Dave Dredge - Global Macro Series - December 21st, 2022

[00:00:00] Dave

The ball spins 96% of the time in the middle of the pitch. It’s only the two, two percentiles that it spins in the two penalty boxes that actually matter. It’s what happens there that matters. Our whole premise is, you construct an investment portfolio based on what you don’t know. So, you make it so that it performs its best in the extremes, because making it so that it performs its best in the expectation means you won’t perform very well at all. That’s the point of that piece. It’s not predicting what you think you know, it’s constructing resilience for what you don’t know. 

[00:00:49] Intro

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Before we begin today’s conversation, remember to keep two things in mind. All the discussion we’ll have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.

Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:43] Niels

Welcome here today to our Global Macro Series. I, along with my co-host, Cem Karsan, want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro driven world will look like. We want to explore their perspective on a host of important issues, and hopefully dig out nuances in their work through meaningful conversations.

Our guest today is like Cem, an expert in the world of volatility. He also possesses an extraordinary gift in explaining complex matters in a way most people will understand. Please enjoy our conversation with Dave Dredge. 

Welcome to our podcast and thank you so much for joining Cem and I today, for what I’m sure will be a passionate and fun conversation on a few explosive topics, no doubt. Now, since this is not your first time on our podcast, let me suggest to our listeners that if they want to learn more about your background they should go and listen to your conversation with Hari, as part of the volatility series, published on the 12th of January, 2022. Which actually makes it almost a year since we last had you on.

How are you doing? 

[00:02:52] Dave

I’m great. Life is good in Singapore. It’s nice and warm here. Unlike Chicago, I hear. 

[00:02:57] Niels

Yeah, absolutely. Now there are many different paths we can take, and many different topics we can start out with, but I’d like to start out with something that I think, this year, I guess, will be remembered for a few different things.

I think one of them will be the fact that, at least at the time of our speaking, investors probably lost more in their bond portfolio than they did in their stock portfolio. So, this is not the kind of balance that they have been hoping for or looking for, and that we’ve been used to and enjoyed during this carry regime we’ve had for a couple of decades, leading into the Roaring Twenties (as some financial media outlets managed to name this decade).

If you don’t mind, can you take us into this topic and share some of the things that you’ve been writing about in your excellent monthly updates that everyone should subscribe to when it comes to the Fortune? Of course, if you want to talk about the 60, feel free to do that as well. 

[00:03:58] Dave

Thanks Niels, thanks Cem. I appreciate you guys inviting me in for the chat. Yeah, I’ve been writing forever and talking forever that the 60/40, the basic optimized portfolio model, is wrong. The 40 is holding capital out of the things that participate in the market, and not providing sufficient, and eventually not providing any, protection to the portfolio. 

The correlation that the Sharpe World mathematics (as I tongue-in-cheek refer to the traditional financial mathematics), the correlation that this whole thing was premised upon was artificially generated from the Greenspan Put Era onwards, which created this negative correlation between bonds and stocks when central banks implemented a reaction function of cutting interest rates when asset prices fell.

That created this sort of multi-decade faux benefit of holding those two things together and, in essence, reducing the capital requirement of your portfolio by both a Kelly Criterion reduction of exposure mindset, and this positive carry correlation benefit. Inevitably, when interest rates get to zero, it is not going to be risk mitigating, it’s going to be risk additive. We got to zero and then some. Then we did a whole bunch of QE and made it even worse. I think (in referring to my writing), I think in my December, 2020 note, I titled it, inflation is Upon Us, 60/40 Is Dead. Then, fair enough.

[00:06:00] Niels

Yeah, absolutely. 

Now I’m just wondering (just staying a little bit on the 40), I’m just curious, why do you think when interest rates got to zero (and as you rightly point out, in some parts of the world, they became negative), why do you think all of these “smart investors,” who run all these big pension funds and other massive portfolios, why was it so difficult for them to see this risk?

Let me put it in context. I’m Danish by background, and I recently read (and heard also on some podcasts) about the largest pension fund in Denmark, called ATP. In their September update, for the first three quarters of the year (2022), I think they published (if I’m not mistaken) a loss of 47% of their strategic reserve capital. That’s in nine months. 

This is crazy stuff. Yeah, interest rates have gone up a lot, but they haven’t gone up to levels where they could go if we have a resurgence in next year of inflation. I’m just curious, why do you think that it was? Most simple math would’ve worked out that this was not a great portfolio structure anymore.

[00:07:25] Dave

Yeah, in my Sharpe World note, I wrote a piece I entitled, Sharpe World Closing in September of This Year. I opined, in essence (I don’t know if it’s the chicken or the egg), but the financial fiduciary industry along with the financial mathematics (what I call Sharpe World – the whole bachelor random walk, Gaussian normal distribution, efficient market hypothesis, modern portfolio theory, capital asset pricing market model, sharpe ratio, value at risk) fraud, has conspired with the financial fiduciary industry. In essence, it was a bribe to financial fiduciaries to enrich themselves at the expense of foregone compounding for the end capital owners, and allow governments the world over to blow through a hundred percent debt to GDP numbers in every major country in the world, virtually.

The only way you could get savers to hold this stuff is to dup them into it through their pension funds, and insurance companies, and banks that bought this stuff on a Sharpe World mathematic, risk regulatory, accounting reporting, annual return incentive structure that loaded everybody up, in the financial fiduciary world, with this debt to the disbenefit of the end capital holders.

My point of the Sharpe World closing piece was that now that we know that, who’s going to own all the bonds? Who’s going to own these bonds now? Even if ye-ha, they yield 3% now instead of zero, still this year (with the numbers you quoted, 40 something percent losses), you’re not going to compound those back at 3% components for a really, really long time – probably never. Particularly again, as you noted, as most of these countries in Europe, the UK, and Asia, are running double digit inflation price stability numbers. You still have this fantastic problem. 

With the UK and their LDI investment being exposed to the world, the Bank of England can’t let long-dated gilt yields go above 4%, or the entire pension system running levered versions of Sharpe World optimized portfolios blow up. Meanwhile, they’re fighting 10%, 11%, 12% inflation. So, you’re trying to get people to hold onto bonds at 4% yields in a 12% inflation environment because you can’t let rates go up.

Now, this is a pathway to disaster. What I get to, at the end of my Sharpe World piece, is that the premise around Sharpe World closing probably isn’t that they’re going to let everyone leave the amusement park. It probably is, they’re going to close the gates and make sure everybody stays inside.

