269 Systematic Investor Series ft. Katy Kaminski – November 11th, 2023

[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.

[00:00:23] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Katy Kaminski and I, Niels Kaastrup-Larsen, where each week, we take the pulse of the global markets through the lens of a rules-based investor.

Katy, it is wonderful to be back with you this week. How are you doing? What’s happening where you are in the world?

[00:00:41] Katy

Well, things are good, Niels. It’s turning to fall slash winter here in Boston. We had the time change. It feels like winter now. It feels like it’s time to start skiing, I guess. I don’t know.

[00:00:56] Niels

You know what’s so interesting? So today that we’re recording, I’m actually in Denmark, and I remember this summer that people were complaining about all the drought, the worst drought we’d seen in I don’t know how many decades, and the farmers were very worried about that crop. Then I switched on the news yesterday and they’re now pretty much on course for the wettest year ever on record.

Now, it tells you a little bit about how bad the weather has been since the summer. But it also tells you a little bit about, I think, sometimes these narratives, how strong they can be. You kind of think, wow, this must be something dramatic that’s causing all this drought and then you find yourself that actually, this might be the wettest year and 2019 was the second wettest year, so maybe it’s not that dry after all.

[00:01:50] Katy

Well, that’s a good point. That’s this idea of short-term data versus long-term data. When you look at last week for example in the markets, everyone was like, okay, everything’s changed. Now two days later, it’s like, I don’t know, maybe not. I think that’s why we’re systematic traders, because we want to weigh that data. It’s kind of like the weather. If you look at long-term data versus short-term data, it will be different.

[00:02:12] Niels

I like how you manage to just get that trend following slang on the whole Danish weather situation here. Love it.

Now, before we dive in, I always say this but I actually mean it every time, we have a great conversation ahead of us with a very important topic, perhaps the most important topic that is from a financial point of view, which we’ll talk about in a second.

But before we do that, I always love to hear what’s been on your radar, something that doesn’t necessarily relate to what we’re going to discuss today but just something that you find interesting happening around you or that you’re seeing or hearing. What’s going on, on your radar?

[00:02:58] Katy

I think what’s interesting this fall that I’ve definitely been seeing, one interesting fact, my husband works in the real estate space, and also, we’ve been doing some recruiting this year as well, and it just feels like people, especially here, are a little bit conservative. People are kind of holding back a little bit. I know Boston, we had the lowest volume in 40 years in terms of house sales.

You’re also seeing when I’m talking to a lot of younger students in the financial programs and place, I was just at UMass on Monday and I was also speaking to some students at BU on Tuesday. It’s just interesting to see that I’m hearing from younger people the challenge of the job market, which reminded me a lot of that I was a tech bubble grad. So you kind of remember that feeling where there’s something murmuring; like people are nervous, companies are getting conservative, and you’re just kind of wondering if there’s a change coming, a structural change, and so people are preparing.

I think this kind of ties into what we’re going to talk about today. Because changing the interest rate environment means that people might have to make changes in how companies and how they borrow, and I definitely feel it that people are thinking about it.

[00:04:24] Niels

Absolutely. We’re going to talk about that in a second. I will say, just as a little precursor I guess it’s called, is that when we talk about change and when we talk about crises we have, and of course, if anyone knows how to talk about crisis, it’s you. Of course, we’ve always thought about that as being equity crises. In the last year or so at least, I would say that I’ve often mentioned on the podcast that, well, what if the next crisis is a fixed income crisis?

What I will say about it and why I’m excited about today’s topic is that as much as an equity crisis is unpleasant and some people will get badly hurt, and maybe you could say that in some countries, it can break an economy, I think a crisis in fixed income, especially in sovereign debt, can break a world economy. That’s how important I think what we’re going to talk about today is.

But before we do that, of course, we have to remember to talk about what’s going on in the trend following world so far. I’m going to just talk a little bit about what’s going on in the last week or so, maybe month or so. But then I’ll let you do a little bit of maybe so far, what you’ve seen this year or in the last few months.

But what I will say about November is that it’s not turning out to be an easy month for CTAs and trend followers and it’s actually not turning out to be a particularly easy or trending year so far. Unless of course you have put all your eggs in a few number of baskets such as long orange juice, sugar, cocoa, hedged with a Mexican peso, short VIX and palladium and then some risk on in Japanese stocks, then you’ve probably done very well. Unlikely to have many managers in those positions only. So yeah, it hasn’t been a great year so far.

