uncertainty. What he did is he said that people have a need for closure. You could actually classify people on a spectrum based on their need for closure. Some, want to have a lot of closure. That means that they don’t want to have open ended questions. They want to be able to have definitive answers. They like to have yes or no. They don’t like to live in the area of gray. He actually came up with a set of questionnaires to be able to determine your need for closure.

What he said is that the people who have a need for closure don’t do very well with uncertainty. Because you’ve got a lot of different information. You’ve got conflicting signals. So therefore, they’re stymied by that because they want to have an answer. They need to say, what is the answer? There may not be an immediate answer. 

Those who do not have a need for closure, they’re actually better prepared. They’re better able to deal with uncertainty. So we’re all on the spectrum.  If I gave you the quiz, or you took the questionnaire on your need for closure, you would be some point on that spectrum. I would be at a different point. If we had other people, we could get different levels of closure. 

Then I said to myself, does that have anything to do with how I behave, or what a quant does, or what a trend follower does? I would probably posit, as a hypothesis, that those people who want to follow models, those people who are quant focused, probably have a greater need for closure than those who are more discretionary traders. 

A model is our attempt to deal with our need for closure. If I’m a trend follower, and if I say trends are up, therefore I’m going to be able to buy in a very simple way, that closes the issue. I now can feel that I could take comfort with the fact that I’ve made a decision. As opposed to when you think about even this Fed decision on Wednesday, I’m looking at the screen, I say, “Okay, here’s the announcement, here’s the reaction. Here’s Chairman Powell, he says something else. What does that really mean? Here’s the dot plots. What should I do there? Here’s the set forecast. How should I use that?” I don’t get any closure when I look at all of that random information. 

We use models as an attempt to gain closure in our trading environment. Your level of complexity of your models may have to do with your degree of closure that you need or how much that you want closure to be simple or more complex.

[00:58:41] Niels

Could you take it a bit further, actually, by saying that the paradox is that most people tend to shy away from trend following because they feel there is no certainty in what we do. We say that ourselves because we say we have no idea what we’re going to do. We don’t know how we’re going to react, and so on so forth.

So, I get the sense of what you’re saying. I recognize the fact that for us it’s comforting that we have our models, our rules to follow. And maybe we can say, yeah, that gives us some kind of closure, in an uncertain world. But then I would argue that most people would take more comfort and more closure from someone saying, “I think the Apple’s going to produce a $2 billion revenue in Q4, and the equity price is going to go to 150,” rather than the CTA saying, “I have absolutely no idea what’s going to happen. I’m just going to follow my rules.”

[00:59:34] Mark

I think that the CTA said, I don’t know what’s going to happen in any given situation, the assumption is that I can’t predict the future, but I do know that a trend will usually continue. Therefore, my closure is the fact that a trend will usually continue. That’s my underlying assumption. I do have problems with people who say we’re non-predictive. Yes, we are predictive. We are predictive that the price momentum, or price trend, that we see will continue and that’s what we’re actually trying to exploit. If you really believe that we’re non-predictive, then you believe that prices are always random on the next day, and you don’t really have anything to say about tomorrow’s price. So, I actually believe that we do have something to say about markets.

[01:00:30] Niels

That might be true, but we would keep that very internal. We would never go out and say we think the markets are going to do this. That’s what I mean. But anyway, it’s an interesting conversation. I’m sure we’ll come back to it. 

It is interesting how these psychological issues, of course, we know they’re incredibly important when it comes to investing. Deep down we believe that human behavior is something that we can exploit, to some extent, through our strategy. Therefore psychology is relevant because that’s certainly part of what makes human behavior. 

[01:01:10] Mark

Right, psychology affects… You’d say “I’m agnostic. I’m going to build a model and I’m taking out all of the biases and I’m taking out all of the psychology when I build a model.” That’s wrong. When you build a model you’re actually embedding a lot of your own psychology into that model. The fact that you’re saying that I’m willing to play the odds through a model is telling you something about your psychological makeup. I think that this is what I’m trying to get at, your need for closure. There’s nothing wrong with that. Given how I’m wired, I may say that I’m more comfortable with building models and having signals that give me a definitive answer, than someone who said I just want to have all the information gathered together, and then I want to process it. 

I always remember the stories, when I first went down to the floor of the board of trade, where you see the visitor’s gallery and you see all the craziness. I always say there’s only two reactions. There are people that have abject horror and say, “I would never want to do that.” Other people say, “This is really interesting, I have to be a part of it.” 

Then once you say I want to be a part of it, then you have to say how can I create an edge? I probably said this, whether floor trading or just using my wits to trade, I knew pretty quickly that’s not who I was, that’s not my makeup, that’s not how I could be able to create an edge. I had to get some closure through a model. I said, “That will give me my edge, because I can’t get it by just living by my wits.” I think that knowing yourself will then determine exactly how you should trade.

[01:03:12] Niels

Absolutely. Absolutely. All right, let’s wrap up our conversation today. Just a couple of things that I’d love to ask our wonderful community to help out with. One is, as I’ve mentioned before, if you could leave a rating and review, if you go to toptradersunplugged.com/review, there are some suggestions as to how you can quickly leave them at the various platforms. So, that would be super, super helpful for us. 

The other one, of course, would be to go and share our link, toptradersunplugged.com/share. If you send that link to three or maybe five of your like-minded friends, colleagues, family members, that would also be a great help for us here at TTU.

Next week. I’m joined by Alan, so I’m sure we’ll be tackling some really interesting topics as well as a review of the month of September. I have a feeling it’s going to be a September to remember already. Make sure you’re going to tune in for that. Send us your questions to info@toptradersunplugged.com and we’ll do our best to answer them.

Of course, you can always check out the website where we publish blog posts, and of course the monthly review that Rich and I do on the trend following industry, and much more. 

From Mark and me, thanks ever so much for listening, and we look forward to being back with you next week. Until next time, take care of yourself and take care of each other.

[01:04:38] Ending

Thanks for listening to the Systematic Investor Podcast series. If you enjoy this series, go on over to iTunes and leave an honest rating and review, and be sure to listen to all the other episodes from Top Traders Unplugged. If you have questions about systematic investing, send us an email with the word ‘question’ in the subject line to info top traders unplugged.com, and we’ll try to get it on the show.

And remember, all the discussion that we 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.

Thanks for spending some of your valuable time with us, and we’ll see you on the next episode of the Systematic Investor.