[00:10:29] Niels

Yeah, it’s very interesting, and I want to let Cem get in here with some of his topics. Before I do, I want to just quote you a little bit from this Sharpe World. I thought it was just fantastic. Everything you write is fantastic, but I love what you wrote from that piece, “We think of Sharpe World as a metaverse fantasy land where fiduciary wealth managers dreams all come true.

In Sharpe World, historical volatilities and correlations always remain constant. Geometric compounding paths are irrelevant. Tails are never fat. Leverage is not risk. Frequency matters more than magnitude. Ensemble averages dominate time averages. Hens lay soft-boiled eggs.” So that’s just a really good way of starting out a piece like that.

Cem, where do you want to go with our conversation today? 

[00:11:25] Cem

Yeah, I think that’s a perfect lead in, actually, because at the end of the day the Fed has driven that correlation more than anything, in the success of 60/40, in my opinion. They’ve created more linear simple reaction functions because they are the 10,000 pound gorilla in the room that’s been able to control an otherwise much more random system, and much more nonlinear system.

You talked quite a bit about Mandelbrot, fractals, and volatility clustering. For those of us in the volatility space, this is a very intuitive concept. If we’ve been out there looking at nonlinear things and how things work, you learn that by experience, if nothing else. 

Can you speak about how you look at fragility in general, and then more importantly, how do you think about it more specifically in the context of the Fed being forced to step away and a bit less control on a system that with inflation, they have a dual mandate all of a sudden that they have to adhere to. Then, what that also causes, in my opinion (from a macro extent), is critical global trends, reversal critical global trends as well, that have been tied to that fed policy like globalization, and inequality, and corporate, versus labor power.

So I’d love to hear your thoughts just broadly. 

[00:12:57] Dave

I wrote back in August, 2021, a piece on self-organized criticality, applying the sand pile theory principle. I said then, when everybody asked me what I thought the biggest risks were (given what I do for living, people ask me that all the time), I said interest rates going up, obviously. Everybody said, “Why would they let that happen?” I said, “I don’t know. I assume because they decided to.” To this day, I still think that’s the best description of what happened. They decided rates should go up. It didn’t just magically happen.

They decided to do it because the negative externality of foregone price stability was more costly than their ongoing desire to forever prop it up. I analogized the withdrawal from Afghanistan in that piece; why did the US military decide to let the Taliban take over all of Afghanistan? They could have prevented it forever, but that came with a cost they were unwilling to bear. So they left. It happened in a weekend. 

I think we think of fragility in terms of (more specifically speaking) uncapitalized tails in the system. The system, again, particularly driven by the Sharpe World fiduciary participants, financial institutions, obviously last time around 2008, it was very much the banking system and the failings, the flaws in their Sharpe World regulatory structure (Basel 1) that allowed them to tranche and construct through derivative innovation triple a super senior tranches of subprime CDOs and call them zero RWAs and lever them infinitely. 

At exactly the time they were trading as though they were the closest thing in the world to US treasuries, the least risky thing in the world, which was driven to that pricing because of the infinite layers of leverage applied to them, they were the biggest uncapitalized tail risk in the world. A very small change in the correlation of house prices, from what was implied, to create that AAA super senior tranche, wiped out all of the capital in the global banking system. That’s the way we think of fragility.

I have said out loud any number of times in the current world, I argue that uncapitalized risk is in the lack of capital supporting the 40. In all of today’s versions of 60/40 LDI risk parody, where that 40 was deemed to be risk reducing. It actually reduced the amount of capital you held against the 60 in its various versions, and much less holding capital for the 40.

That has left the Fed and all the other central banks… I think the Fed, (we’ll probably talk about this as we go), the Fed is the least of the problems. The Fed is arguably one of the better circumstances in the world of central bankers. The rest of the central banks in the world are all hoping they can coattail ride on the Fed’s, soon to arrive, immaculate recession. That there’s going to be this beautiful recession that’s going to save the world for everybody, because rates won’t have to go up.

Now you’re in this thing, as we were talking before, where they’ve got to walk this tightrope where they can’t raise rates so much that they blow up this leverage in the fixed income fiduciary savings pool, but they need to raise rates enough that they restore price stability. Otherwise, that’s going to blow up the back end of all the fixed income markets in the world.

They’re walking that tightrope and playing the usual mythology games of neo-Keynesian economists, by saying, “Oh, we have to protect jobs.” All the same stuff that Arthur Burns said were the mistakes that he made in the seventies. They’re making all the same mistakes today and trying to soft-step and be very asymmetric.

They don’t have lengthy meetings, and guidance, and talks about blah, blah, blah, when they need to slash rates to zero and jack up QE $7 trillion. The asymmetry around their measures of inflation, being 20 basis points below their target, is a hell of a lot different than when it’s 800 basis points above their target.

It’s unbelievable. Now they have to plan, and signal, and guide, and we’re not even thinking about tapering. Now, we’re going to slow down purchases and we’re going to signal you months in advance before we’re going to do an initial hike. They play this game, and that game has gotten them in trouble as they have fallen way behind.

The further you’re behind, the more you subsequently have to do. J Powell’s the only one that has shown any understanding of this problem. I will argue the Fed, through all of their post repo crisis in September 19, and bailing out the fixed income markets in March 2020, is the one who was most cognizant of the amount of leverage in the fixed income markets, and has done the best job of keeping the yield curve as inverted as possible to protect the backend of their fixed income markets.

So that’s kind of all over the place, Cem, but where my head is at. 

[00:18:50] Cem

Yeah, absolutely. I wrote about this about six months ago, but I’ve likened where we are to this sumo match. It used to be these little skinny, scrawny wrestlers and they’ve just gotten bigger and bigger and bigger.

It still has been very balanced. We’ve been at some equilibrium despite the increased potential energy between the two, because of the balance and because of the Fed’s ability to control that game. I think the issue is balance. The second you start to get imbalanced, given how much more potential energy there is in the system, it just becomes a much more dynamic system.

I think we’re in a much more dynamic system. I think that the thing that ultimately will kick off something, a bigger fat tail ultimately, is something more than just what happens every five to 10 years, call it. Is the decreased liquidity and the Fed stepping away.

I think that’s why the Fed is so important to this whole picture. On that end, how do you think about liquidity? 

Top-of-book liquidity in futures, as well as market depth and options has reduced dramatically in the last six months as the Fed has raised interest rates. It’s now below the 10th percentile to zero percentile, depending on what metrics you look at. As you and I both know, we’ve both been in this business for some time; liquidity and volatility are cousins. They’re two sides of a similar coin.

I’d love to hear just your general thoughts about how you see the relationship with the two, and how you witnessed their interplay play out in different markets in 2022, and what you see for liquidity in 2023 and its potential effects. 