Before I let you talk about this, Katy, just to mention that my trend barometer closed yesterday at 43. That is neutral, so nothing, no hope right there. In terms of performance, BTOP 50 is down 2% or so for the month, down 0.3% for the year. SocGen CTA Index down 2.73% so far this month, down about the same for the year, and the Trend Index down 3.6% so far this month and down about 2.6% for the year, and the Short-Term Traders Index down about 1.4% so far this month and down 2.7% this year.

In terms of traditional assets, MSCI World up 3.3% so far in November, up 10.6% for the year. World Government Bonds, for a change, of 1.4% for the month and actually up 7% for the year in fairness, and the S&P Total Return Index up 3.7% and up 14.79% so far this year. Trend from your perspective so far this year, this month, Katy, what have you seen so far?

[00:07:26] Katy

Obviously, this month has been very tricky because it’s been somewhat of a reversion from the fixed income trend. But let me step back and talk about this year and some of the dispersion we’ve seen and some of the key themes that are important.

I think what has been frustrating for most CTA managers this year is that if you actually took out the regional banking crisis, that one event, the year would have still been relatively positive. But on the other hand, I also try to think about this as more of a big-picture trend.

If you look at what happened last year, from a macro perspective, we go through phases. So we went through this massive reflation trade, which turned into a rising rate inflation trade, which created massive trends that had to consolidate and readjust. This year and the end of last year has been part of that readjustment period. It turns out the only trend that actually has been pretty positive, at least still to date, is the short fixed income trade in US equities, which is shocking (not US equities, US bonds) which to me is surprising considering the hit it took in Q1.

So if you look at that yield curve, that 10-year, the 10-year made it up to 5% this year, so it is actually a trend. It’s just that the amount of noise and how tricky this has been this year is clear. So for me, I see the whole picture. The biggest trend has been fixed income for the last two years. It has been the driver of change in terms of the biggest changer for most people’s portfolios.

In general, it’s been a tricky environment because trends have been very back and forth. You’ve seen a lot of divergence in terms of frequencies for monetary policy for different global economies. Thus, it hasn’t been as easy of a trend environment. But we’re all used to that in the trend space. It goes in cycles, and in some sense, it feels a little bit like the calm before the storm. We’re not sure as trend followers what that storm is going to be, but usually, there is a storm and that storm will occur somewhere at some point. So I think that’s what I’m thinking about now is what the next big trend is going to be, and it could be fixed income again. We’ll see.

One more point I wanted to make too because I took a look at our style analysis, Niels. I’ve written a lot of papers about styles of themes of trend that show some relative performance and there’s not a lot there but there’s a couple of things, and you hinted at it a little bit. Number one, faster trends definitely suffered more because there’s been more head-faking this year. Number two, correlation factors; so more correlated markets suffered more than less, and you already hinted at it with orange juice and the yen.

So really, those key multi-asset global trends have been trickier than the diversifying trends this year despite the fact that trends have been not as easy in general. Then things like carry and roll down have helped if you have a diversified trend program. So in general, I’m mixed here with some spots of places that might have helped if you were very strategic or if you got lucky, as you pointed out, Niels.

[00:10:53] Niels

Also, I would just add to it that after such a strong year last year, I think, with a lot of the indices being pretty much flat as we just talked about a few minutes ago, I actually think personally that this is pretty good and these transitions have to occur before we see what the next picture will be. Actually, I like your little teaser about maybe the next big trend is actually the same trend that we’ve been in for a while. We’ll see about that.

I know definitely when my producer is listening to this, he’s going to get the title. Probably something like “The Big Bond Short” is probably what he’s going to name this episode, so why don’t we just jump in with both feet.

I think we’re going to start with a paper that you’ve written. From memory, I think it’s called “The Short on Shorting Bonds” if I’m not mistaken. I know you wrote this a little while ago, but then it was featured I think this week actually in a CAIA magazine, so this is great, very topical. We’re going to hear something about pigs flying. So let’s jump into it, Katy.

[00:12:11] Katy

Yes, I love that article. What was fun was that one of my colleagues, the first sentence of this, I said, “You know, it’s like the pigs fly trade.” And she said to me, “What do you mean? Pigs don’t fly?” And I said, “Exactly.” So I was explaining to some of my colleagues what that phrase meant, that this is a trade that doesn’t work. Last year, we wrote this paper, basically, we were trying to, and even myself, I was trying to understand.

If you’re a trend follower and rates go into a rising rate environment, when are you going to be short and when are you going to be long and when is it going to be good or bad for you? It was that simple. And what is the roadmap going forward in this new regime? Because none of us have a roadmap, Niels. None of us have lived through a rising rate environment at least that we remember. I know maybe some of us were alive in the ’70s, but we certainly weren’t trend followers then, at least none of us here, either way.