[00:20:44] Dave

Yeah, exactly. We think of ourselves as value investors in volatility, but really we’re just stores of highly convex liquidity.

We’re just big stores of liquidity and we’re looking for those places where those uncapitalized tails exist, such that when markets move into them, liquidity becomes desired, desperate even. In general, in our world, and I think maybe the big picture with what we’re talking about right now, again, I would argue the US market looks pretty good.

If you look much more closely under the hood in Europe or certainly in China, what’s been going on there, it’s a much more complicated problem. Now, as I know Niels is a fan of some of my writing about Japan. Japan has a particularly unique challenge, having maintained an interest rate peg, a hard peg for far too long at levels that are unsustainable. One of the standard Dredgisms is “pegs end badly and all pegs end.”

That’s going to be one of the most interesting things we see in liquidity. It’s a world we operate in, Cem, where we’re really looking to absorb volatility supply, and we’re not trading in active liquid, high frequency markets like VIX or even exchange traded vol in general. We’re absorbing volatility supply in the complex structured product markets and across asset classes and around the world.

We’re looking to absorb that liquidity, cognizant that’s likely to be the place where liquidity is in the most demand. An obvious example, coming through this year and what we’ve seen this year, interest rates have really been ‘the place.’ 

Interest rate volatility is what everybody wanted to sell, whether they knew they were selling it or not. Generally, the form that they’re selling it is in simple, cullable note structures. They may not even think that they’re selling volatility when they’re buying that 20 year-two year call, because it became so accustomed to that just behaving like a two year bond. You just mark it as a two year, in your books, if you’re a Taiwanese insurance company, or a German pension fund, or whatever, a Japanese bank.

That burst in supply of volatility, from really summer of 2020 through summer of 2021, across Korea, and Australia, and Japan, and the US and Europe, Europe, Europe. The reversal of that, when rates did move, and then you get into the stuff that Niels may not want Cem and I to talk about, but you get into Vanna And Volga problems in that world were the book runners.

You think about the volatility that has occurred in interest rate space, and I’m really talking swap space, but you’ve seen it as well on Euro/dollar futures, and your IBOR futures, et cetera. Really, in the longer dated interest rate swapping space, that volatility is simply the pain of the dealers in trying to hedge these products.

The guy who shorts the end volatility in all of those products still owns it on his books, not mark to market. This is one of those classic examples, much again, like we saw with Mortgage Securities back in 2008, where the real losses are in the system, just nobody’s accounted for them yet. The concept of volatility in some of these markets should (who’s to say they ever will), but should the end holders of those things ever come to the market and say, “Hey, I need to unwind this stuff.”

Either I don’t want to, or my regulator won’t let me, or I can’t now take something that I’ve had on my books as a two year, three year, four year duration, that’s now a 20 year, 30 year, 40 year duration at the zero yields. I want to get rid of it. To me, that’s really the yet to come problem with liquidity in the interest rate space.

That problem exists in interest rates on a scale that just never came back again in equities after what happened in March of 2020. 

[00:25:21] Cem

Yeah. I think this is an interesting topic. Again we might go a little too far down this road. Niels might have to break this up. This is a love fest. 

The reality is if you look at equity vol, for example, as a proxy for how vol tends to perform as a function of liquidity and dealer positioning, you brought up the specter of dealer positioning (you have me excited about this topic). But the reality is that over shorter timeframes, meaning months, quarters, maybe a year, dealer positioning really is a very strong negative predictor for volatility. If you look at equity vol (in terms of risk adjusted returns), just historically (for most of that dataset) the lower vol is, the worse the performance is for that volatility in the short-term.

I know you’re making the opposite argument, but I think that’s because you’re looking over longer timeframes. From our data essentially (and we saw this in 2017 again), so few people talk about 2017 and how historically important it was, but it was the lowest realized and implied volatility in 150 years of equity history. Not by a few percent, by 30%. The driver of that, we know that because of a lot of data we can get into later, or maybe on a different show, but because of implied vol supply and the compression that came from that during that period.

Reflexively, there’s this effect where this isn’t tornado insurance we’re selling at the end of the day, or we’re buying. This insurance is affected by the actual insurance in the market. There’s this reflexive effect, and that’s so critical to markets in the short-term.

That essentially leads to over-leverage – things going too far one direction, and then eventually ( as we saw after 2017, XIV) blowout a bigger spike when it finally does need to, under some conditions, reverse. I agree over a longer timeframe you’re essentially stretching the rubber band and creating a bigger tail.

Ironically in the short-term, it usually is the worst period to buy increasingly lower volatility. Again, it’s a matter of timeframes. It’s a matter of trying to navigate that. That relationship is one of our challenges in the long volatility space.

Understanding what does cheap actually mean, and over what timeframe? Let me hear your thoughts about that, and how you’ve thought about that, and then how you’ve seen that interplay, maybe this year, and what you think in different markets going forward. 

[00:28:20] Dave

Yeah. Cheap is what we do. It’s unbelievably subjective. We’re a little bit unique in our world  (you guys know more people than I do), but we’re probably as broad, geographically, an asset class as anybody that does what we do. Maybe some of your listeners will call and correct me on that Niels.

How we decide what is good value. Like I said, we call ourselves value investors in volatility. You’re right Cem, we tend to be much longer term than most people’s perception that we’re much, much longer data than most people perceive us to be. We’re probably more diverse than most people even think we are.

It comes down to understanding the supply and demand. For us it’s really the supply that we’re focused on is this structured product machinery. The reason we sit in Asia is because that structured product machine, which, if you go back and listen to my interview with Hari from a year ago, I was a part of in the very early days in my banker’s trust businesses back in the late eighties, early nineties, creating this yield enhanced thing to monetize this financial repression that has really existed out here since Japanese interest rates collapsed in the late eighties, early nineties, and all of the Asian countries were pegged to the dollar, and the financial repression has been a thing. 

We really try to understand the supply, where it’s coming from, what they’re doing, how the banks, the various food chain of banks and how they’re managing the risk, both the credit risk and the complexity of the derivative risks. What their regulatory accounting risk treatments allows them to do, won’t come as a surprise to most people that most bank traders, who operate on a fairly short incentive horizon, like positive carry and will optimize they’re available basis risk within their hedging strategies to optimize around a positive carry structure.

Knowing how they do that and where they’re willing to do that helps us find things that we think are valuable. Knowing what’s the driver of the end provider of that volatility. I used to be in that business and had the chance to speak to companies all the time that were active in these products.