So this paper’s goal was, what’s going to happen and what possibly could happen, because as trend followers, we believe in patterns. We think about history repeating. We don’t think about predicting, we think about common patterns in returns. So this paper basically looked at how trend behaved in rates or fixed income in general with the 10-year during the rising and falling rate periods over different shapes of the yield curve to determine how likely are we going to be to be long or short and is it going to be better for us to be long or short?

That gave me a sense of what type of environments we would understand to do well and then when things might become more tenuous for us as a strategy, which helped me to really have a roadmap even through last year’s really crazy market experience.

[00:14:11] Niels

I’m going to let you go through the paper, some of these critical findings, because I think this is really eye-opening. I think most people have never done this kind of research. Even our colleagues will probably not often sit down and actually do the work and find out what the environment actually these strategies tend to do well in when it comes to fixed income or not. I think that both of you, before we turned on the record button, we both said fixed income is really the topic that comes up in every single conversation and dominates the conversation at the moment, and rightly so.

I think in particular for us in the trend following space, and remember we talked about this last time you were on where people would kind of be a little bit critical of trend followers because they were saying, “Well, you made all the money in the last 20 years by being long bonds.” If you go back a couple of years, of course, this is where pigs don’t fly comment comes from, because if you brought that up and said, well, one day, fixed income will be a great short, people would say, well, definitely not.

So I think a lot of, and this is my personal feeling is that I don’t think it’s completely sunk in yet, in the financial community, what it really means to be in a rising interest rate environment. For us as trend followers, it’s very simple. It just means that we’re short instead of long, predominantly. But I think for most portfolios, it has much wider consequences.

So I’d love for you to go through some of the things you did in the paper, some of the things you found. Obviously, people can’t see the charts but they’re great, and they can always find it I’m sure on your website in any event. So I’ll let you drive from here.

[00:16:06] Katy

Why don’t I just go through some of the results in the paper, and then we can talk about what happened in the last two years. What’s going to be really neat about that is you’re going to see a lot of similarities between what you saw in this paper and what has actually happened and some of the intuition. That to me is very fascinating.

So within the paper, what we did is we divided up a period with rising rates and falling rates and we examined simple trend signals and their profitability based on whether they’re long or short, and then we also examined different shapes of the yield curve, so inverted, flat, and rising or steep. What was interesting is there’s a very clear picture during a falling rate environment.

When the curve is inverted, flat, or steep, trend following is going to be about 75% long and it’s always going to be more profitable to be long in a falling rate environment. That makes total sense because what has happened over most of history is every time trend following started to go short, we had that miraculous Fed put or we had a situation where yields eventually went back. So anytime you started to build on a rising rate trend, that trend would revert and it was generally a very unprofitable place to be over a 40-year horizon.

So in general, it became common knowledge, even in the trend community, that anytime you’re going short, it was a tenuous place to be. The data shines through there that no matter what the shape of the yield curve was, it was always better to be long than short, and long positions were dominant through all periods with falling rates. That’s the world we lived in. But when you look historically at periods where you have very different characteristics, not saying that we’re going to have that exact world, but when you have a world where rates are actually rising, you have very, very different results. Let me go through those, because this is interesting.

During a rising rate environment, in periods where rates are going up on average, shorter-term strategies like trend following that look at changes in rates, they’re going to be more likely to be short than long. Now, it’s not as equal. It’s about 65% of the time. So 65% of the time, in this analysis, we were short as opposed to long. But where the asymmetry comes in is that the shape of the yield curve matters a lot.

When the yield curve is inverted, that’s when the short positions were the most profitable for trend following, meaning that us being in short positions worked very well versus being long and it was more likely to be short than long. Now, as the curve flattened out, the profitability of those shorts diminished in relative terms and longs continued to be also challenging in a flatter curve environment.

But as you move into a steeper curve environment, where you have a duration premium again and you have that carry that’s more clear in the market, what you see is that trend following is slightly more positive to be long and then the shorts again become negative P&L contribution. So you have this very curve-specific trade for longs and shorts in a rising rate environment, which means that basically in the world we were in before, all you had to do is be long.

In the new world, where you have rising rate environments and you have changing curve structures, trends are going to vary quite a bit depending on what the yield curve structure looks like and also where the yield curve is moving. So that means that it’s a much more complicated environment. But when we do actually have that very steep yield curve, that’s when trend is going to perform the best, and that’s exactly what we saw last year. Isn’t that interesting, Niels?

[00:20:30] Niels

It is. Actually, it’s so interesting that it came as a big surprise for one of our friends in the industry, because I remember back in 2014, ’15, I interviewed Roy Niederhoffer, and I can say it publicly because it’s on record. I confronted him earlier this year as a little teaser because he wrote a very popular paper around 2016 or whatever it was saying, well, hang on, long-term trend followers have made all this money being long bonds, but the day interest rates start to go up, they’re not going to do so well, and of course we did.