When you get a guy… We tell the story about the Korean FX vol. One of the biggest movers in 2008 was the Korean FX vol. We show a picture showing that VIX went up three X, and Korean FX vol went up 12 X. The reason the Korean FX vol went up 12 X isn’t because it was a Korean crisis. It was because of the structured product dynamics, the positioning in that market. That structured product was properly known as a KIKO – knockin knockout, and the big exporters were all earning enhanced yields on their massive surplus balances by selling complex exotic dollar call options. 

I knew the main guys doing it. They were the largest shipbuilding companies in the world. When I went and talked to them in early ‘08 (I think they called them hedges), “I think you guys are hedging too much.” The two largest shipbuilding companies in the world, at that time, both told me that day, “No, Dave, you’re underestimating our growth. Were hedging based upon expected 40% compounded growth for the next eight years, in early ‘08.”

These guys had basically hedged enough dollar proceeds to build enough ships that you could walk across the ocean on them. The year before, they were just about to sell no ships for the next two years.

Sure enough, when the dollar moves up, having nothing to do with Korea, the guy who should be the seller of dollars in a rising dollar environment becomes the world’s most aggressive buyer of dollars. The whole thing explodes. All UK LDI investors. You would expect the UK pension funds, desperate for yields, would be buyers of gilts when yields went up. It turns out they’re forced panic sellers. 

Same thing in Korea throughout this whole process now. The Korean pension funds were massive holders of Korean cullable note structures. So throughout the entire hiking cycle in Korea, and Bank of Korea has been relatively active in proactive in hiking, but through the whole thing, they have to keep activating the emergency bond stabilization fund because the back end of the market keeps melting down because the pension funds are all forced sellers on these cullable note structures that forces the reduced duration, because they’re durations exploding on their books.

[00:33:23] Cem

Yeah, the Korean analogy is a great one. A lot of people on our side of the pond aren’t as familiar. The auto cullable demand is so big. The part of that story you didn’t really reference, we all (like to as long vol managers) talk about the powerful 15 X outcome when it comes. We both know how rare that is, and in the meantime, that was just the widow maker for so long – just vol, just compression in Korea was so powerful. Vol would perform in other places and just not perform in Korea forever. That’s how it works, as you know. There’s just long periods of vol compression that come from that supply of that dealer positioning, if you will.

That reflexively pins something. Again, 2017 followed by XIV, but there can be very long stretches and very painful stretches in those. How do you navigate that, A (and again, specific to 2022)? 

Let’s try and dive in 2023. What are you seeing? Where are their dynamics? How are you going to time different markets? Where are you seeing it, just getting so long in the tooth along that path that now it’s time maybe to step in? You don’t want to step in too soon on some of those things. That’s where the rubber meets the road for us.

[00:34:49] Dave

I don’t want to break anybody’s opinions, but we don’t time anything. We have no market view. We’re neither bearish or bullish. We are timing, we’re simply trying to understand value. We’re the garbage collectors of volatility. We’re like distressed credit investors.

If you want to sell it at 10 cents on the dollar, I’m your guy, call me. 

[00:35:16] Cem

Yeah. The question is value a function? Does timing affect value? Is your distribution always constant? If you’re assuming your distribution is always constant, then you can be the garbage collector and just continue to buy, at a cheaper and cheaper price.

If you’re going to model the distribution at some point and say, “Hey, the distribution’s different.” Then there’s a bit of market timing defined within that. What’s cheap is often a function of what does the distribution look like? Again, that doesn’t mean you gotta predict, “Hey, something’s happening tomorrow.”

How has market structure changed? I’d like to just hear your thoughts. 

[00:35:51] Dave

So again, I’ll disappoint you a little bit here. We’re not predicting anything. I’m not making any assumptions about future behavior. I’m simply making decisions about asymmetry, potential asymmetry, and what we’re able to source. My whole philosophical reference is I don’t know anything.

The only thing I know is that it’s what I don’t know that matters. All I’m looking for is something that’s priced like it can’t happen. Somebody’s willing to sell it to me. Now, we do stuff obviously that is nearer on the surface, higher probabilistic outcomes, because it’s attractively priced, and it’s cheap, et cetera.

What we’re really looking for, we’re doing that stuff, we’re owning gamma that’s cheap because it helps us recover cost to own more stuff that’s out there somewhere that is really, really super asymmetric. We’re very, again, we’re much longer dated. We’re working closely with our counterparties who have the volatility supply that they’re trying to recycle.

We’re constantly, our daily life is trying to extend duration/extend convexity, extend duration/extend convexity, extend duration/extend convexity. The complexity of a book that’s always marching in on you, that’s losing sensitivity when what you’ve committed to your partners is to grow sensitivity through time in something that naturally loses sensitivity.

We’ll go back to, I know Niels likes my Formula One race car analogy. We’re the brakes. That’s it. I’m not trying to make money. I’m just trying to be the best brakes so that you can confidently go out and drive your race car as fast as you want to, knowing you’ve got good brakes. The way you pay for having good brakes is you drive faster. 

At the end of that race, at the end of that 40 lap compounding path of a Formula One race, the guy who won is the guy who had the best brakes. Yet, I don’t know anybody yet who really understands how to measure the contribution of the brakes. They’re still going to measure speed.

They’re still going to measure goals scored in a football match. Yet the goalkeeper’s the most important player on the pitch because he’s what decides the compounding through multiple matches. Cem, we’re just really focused all the time on defense, all the time on being a bigger goalkeeper, being stronger brakes.

How do we get there? If vol is getting cheaper, we are happy as clams. Nothing makes us happier than cheaper vol. When a year like this year when vol generally gets more expensive, our life gets much, much, much harder. Going into this year, going into 2022, was easy because we had recreated the level of potential asymmetry that we had last had in February, 2020.

We had once again grown to peak goalkeeping capacity and at just the right time, which is in a sense what we try to commit to our investors. I’m not trying to make money, but what I am going to do is have the biggest goalkeeping capacity right before you need it. I grow, and grow, and grow, until we get there.

Now it’s much more difficult. Interest rate vol that was easy to source a year and a bit ago, is now really hard to source. Fortunately, there’s still dynamics in markets (actually more than you might think) where central banks are continuing to be conducive to suppressing volatility and providing liquidity to systems that still incentivizes and allows for volatility supply.

FX continues to be a place where we can find opportunities. This recent move, and I heard Niels, you and Alan talking about the scale of some of the market moves in the last month. The turnaround in some of these FX markets has been phenomenal. The impact on volatility is great. That creates some interesting opportunities that may come back our way; stuff that we were very active in early in the year that may have gotten a little bit pricier that we can get back in. 

Even equities, you never know, equity vol might, in some markets, come cheap again. S&P and VIX, to us, is a market that there are a lot of players in and a lot of experts. It takes something pretty extraordinary there to get our attention, in terms of real imbalances of supply and demand. But even we noticed that skews, which were terrifyingly expensive for most of the last couple of years, aren’t nearly as expensive now. We’re cognizant that vol of vol is cheaper than it has been, and so we might pay a little more attention to it than we have been.

It’s still not what we would call cheap, relative to what we could find not just in other equity markets, but in other asset classes. Credit is another one that I think in some markets in particular is maybe. I mentioned my new catchphrase “the immaculate recession.” There’s a number of markets that are counting on the US to deliver this global immaculate recession without any thought that possibly in a recession historically tight credit spreads could somehow change, but we’ll see.

[00:41:42] Niels

So I know, Cem, you probably have more questions going down that rabbit hole, and that’s perfectly fine. I do want to just throw in a question maybe for both of you actually, you talk about this Korean shipbuilder example. I’m curious first of all also because there is obviously the Ukrainian conflict and the world looks very different today than it did last time you were on the show, Dave. I was just wondering, do any of you have any suggestions as to where the next Korean shipbuilder is today? 

[00:42:19] Dave

I think that in the sense of where there’s been a lot of cleansing out of volatility, overhang. The biggest one was probably the European interest rate vol, a year ago. That’s been taking a good beating. In particular, the Vanna there has been phenomenal, where the front end vol… If you go back to summer of 2021, two-year vol was 40 normals, and 20 year vol was 50 normals. Now, today, two year vol is 140 normals, and 20 year vol is 60, because they all have to buy back the front end Vega as their Vega duration extends (or with the duration of these cullable structures) and sell out the backend Vega.

You get this dynamic where you’ve had this double whammy of the US particular extreme inversion of the yield curve, but also really extreme inversion of volatility services, which, Cem knows, creates some interesting dynamics for guys like us. You’re like, “Whoa, wait a minute. I can own stuff that has this positive role dynamic to it, and has a whole bunch of Vega duration, and it gets exciting.”

It forces us to make decisions about shorter dated things that need dealing with in much higher vol environments. The obvious area, Niels, that still has a whole bunch of pending potential complications, in terms of derivative overlay in the system, is Japan. There’s nothing quite like the Japanese structured product market.

It’s the oldest, biggest, longest at zero interest rates, longest with massively suppressed volatility, longest with absolute certainty, that it’ll never go away. The central bank will never change, and the 10 year JGB is still pegged at 25 basis points. Now the market has, obviously, pulled away in terms of the swap market pulling away from the bond market, and the volatility on the swap markets pulling up from the crazy… 

Like I said, if you said euro interest rate vol was at 40, in the front end, last summer, and that was the craziest, lowest ever in history that doesn’t compare at all to Japanese interest rate vol, which was at 10. Yeah, the vols pulled up and the swaps have pulled, which had forever traded (give or take) flat to the bonds and, and now,is trading, maybe two X or three X the absolute level of the bond – 50 to 75 basis points on the 10 year swap, depending on the day. The tens, and tens, and tens of billions of dollars that the Bank of Japan buys, of the JGBs, almost every day, it just goes on and on and on. To the point now, when you talked to Grant months ago, you referenced one of my notes saying that I had said something about what’s going to happen when they own all of the bonds? Sure enough it happened last month, Niels. So, the now most active on the run bond; so there’s three most on the run 10 year bonds are the ones eligible generally for the fixed rate operation – the unlimited, everyday buying at 25 basis points. The most on the run bond, as of the end of last month, they owned 109% of the issue of that bond. 

[00:46:11] Cem

What does it mean? 

[00:46:14] Dave

I don’t know. 

[00:46:15] Niels

No, it just shows you how crazy this world is now. Again, before I get to Cem, and so on and so forth, but you did say in all of the fancy terminology you were using before with Cem, you did mention something that resonated with the trend trend follower, something along the lines, “knowing what you don’t know was one of the important points.” 

You actually wrote a memo. I say a memo, but that’s because I’m thinking about Howard Marks, here. You wrote a piece about the pointlessness of forecasting about a month before Howard Marks wrote his memo, kind of in the same vein.

Maybe you can just enlighten our audience a little bit about this particular point, because, of course, it speaks so much to what we do as systematic managers, as trend follows, for all of these decades. We think it is pointless to try and forecast anything. That the true value lies in realizing, knowing, what you don’t know and internalizing that.

But where were you coming at it from your perspective? 

[00:47:19] Dave

Yeah, same point. We track numbers, we use the long-term historical returns of the S&P, and show the importance of the outliers – the two percentile best months and the two percentile worst months. So, over a 40 year track, the 10 best months contribute about 30% of the long-term compounded return. The 10 worst months contribute about minus 40%. The middle 480 months, 460 months, contribute the other 30%. 

The point being, what matters is what happens in those two percentile tails. What happens outside the two standard deviations is what drives the return. To what Howard wrote, and our pieces are uncannily similar, he talks about asymmetry.  I talk about convexity. Nassim Taleb writes about it. Literally Friedrich Hayek wrote his entire Nobel Prize acceptance speech on the pretense of knowledge – on the same subject. Shannon’s information theory – it’s what happens, the information, the entropy is what people don’t expect.

If you’re out buying stuff, or investing in stuff, or making trading decisions inside the expectations, the asymmetry of returns is not likely to be very much, because it’s priced fairly. It’s the stuff that exists outside the expectation, or even the imaginations of people, where asymmetry is possible. So, it gets down to Mandelbrot and that it’s magnitude not frequency that matters.

I’m sure you’ve seen, I draw the Gaussian distribution and then entropy curve on a football pitch, and draw in my contributions to the compounded returns as the area under the entropy curve. Which is exactly like a football match. The ball spins 96% of the time in the middle of the pitch. It’s only the two, two percentiles that it spins in the two penalty boxes that actually matter. It’s what happens there that matters. Our whole premise is, you construct an investment portfolio based on what you don’t know. 

You make it so that it performs its best in the extremes, because making it so that it performs its best in the expectation means you won’t perform very well at all. Which is why (and we talk about this all the time) the Sharpe World practitioners, when we pitch up and say, “You should be convex.” They say, “We have this problem. We haven’t compounded nearly as well as we wish we had. Looking back, our expected returns were this, but we never achieved them.”

We say, “Here’s your solution. It’s convexity. It’s performing outside of expectations that makes the difference.” They say, “Oh, great. That’s fantastic. Then going forward, Dave, what’s your expected return?”