When I confronted him earlier this year in our conversation, he said, well, I didn’t expect the yield curve to invert. So of course, you’re absolutely right. But what I would love to do, maybe just to take that example, can you explain for the audience why the shape of the yield curve actually makes a difference?

[00:21:23] Katy

That’s a great finance question. I love it, Niels. This is so important because I think what happened in the market, if you think about what happened to rates in that if you think about the nominal rate, the actual yield as the inflation rate plus the real rate, and the real rate is the growth of the economy, that can’t have changed that much. That’s sort of like a pretty stationary process.

When we had COVID, basically, it shocked the system and inflation went flying up. We ended up with a situation where the nominal rate was low but inflation was high, so there was a huge mismatch in rates versus inflation numbers. You can’t expect growth to change that much. The real rate can’t possibly change that much. So what central bankers had to do was, say, oh, geez, we’ve got to clamp that down so that we can figure out the nominal rate where it’s going to be.

So as the shorter-term rates go up, then what that does is it’s trying to push the inflation rates down to get these to an equilibrium. And then once rates went up to a number around 5%, close to 5%, if you think about what that means and what was fascinating to me is that if short-term rates are 5% and long-term rates are 3%, to me, the entire year, I’ve literally as a trend follower been saying trend signals are short because the long end of the curve is mispriced unless we miraculously get rid of inflation today and that rates can come back down very quickly, which I think is optimistic.

So the point is the long-term average of where the yield has to go, the overall yield, if inflation goes down to 2 or 3 and real rate is 2 or 3, maybe it’s 4 or 5. But because of the shock, we had to get to a new equilibrium in yields. My general view is that the market, especially for long-term yields, was complacent, just like the equity market is complacent, right, Niels, about the impact of long-term higher rates for almost two years.

So for two years, short-term rates higher, long-term rates lower, inverted yield curve suggests that we need a repricing in long-term yields to get to a point where that makes sense. Because if you think about it, why would you buy something with a yield of 3% if you can get 5% for shorter term unless you believe that this is a temporary phenomenon and that everything is going to go back to normal, which I think the market did. Either they believed it or they just didn’t want to believe it, which those are also valid points.

So I think that’s why this is a good trade. That’s a massive change in valuation that is going to happen if you’re going to move yields from 3% to 5% in the 10-year, which is what we did. So inverted yield curve suggests a massive repricing in long-term debt.

[00:24:53] Niels

Can you also then tie it in just one more step for the audience as to why trend followers tend to make more money when the yield curve is inverted and whether in a sense that it’s also based on the fact that usually, it flattens out afterwards and we get that extra kicker from being short the long end towards the end of the quote-unquote “rising interest rate environment”?

[00:25:22] Katy

Yes. I think the key is when central bankers tighten policy and they raise short-term rates, they have the goal which tends to equilibrium. Longer-term rates eventually should go up. If you think about what’s so exciting about the rates markets, when rates go up, that has a massive repricing and valuation, and since trend follower’s focus is really in rate of change in value, change in the rate has a much bigger effect than the change in the coupon, because if you increase the yield, the value of a bond goes down a lot.

So that means that you can have massive changes in value, which is huge trends in the value of bond valuations over time, and I think that’s where the opportunity is, is that you have massive revaluation of long-term based on long-term rates going up. I think investors are just not used to thinking about this in this environment. But if you look at history, that’s what inverted yield curves tend to mean. They tend to mean that there’s going to be a revaluation of cash flows and devaluation of cash flows that are in the future.

So if short-term rates go up, those long-term cash flows are now worth less, which means that a short position in fixed income, a bond is not worth as much over the short term, if that makes sense.

[00:27:03] Niels

We’ve kind of touched a little bit on this first myth that you mentioned in the paper. There’s a second myth which I also think might be quite interesting maybe to talk a little bit about, whether actually higher rates always means that we’re going to be short bonds or not.

But actually, before that, I just wanted to, for people to remember, so to speak, that not only did we see big trends in long-term bonds last year and this year, and that was great, but something else happened last year that people should be aware of, and that’s this thing about short-term interest rates, where for the longest time, they didn’t move because central banks kept them completely flat. That meant as a trend follower, we couldn’t really make any money.

I think sometimes, people might believe that, well, if a market hasn’t made you money for five, seven years, you probably should kick it out and trade something else. But I think last year, we were reminded that that’s not always a good idea because some of the biggest profits were actually made in the shorter end of the yield curve having been so unprofitable, so to speak, or flat in performance for many, many years. So I just want to throw that in. You don’t have to comment on it.