I don’t know. I know it’s better than that, but I don’t know what it is. 

That’s the point of that piece. It’s not predicting what you think you know, it’s constructing resilience for what you don’t know.

[00:50:42] Niels

It’s so funny actually, that you used this football pitch analogy, because of course, in football they have introduced something called VAR, which correlates well with the terms that we use. There we are. 

Cem, back to your train of thought. 

[00:51:00] Cem

Yeah. I wanted to stir it up a little bit on that topic. I think it is an important topic, and at the risk of sounding like I’m going against Mandelbrot and Hayek.

[00:51:16] Niels

That would make it fun!

[00:51:18] Cem

I think it’s important to dive into. I don’t want to be overly simplistic in how we talk about prediction and say, “Hey, there’s no ability to gain an edge or think about prediction.” I think that is, in my opinion, this is probably the few places we might disagree.

I do think that you always want to have convexity, and I agree with the lack of continuity in real systems, and how the Gaussian distribution is incorrect. We agree on all that, but I do think it’s important to note that there are forces enacting on systems, and these are real forces that you can know.

I think of them as gravity as an example. These are physical constraints, and they’re things that can change based on different scientific realities. I think to ignore those changes, or those things that we can know, is foolhardy.

Yes, we can sit here and say, ”The system always works as generally as such, and we’re just going to assume the system is now.” That doesn’t mean we’re predicting up or down, but you can predict and understand the forces that enact on a distribution and hence change, and slightly alter how your approach might be based on that. 

I think that’s an important distinction. That hearkens to this idea of dealer positioning that I talk so much about. It has allowed us, over time, a real edge that allows us to say, “Okay, look, the whole world is hedged here.”

The distribution is probably a bunch of short people, on the other side. That means there’s a fatter tail, but that it’s probably much more contained during this period. It doesn’t mean that the tail is not possible. If anything, it means the tail might be fatter in that scenario, but it does change the distribution and the forces of supply and demand that are enacting upon the system.

There are things, in my opinion, have been born out throughout time, and in our research, that you can measure. I think the ability to measure and understand at least the general forces exerted upon the system, I think are very important.

Again, I don’t think we’re in disagreement on that. I think we do agree on the broader thesis. That distributions are not Gaussian, they’re not continuous, and that tails themselves are underpriced. We’re all in agreement there. 

I do think the distributions change and the forces that act upon them (at least some of the bigger forces that are somewhat knowable; with a higher probability), you can measure as stronger or less strong and are important. 

I’d love to hear your thoughts. Again, I know your view is, “Hey, it’s cheaper. If it’s cheaper we can buy more.” Again, I think there’s this difference on our end where again, cheap sometimes does not just mean less expensive because again, the distributions change. It really is a function for us of two things. How have the forces enacting on the distribution changed? How do those compare, the new distribution relative to how cheap things are? 

I think that comparison between the two is very powerful. It doesn’t mean you ever cut the tail, that you ever assume it’s continuous and simple, because it’s not. I think understanding and broadly managing understanding what are those major forces are that are interacting on the distribution and reality.

[00:55:12] Dave

Yeah, listen, I know lots of people who have been very successful in running various investment strategies, whether they’re systematic, or macro, or stock pickers, or long/short. I’m just in the math business. To me, it’s just math. The mathematics of the big numbers make a much bigger difference than the mathematics of the small numbers.

What happens near the mean of the distribution, over the long run, is almost meaningless to the compounded returns. I’m sure that there’s a whole bunch of people that can actively manage risk, and trade, and short-term chase momentum or imbalances or whatever. Most pension funds, or endowments, or large family offices can’t do that with the bulk of their assets.

Most of them are very structurally invested in either just totally long equities, or some sort of balanced portfolio, or in the pension fund world, some version of a Sharpe World premium, call it risk parity, or LDI, or whatever you want to call it. We just come along and say, “Improve your convexity.” You improve your convexity, you’ll improve your life. 

How people go out and figure out how to better participate in the upside, how to put to work more efficiently capital; in a more efficient way, with better constructed diversification, good on them. I’ll help them if I can. My job is to be the brakes, and I just want to be the most capable brakes I can be.

The only way I can figure out how to do that is to buy vol that I can see. Again, the distribution as you put it, Cem, we’re not doing a…

[00:57:17] Cem

My job is to be the brakes too, to be clear. I have a long vol fund. I’m not arguing. I love your race car analogy.

That said, I’m going to add a wrinkle. You don’t just sit on the brakes the whole time. If you sat on the brakes the whole time, yes, at least you have brakes. You’re not going to blow yourself up. You’re going to do better than the car that didn’t have brakes.

If you can manage those brakes, there’s a lot of power. I think that’s more the metaphor. 

[00:57:50] Dave

I’m not saying you’re on the brakes the whole time, but you always have brakes on the car. You don’t drive the car off the lot without brakes on it.

You say, “I’m not going to save money on my car by telling the guy, don’t put brakes on this one. I don’t think I’ll need them.” You pay the money up front for breaks on the car.

The other thing I talk about all the time is the best institutional convexity in the world is government guaranteed deposits. JP Morgan pays a price for deposits. They don’t complain about it every year. They don’t say, “Oh shit, these things cost money. Let’s get rid of them.” It’s the only reason they exist. They have this massive, massive book of long convexity, of non-recourse leverage, and they go out and lend the money to somebody else, keep the spread for themselves, and if they don’t get paid back, the government pays the depositor.

It’s a guaranteed win. That’s my concept of brakes. You want brakes all the time. Yes, those come with a cost. They should come with a cost. You’ll find out that by having them, using them wisely, driving faster, you’ll never see the cost. 

Unless you strip down and say, “What did the car contribute in terms of speed? These brakes didn’t contribute anything. Get rid of them.” 

Nothing will get me out of a meeting faster than somebody saying, “Oh, but what’s this line?” As Nassim said (I believe in an argument with gentleman from AQR), he said, “We managed to find clients that can add two numbers together.” 

[00:59:26] Cem

Yeah, we just talked about the universal AQR spat actually on a podcast with Niels, just a week ago or not even. 

I’d love to, just last thing here, is to pull on the final piece of this thread, which is, okay, we agree broadly. We’re long vol managers. We agree on the major concept, our implementation and how we might do it, obviously, might be different based on some views. Now, let’s have rubber meet the road here. I think listeners will find this interesting. Given how you approach it, what are you seeing as cheap now?

I’ll give my thoughts and I think that’ll maybe be interesting to the listener, how they might approach that at this point.