But I would love this second myth that you just touched on as well in the paper where people might feel that, okay, if interest rates keep going higher, will we always be short? Or if they stay high, will always be short?

[00:28:39] Katy

That was another important point because I’ll just be honest, people were uncomfortable with us being short, and that’s why I wanted to answer that question, Niels. Because they’re like, how long are you going to do this? Is this forever? And I was saying, okay, let’s do some analysis and I’ll tell you. I agree with you on the short rates point as well in that we saw a massive P&L and we saw- actually, I kind of ignored short rates. They’re there.

But then last year, I started to think, oh, there we go. Something interesting going on there. Because there’s no volatility and now there’s something interesting there if you’re going to be seeing those move at some point. So let’s go back to the question you asked about when rates are rising or in a higher rate environment, will you always be short? I can connect this a little bit later to what has happened because I think that’s the thing we should talk about next after this because that’s so important.

If you look at this paper, what was interesting in this paper, and I pointed it out, that once you have a steep yield curve, that trend is more likely to be long even in a rising rate environment. So if you think about what that means, to me, a steep yield curve is much more of an equilibrium. It’s a place where you have a duration premium. It’s a place where the market has decided that we know the supply-demand dynamics for long-term debt. Thus, you want to own bonds again because they have carry.

Let’s just be honest. Bonds are positive. Bonds are good. I think this is part of the problem where people have a conundrum with what trend does in terms of shorting bonds, is they always think, “But wait, bonds are great, they give you coupons. They have a yield. Yield is good.” But I say, well, that’s fine, but there’s a trade-off between NPV destruction, when yields go up, and the positive carry.

When you have a stabilized yield curve and people feel like there’s some level of duration premium, then it is actually good to hold bonds long. That’s what you see in the data as well. So what I’ve been looking for in the last two years is the two-phase transitions. The first phase transition is inverted yield curve, extremely profitable trend signals moving to a flatter yield curve which is profitable but perhaps not quite as profitable short. Sounds a little bit like this year, right, Niels?

Then we hit the flatter yield curve, and once we’re at the flatter yield curve, we sit at the point of question. What’s next? How do we get to the stable yield curve? How do we get to a steep yield curve? Is it going to be that the yield curve steepens on the top, the long end, or are we going to see a short end of the curve that makes a steep that way? So that’s the question we’re asking ourselves right now. We can talk more about that because that’s bringing this conversation into today.

[00:31:49] Niels

Yeah, we should indeed talk about that. There’s one thing again I just want to throw into the conversation, because again, when I talk to people, I think a lot of investors have been tempted of changing their asset allocation and simply just buy some bonds because finally they’re getting 5% or more. I understand that. Obviously, it’s not the real rate they’re going to get but it’s the nominal rate, and that’s fine.

But one thing I just want to remind our audience is of course that to me, one of the beautiful things, and the list is long about trend following, is of course that we pick up a lot of interest income in the fund vehicles that managers offer and where essentially just it’s earned by the fund and therefore the investor. So it’s not really a choice about do I want to get 5% or do I want trend. Actually, with trend, you almost get the full 5% and you get the returns from the trend.

But then I was thinking about this, and this just shows you that it’s been a while since maybe I was in the nitty-gritty of things, and that is, because I always say to people, you get probably full interest on about 80% of the money that’s not being used for margin. But then I was thinking, well, is that really true? I don’t mean to put you on the spot here, Katy. Maybe we’ll just have to kick it to the side. But I’m thinking, maybe we actually do also earn some interest on the money that’s put up for margin. I wasn’t entirely sure about that. Do you know this?

[00:33:29] Katy

I think it might be small, but it’s small. If so, it would be small in comparison to the collateral yield. I think you bring up an extremely important point and this is interesting because someone was asking this week about a bond replacement fund to me, and I haven’t heard anything like that in a long time. The reason for this is that most people do not understand that futures-based portfolios use 80% to 85% of their cash in treasuries and yield instruments. So they earn a collateral yield which today is around 4% to 5%.

Now, that is very interesting because for most hedge fund strategies, and I’ve actually been running a project with some students at UMass and the project I gave them was to investigate how interest rate and borrowing costs would affect the alternatives business. It’s very different for many hedge fund strategies where borrowing costs have now become extremely high.

For strategies that use futures which are very collateral efficient, we can earn a yield on the collateral while still also allowing for a dynamic trading strategy. So I think there are a few strategies out there that are really excited. How cool is it to earn collateral yield and be short fixed income at the same time? That to me is like yay. It’s kind of going both ways, right? You can earn 4% on your collateral and be short the 10-year at the same time, which is kind of an interesting thing to scratch your head about, right?