[01:00:16] Dave

As we say, we’re agnostic. We don’t have views. I really don’t care what the underlying is. It can be potatoes for all I care, but the underlying, in fact, does matter, because underlying, to a great extent, drives the appetite for the supply of volatility.

We tend to find the cheapest volatility, the greatest volatility supply around underlyings, where there’s a whale who’s actively suppressing volatility and, generally, in the act of that suppression, providing liquidity to the system. The obvious one right now is Japan.

Nowhere else is there a guy who’s providing unlimited hundreds of billions of dollars a month, in 10 year liquidity at 25 basis points in this world. That means that throughout Japan and the structured product overlay there, which is a larger derivative canopy than any other shade tree in the history of the world, is probably the best place to go look. 

Conveniently, right next door to it, just across the water is the guy who was the single largest, almost the singular creator of credit for the last 12 years in the entire globe. Who also, conveniently, has a central bank who is actively suppressing volatility in the form of their currency, which then also leads to suppressed volatility in interest rates; who is incentivizing, right now, large state related institutions to buy bonds. They’re, in effect, doing quasi-informal QE, again, in China. 

Those two countries, right now, relative to the rest of the world are not fighting inflation. It doesn’t mean, particularly in the case of Japan, they don’t have inflation, but they’re not fighting it, and they’re actively providing vol suppressing liquidity in both of those markets.

That creates some interesting opportunities for us. I still wouldn’t totally disregard what’s going on in Europe. I know that sounds maybe bizarre given how much some things have moved in Europe, but the ongoing (in essence) provision of QE, the ECB is not shrinking their balance sheet. The ECB is still technically, through TPI, providing QE to anybody who actually needs it.

The ECB has hardly lifted their policy rate above zero as inflation is skyrocketing and bonds, for whatever reason, naturally or artificially, are still at extraordinarily low yields in the backend as LDI managers (in countries that Niels is very familiar with) continue to hold massively levered positions.

Rightly so, if you want to pick a place that should have a recession, it’s probably Europe. The impact of 50% annual PPI increases on industrial nations is probably a good path to recession. Maybe bond yields should stay really, really low. The fact that they are, and you have this massive inversion of yield curves and vol services, means if you have the willingness and appetite to go further, further, further, further out vol surfaces, there are interesting opportunities both in rates and FX space. 

FX again, generally, is another thing that is interesting in all of those markets, and credit. I did a call with some people, not too long ago, who were saying, “Is there anything left to buy?” I said, “Get on a call and I’ll explain it to you.”

They’re like, “Oh, Dave’s going to talk about Vanna and Vulga and stuff.” They said, “Okay, make it simple. Where can you still find stuff?” I said, “I’ll make it simple. Japan, China, and Europe.” They were like, “Whoa, that is simple and that can’t be true.” 

Yeah, it can, and it comes down to the same thing, Cem. It comes down to central bank largesse in liquidity provision and vol suppression. Then you have different dynamics where you have, in some of those places, Japan in particular, you have ongoing flow of structure product activity. 

In Europe, you have the complexity of managing a massive stock of existing structured product stuff. Not necessarily new supply, but the management of Vanna and Vulga as banks go through the complexity, and go from desperate to buy here, and desperate to sell there. Whatever behavior you want to describe to the Swiss National Bank, and the Bank of England, and various other guys. The one thing that we’re not seeing, to be blunt, is equity vol.

We still do not see people coming to us saying, “Hey, would you look at this? Would you look at that?” Now, maybe a little infrequently, but obviously the last real sort of supply that we saw out here, relevant in the equity vol space, was June, 2021 when there was a big surge of accumulator products on names like Alibaba, Tencent, and Ping An.

That vol became cheap, and skew (in particular) got cheap for a brief window. Then not surprisingly, those are all the ones that had the biggest blow ups and went down the most. Now some of those (one of my guys told me yesterday), that from the bottom in October, Ping An is up 70% (or something) off the bottom. Now that still means it’s down 60% on the year, but it’s up 70% from the bottom. Maybe vol supply will come back and we’ll start looking at that stuff again. 

[01:06:314] Cem:

So, again, our approaches are orthogonal, and I’ll just weigh in very briefly. I couldn’t agree more on the JGB, that it is that vol is incredibly cheap. That said, it’s been cheap for a while and I wouldn’t have agreed with you, a year ago, or two years ago. 

I think the distribution of potential, again, to my analogy before, has changed. It is cheap, which is incredibly important to that comparison of what’s cheap, what’s expensive, just in absolute terms. The distribution of outcomes because of the Fed, and inflation, and their need to step away and no longer… 

Japan’s sponsor is, ultimately, the US. Japan is a big enough sponsor, but when things become hairy, ultimately the Fed can backstop (in theory), Japan. The Fed’s ability to do that hasn’t diminished, which is what makes that peg and that kind of control at risk, and what changes and elevates the potential tail, in my opinion, in the distribution in Japan.

Those two things working together make for an incredibly powerful investment thesis in JGBs. That’s how I think about it. I’m looking at that distribution a bit more and what’s possible, and I know that’s dangerous, that’s not necessarily what you do, but to give it a little bit of lip service on our end as well.

[01:0744] Dave

In a sense, we look at some conditionality around distributions and stuff, so we do some work on conditionality on stuff. 

[01:08:00] Cem

Major forces that you can broadly understand. 

[01:08:01] Dave

More around ‘what ifs.’ So, we do a lot of work (and this, obviously, was a big deal in what has gone on in Europe and likely to go on). If we can isolate parameters at really attractive levels. – if we can isolate skew or if we can isolate vol of vol type parameters. When you get the vol supply, like we saw in Euro or in Japan prior to March of this year, going back to forever, if you could isolate vol of vol at zero, it was a good buy. Timing doesn’t really matter.

You can run conditional what if scenarios and it always works. It’s massively asymmetric. If you can construct wing stuff where the cost is so de minimis, you can own that stuff. We have yen stuff on the books that has been there for over a decade that looks really good right now.

We also have yen stuff on the book that’s been there five years, yen stuff that’s been there four years, three years, two years, one year, six months. We’ve been carrying it and recovering cost, and carrying it and recovering cost. I did a podcast with Grant way back in his Real Vision Days, in 2015. We did one just before China devalued, which I had mentioned, not because I thought China was going to devalue, but because vol was really cheap. I said, “That’s likely to be interesting, but it’s not a big deal. What’s really going to be interesting is when yen rates drop below zero.” Then in January, 2016, and again, nobody talks about it because people around the world don’t see it.

By far, the biggest event, in what was that little mini emerging market crisis from the China deval, in August 15 through January 16, was the negative interest rate announcement by the Bank of Japan. It was the single biggest vol move by miles, and it just happened to be the cheapest vol.