[00:35:12] Niels

It is indeed. It is indeed. Okay. Now, you said you wanted to go back and talk about something before, which I forgot.

[00:35:20] Katy

Yeah. I wanted to talk about where we are in the market right now based on this paper, which is interesting to me. We wrote that paper as an empirical exercise. What is trend going to do in this new environment? The basic findings, if I summarize them again, is if the yield curve is inverted, it’s going to be very profitable to be short and more likely to be short. If it gets flatter, it’s going to still be profitable to be short but less profitable, and it’s still going to continue to be short.

The next phase is when the yield curve is steep, we’re likely going to be long and long is going to be somewhat better than being short and short will be more tricky. So I think what’s been the question for me this entire year is that we have been looking all year for a dis-inversion of the curve, and we finally got it. We’ve been saying all year, short bonds, short bonds, and none of the fundamental guys out there or girls out there have agreed with us until recently.

Then in October, we got that 5% on the 10-year for the US, and now I’m sitting here going, what’s next? I think that’s where we are. We’re kind of in between phase two and phase three. Where are we going? So that to me are the questions I’m asking myself right now is, what gives us that steeper yield curve? Is it a blowout in the fixed income curve? Yesterday’s action or earlier this week the 30-year auction having trouble, it made think there could be something there.

Also, if we do have deteriorating financial conditions or if the Fed does come in and cut next year, we might have the other direction of the yield curve. So it’s interesting to see that trend will eventually go long at some point, but I don’t know what’s going to get us there. That’s what we’re thinking about.

[00:37:28] Niels

It’s kind of interesting to me because you do a lot of great papers, you do a lot of great talks, and you have also in the last few years done a lot of great work for the industry by being invited on to financial mainstream media such as Bloomberg and other outlets to discuss some of these things. What’s interesting to me of course is that, in a sense, you have to kind of try to explain the why, even though we come as trend followers from the standpoint that actually the why doesn’t really matter. It’s just about the price.

So you’re right. There’s these two eventualities. But of course, there’s also the fact that even whether it’s the short end where interest rates come down or whether it’s the long end that has blowout to the upside because there’s not enough demand for the debt, who knows, really? But then there’s all the other things, namely, how does that impact all the other markets that we trade, all the other sectors that we trade?

Of course, you and I don’t know and we’re not really here to speculate as to what may happen, but I think these are some of the topics, some of the things that I still feel investors are struggling with. This urge to try and forecast how it’s all going to play out is something that is very hard to change. That behavior is so difficult to change. In fairness, it’s sometimes also difficult for us practitioners not to speculate about what may happen because we are faced with a question, we’re curious, right?

[00:39:07] Katy

Yeah. I think for me, the biggest thing that has been surprising in the last two years being so obsessed with fixed income, it’s just how complacent. We talk about complacency all the time in equities. We say, oh, well, people just ignore the risk that they may go down. The fact that people kind of ignore the risk of repricing of cash flows and refinancing risk I think has been the biggest shock to me.

So this idea that borrowing costs are more and that this is going to change, I think that is what has been the most surprising thing for the last two years as a trend follower. Let me put this into context. It’s just that when you’re a trend follower, as you know, Niels, you follow the signals, and the signals say short. So you get in a position that is completely opposite from what everybody else is saying sometimes.

The more opposite you are, sometimes the better the position is. So some of the best trades in your career are when everybody just refuses to believe in something. I think that’s what the last two years has been for me, just watching people not want to believe that things have changed in fixed income. Those of us that focus on data, we just say, well, look at the data. We’ll just look at a longer horizon and the data in this period looks like this and so this could happen.

We’re not stuck on this idea that it has to be a certain way, and it helps us to be in a very, very different perspective for longer periods than some others in the space. That’s why I think we should be talking in the media. We should be talking about what we see, because honestly, from my perspective, a lot of times people talk out of both sides of their mouths. They say I love bonds and then they’re selling bonds at the same time. So I think their behavior is the market prices, and we measure them.

[00:41:12] Niels

You brought up something that’s quite interesting because I remember a conversation I had with someone, a group that we work with, where they get invited to conferences that includes many different strategies. This was probably sometime maybe a year ago or so. I remember being told that a lot of these big well-known hedge funds were out saying how negative they really were and how they saw interest rates going higher, and so on and so forth, which of course, when we looked at our positions, we would completely agree with.

But then when the question came to these big managers about how are you expressing it, how short bonds are you, well, actually, none of them were very short bonds, which is kind of the funny part. The other thing that I’m reminded about when I hear you talk, and of course, this is looking in hindsight but also speculating a little bit about the future. What strikes me as being very interesting about this environment is the fact that we have seen rates, up until a few days ago, pretty much tick higher and higher and higher.

At the same time, we have actually seen commodities, many of them go significantly lower than what they were 18 months ago. I find that very, very interesting, because normally, you would think commodity prices could actually be part of the fuel that leads interest rates higher. You can’t, at least I can’t help wondering, well, what happens the day if commodities actually start moving significantly higher?

I’m going to throw a couple of headlines at you and then we can talk a little bit about that as well. Because you told me that you had been on Bloomberg, so I just kind of went on the Bloomberg website and I found a couple of interesting headlines. Of course, one of them came from a conversation where Druckenmiller sat down with Paul Tudor Jones very recently.

Of course, where Druckenmiller, I think maybe he said this before, but he’s so right when he says, and you’ve talked about it, that refinancing, like 80% or whatever the number was of US households managed to refinance when interest rates were low. There’s just one person who didn’t, and that was Janet Yellen, which of course will have significant impact potentially on the whole US economy, which is quite funny.

But then I also saw Ken Griffin coming out on Bloomberg and being interviewed, and he’s basically saying that, and I’m quoting, the headline was, “Griffin says peace dividend over, high inflation to last for decades.” So when you have people like that saying that this environment could last for a very long time, I think we have to pay attention. Druckenmiller of course said last year that he thought that stocks could go nowhere for 10 years. So far, he has been absolutely right. They’ve gone nowhere really.

What’s of course also interesting is that as soon as you ask someone who’s been in touch with the central banks, you get a completely different picture. So Mario Draghi was out this week I think at the IMF meeting saying that the outlook for Europe is for soft landing with inflation declining gradually. He said it’s almost sure we’re going to have a recession by year end. It is quite clear the first two quarters of next year will show that. So different people, different perspectives.

Then you have Jerome Powell coming out this week actually saying that, and I think this was at also the IMF maybe, he said that we are not confident the Fed has tightened enough to bring inflation down to 2%. He also said that they would monitor economic conditions closely to avoid the risk of having raised rates too high and the risk of having been misled by a few good months of data. It’s probably me misquoting it a little bit. I think he’s worried that they haven’t raised it enough because they’re being misled by a couple of decent data points. So it’s all very interesting.

You can throw in one more thing, just to give you some time to think about all these things, and that is, in the unfortunate world we live in right now where conflict is just increasing and that we have on the podcast spoken a lot about with people like Peter Zeihan, Neil Howe, who obviously expects this environment with global conflict to last for many years still, you have to ask, what does military spend alone do to inflation?

I think this could be the canary in the coal mine that we haven’t really seen that. Not only haven’t we seen a high interest rate environment for a long time, but we haven’t also seen the need to be spending so much money on these kinds of things at the same time as many countries are seeing their welfare state under enormous pressure and where more money is needed for that. So you can certainly find arguments for higher inflation in general, and therefore, I think the higher for longer is probably quite appropriate. That was a lot of rambling, Katy.

[00:46:41] Katy

Well, I think you just made a great point for trend following, because that’s hard to digest. How do you build a portfolio for all of that? It’s hard. I think that’s where trend following is such an interesting space because people ask us all the time, what are you going to do? And I say, well, we’re going to do what happens next. I think right now, there’s a couple of things that seem clear. One, inflation is probably higher. Is it extreme? Maybe not, but higher than what we’re used to perhaps.

Number two, there’s definitely more deglobalization and there are supply chain issues that are somewhat clear more than before. How much is that going to impact asset values and things that you invest in? It’s going to do some of that. How much? We don’t know. Could commodities come back if they’re complex? Yes. If there’s other issues? Yes. So from our perspective, there’s a lot of macro uncertainty and there’s a lot of chances that there will be a crisis of some sort, of some incarnation, and so there are going to be a lot of tactical opportunities for investors.

It is not a 60/40 world per se. There’s going to be things happening that could provide opportunities, and I think that’s where it’s an interesting environment for us. I think next year is going to be potentially many different scenarios could occur. I’m hoping for a soft landing, but that’s quite optimistic.

[00:48:15] Niels

A couple of points before we start to wrap up, Katy. We’ve talked a lot about a paper that you wrote where you went back and you used historical data because, well, I know now that you weren’t even born back when we had inflation and many firms didn’t exist. But as you know, I actually work for a firm that has been around for 49 years, so we did trade through the last time interest rates were rising. So we have data, and of course, it confirms what you said about the fact that actually trend following did very well, certainly a lot better than the last 20 years on average where everything was very odd with central banks doing what they did. So I think your paper is very spot on and people should go and check it out.