By far the cheapest vol of anything in the world, after the China deval, was Japanese interest rates. I say all the time, our job is simply to go out and find where the biggest clumps of dry trees and dry brush are, because we’re hedging against correlation. I’m not trying to guess when the lightning strikes are coming, or where the fire’s starting. I’m just cognizant of the fact that whether it’s lightning or kids playing with matches, that only starts one tree on fire. Every other tree catches on fire because of the tree next to it. So my job is to find the parts of the forest where the biggest fire risk is, and that’s a purely endogenous risk.

I can find that in what we do by understanding this supply and demand imbalances and the lack of capital in the Sharpe World food chain that’s playing in these worlds. It’s funny, I say this all the time, it’s funny how often the biggest clump of dry brush finds a spark. It’s uncanny. 

One of the best stories (and I’m sure you’re aware of this, Cem), in January this year, (if you talk to me and, of course, I’m never going to really say specifically what we’re doing at the current moment in time), in January of this year, if you’d asked me, “What’s the cheapest vol in the world?” I would’ve said Euro/FX vol, Euro/dollar, Euro/Swiss, Euro/CNH, in particular.

Now that found a spark when Putin stepped into Ukraine and it stopped being the cheapest FX vol in the world really fast, and hasn’t been that cheap since. Then funnily enough, shortly thereafter, the cheapest fall was dollar/CNH.

Then no sooner than you had gotten that out of your mouth then it devalued more than it devalued back on August 15th when it was an explicit deval. It’s funny, if you just keep owning what’s cheap, you get opportunities to recover cost. Stuff comes along, noise comes along, you build the book with good (we talk about) layering of convexity, good layers of convexity, so it’s efficient to monetize some of the things that are lower convex outcomes and use that to own more through time. This building, and building, and building through time of the more convex, more insurance-like payout things that you’re really trying to hold for when it matters. Again, it’s that two percentile tail, that’s where the big payout comes and where the big pain is for the guys we’re working with.

[01:12:57] Niels

I’m glad we had a chance to voice our differences on this topic in such a polite manner. It sounds like, speaking of cheap, that maybe at some point in the near future central bank credibility will be incredibly cheap. I don’t know how to buy it (I have to say). I will want to try something a little bit different as the last question to both of you actually, since we are recording just before the end of 2022.

It goes against everything we’ve said, all of us, about not predicting. I’m inspired by I think it’s Saxo Bank that does these outrageous predictions for the coming year. Do any of you have an outrageous prediction that you think could happen? Doesn’t have to happen, but it could happen. 

I know one of them, one of their ones was the dollar being pegged at 200 against the yen. Any outrageous predictions, Dave? I’ll let you go first. 

[01:14:02] Dave

I don’t know if it’s outrageous because I’ve written about it, but are they going to close the gate? Who’s going to own the 40? I think what’s coming (and again, it goes back to what happened in the late twenties), I think capital controls are coming. I think the enforced recycling of domestic savings into sovereign bond markets is almost an inevitability. You can’t possibly let your nation’s savings go and fund somebody else’s debt.

Obviously we’re seeing the rationing of critical energy and food resources, the friend shoring of stuff – we’re only going to let oil go to our friends, or food – we’re holding onto our food. I think, inevitably, you’re going to see the same thing with capital, places that you thought would never have capital controls (Japan, UK, Europe, obviously China) will continue to tighten theirs.

I think that becomes much more of a norm. Again, I remember there’s a quote in Eddie Chancellor’s new book, he attributes to Keynes, saying in 1933 about nationalism, and most of all our capital and savings must be trapped. I think that’s probably what people aren’t thinking about that I think very likely could come, is increasing forms of capital controls and forced recycling of domestic savings, forced pension funds, holdings of sovereign bonds, forced banks, even greater pressure on banks through the basel risk weighted asset methodologies to halt domestic sovereign bonds. That kind of stuff.

[01:15:50] Niels

Yeah, I think that’s a pretty pretty interesting suggestion. Cem, do you have anything? 

[01:15:56] Cem

Yeah, I have a couple. At the risk of sounding bombastic, I could see (maybe not one year), maybe on a two year time horizon, the 10 year going above 8% – a really high number. I think yields will flatline or go lower before, but similar to the late 1960s, I think the Fed is stuck. I think the more we head into recession, and the 10 year stays sticky, and long-term inflation expectations start to rise, this could start to accelerate, ironically, into what is now likely the beginning of a recession.

It’s counterintuitive, but I think, steepening our trades could be big home runs this year. In a way people are entirely not expecting. Then two, a kin to what Dave was talking about, price controls. Price controls are hidden fiscal stimulus.

It ultimately exacerbates longer term inflation. I think history tells us that politically when you’re between a rock and a hard place, politicians will have to do things that are unthinkable. Nixon did it. Nixon was the most laissez faire Republican, coming in, you could imagine. Ultimately he did end up doing some of the most populist, non-free market policies because he didn’t have much of a choice. Inflation puts politicians in a really, really tough spot. So, those are my two. 

[01:17:42] Niels

Well, I think that’s… 

[01:17:44] Dave

I agree. I agree strongly with that. I don’t think they’re solving the inflation problem. I don’t think they have the monetary policy will to solve it. I don’t think they have what it takes. I’ll argue what it takes is everything that they did in QE was negative value and must be unwound to fix this problem. I don’t see any of them doing a hundred percent QT anytime soon. In which case you get a whole bunch of price controls, in which case inflation doesn’t get solved. It gets worse.

[01:18:24] Cem

Yeah, I’ll one-up that. I one hundred percent agree with you, but counterintuitively, what they’re doing (we saw this in the sixties, seventies, and this is not what most people would say) is exacerbating structural inflation.

Yes, cyclically, you’re helping issues in the short-term, but you’re ultimately making things worse.

[01:18:42] Niels

For two people who don’t make any predictions usually. I think we’ve done a pretty good job in scaring our audience as we head into 2023. Dave, this has been another unbelievable, insightful, and fun conversation.

Thank you so much for doing this today. We have thoroughly enjoyed it, as I’m sure all of our listeners will. Before we go, let me just encourage everyone to go and follow, subscribe to the amazing content that they produce. I will, of course, put a link in the show notes because as you can tell from today’s conversation, we are living in a truly global, macro driven world, and it is perhaps more important than ever before to stay well informed. 

From Cem and me, thanks ever so much for listening. We look forward to being back with you as we continue our global macro series. In the meantime, take care of yourself, and take care of each other. 

[01:19:32] Ending

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