But I have a question for you. Now, when aspiring quants come into this world and they say, well, I’m going to build the best trend following model I can, they’re going to grab the usual datasets, which is probably not going to take them much further back than the ’80s for fixed income products because that’s when the futures markets began. So if they don’t want to do all the dirty work, that’s kind of their starting point.

So if they do a trend following model and they start thinking about which market should I trade, etc., my guess would be that they will get a lot of suggestion in putting a lot of fixed income markets in that portfolio because they have done really well. How do you think about that from a research perspective? How do we not rely too heavily on that wonderful period of time we’ve really had for the fixed income sectors in our portfolios because we don’t know if this is going to repeat? So how do we avoid being tempted to overweight fixed income when building trend following portfolios?

[00:50:22] Katy

I love that question, Niels, and it gave me a chance to promo another paper that I wrote on bond bias. It’s called “Beyond Bond Bias” and we actually think about this question Because I think the real (and this goes back to this concept of divergent trading and a philosophy of a trend follower), you need to go back to thinking about being as agnostic to the different potential trends going forward. So if you torture the data to try and find the best possible opportunities, you’re likely to best fit the past as opposed to fit the future.

It’s more about an ideology that you kind of have models and approaches that are robust to different scenarios and that can adjust to changing market conditions appropriately. That allows you to be a more adaptable trend follower. I think last year was a particularly important environment for that because it was a stress test for a lot of people’s models. Will you short fixed income or not, and what have you possibly done to fit your model such that you might not do that?

This paper that I promoted as well that we wrote about this concept talked about machine learning, it talked about risk constraints, and also talked about fitting your models in selection like you mentioned. I think these are very important issues as a trend follower that you have to think about. The future can be very different from the past and it’s always about creating models that are more agnostic, that can actually pick up what happens.

You mentioned this idea of short rates. I remember back in 2012 doing a project on should we never trade metals again, because metals apparently never worked. Then I remember thinking about that when COVID happened and thinking everyone was going to stop trading metals because they never work, and metals was an important trend in what happened in 2020. So I think that’s a philosophical point, that it’s really about making sure that you realize that the future is very, very different from the past and that things can change in very, very structurally different ways.

So I think for me, it’s more of an ideology than it is. And then it’s implementing that in your back testing framework and it’s about teaching and learning how to think like that as a researcher and to be open-minded that the backtest is not going to repeat, and some of the common pitfalls.

[00:53:03] Niels

Absolutely. As you’re explaining that, I’m actually reminding myself that I think we talked in more depth about this particular paper last time we spoke, so people should go and check out the last episode we did a couple of months ago because it was very valuable insight that you shared there as well.

Katy, any last thoughts? Anything that we’ve missed in our big bond short episode here?

[00:53:30] Katy

No. What’s exciting as we were looking at the data, I think the last thing that I wanted to point out as I was looking at some positioning and trend following has been net short for nine quarters in fixed income, and that is the most consecutive quarter since 2000. That’s because that’s the data I was looking at that period.

So I think we’re definitely at an interesting point. Where are we now? I think that’s where I would say that I’m definitely wondering what’s happening next. I can’t tell you because I’m a trend follower, so we’ll see what happens. But we’re definitely at an interesting point in history in terms of fixed income.

[00:54:12] Niels

It’s so interesting when you say that trend followers have been short fixed income for about nine months, which completely ties into…

[00:54:20] Katy

Nine quarters. Yes. Not even nine months. Nine quarters net. Not absolute, but net.

[00:54:28] Niels

It ties in with what I see on my side as well. But what I thought was really fascinating is that it was probably only about, I don’t know, 12 quarters ago or maybe 16 quarters ago that Austria was selling a 100-year bond at 1.2% interest rates and people bought it. Talk about a change in sentiment and environment. Well, that’s what makes the world of finance interesting. That’s what makes the world of trend following absolutely fascinating.

Katy, I can’t thank you enough. This was a wonderful conversation. Thanks for taking us into your research world. People will definitely have to go and check out the papers as usual. If you love these conversations like I do, then please go and follow and rate and review the podcast on iTunes, Spotify, Amazon, wherever you prefer to do it.

Next week, I’m joined by Alan, who has been graciously sitting in for me while I was on holiday. I’m catching up with him next week and I’m sure if you send us some questions, we will be happy to deal with them as well. From Katy and me, thanks ever so much for listening. We look forward to being back with you next week. Until next time, take care of yourself and take care of each other.

[00:55:50] Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoyed 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@toptradersunplugged.com, and we’ll try to get it on the show.

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