The Hidden Risks Beneath the Treasury Market ft. Mark Rzepczynski

[00:00:01] Intro

Welcome to Top Traders Unplugged. In markets success doesn’t come from predicting what happens next, it comes from being prepared for what you can’t predict.

In each episode we go deep with some of the world’s most thoughtful minds in investing, economics, and beyond to understand how they think, how they prepare, and how they decide, and the experiences that shaped how they see the world. No noise, no short-cuts, just real conversations to help you think better and invest with confidence.

[00:00:35] Niels

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

Mark, it is really great to be back with you this week. How are you doing? How are you doing? And how was summer for you?

[00:00:55] Mark

Summer has gone by really quickly, I don’t know where it’s gone. So, we’re already here in mid-August and before you know it we’re going to be in the fall foliage season. So, it escaped me. Summer escaped me.

[00:01:12] Niels

Summer escaped you? Yeah, it has been a busy one for sure. We’ve got lots of great topics thanks to you, so I’m very excited to dig into those. We’ve got a few other things lined up as well. But I’m also very curious, as always, just to get a feel for what’s been sort of coming across your desk on your radar that you might have found interesting in the last few weeks.

[00:01:42] Mark

Well, I’ll go back to a summer analogy. Oftentimes, especially if you’re in the Midwest, you’ll have thunderstorms roll in. So, before the rain, before the winds start coming, you might hear some rumblings in the background. There’ll be thunder, off in the distance and then, and you know the storm is coming, but it’s not there yet.

And I probably would sort of say since the last time we talked, I’m seeing a lot of rumblings that are starting to bother me, and we’ll sort of say let’s look at the rumblings of situation awareness. Now, it’s not really related to trend following or futures trading, but someone loses 67% in a single month. Well, we find out once again that leverage hurts or leverage kills.

We had the Korean stock market bubble at the end of the other month, which was just a horrific decline in Korean stocks. But this is after a huge move up. This was clearly a bubble.

We’ve had stock issuance that people are now sort of moving to increase stock issuance. And we’re seeing some of those new issues sort of have big reversals and usually it’s a sign of an overvalued market when there’s more stock issuance.

And finally, we had the yen intervention, both from the Ministry of Finance in Japan, but then the Fed actually joined in which you’re seeing that intervention tells you that someone doesn’t like the way the direction of the markets, and they’re trying to stop that from happening. Intervention usually doesn’t work in the foreign exchange markets, but that hasn’t stopped governments to say, like, we’ve got to arrest what is going on in the yen market and the currency markets. And all of these are rumblings that suggest that things, they may not be as nice or as good as what we think they may be.

[00:03:54] Niels

I completely agree. And actually, there’s been one more rumbling, which we’ll talk about in a second and that’s in the treasury markets in the last 48 hours or so. So, there’ll definitely be some interesting conversations on that.

But I tend to agree with you that sometimes we need to, even though we don’t try to predict the future, on a personal level, you kind of take a note of some of these things. Regarding the Situational Awareness Fund, I also thought the headline about the loss happening at Jane Street. Now I don’t know much about the firm other than it’s highly profitable and highly successful, as far as I can tell, but the headline suggests that it lost US$15 billion alone in the Situational Awareness Fund.

And again, with very limited information about these things, I would just say that my first reaction was, that’s kind of a concentrated bet to be losing that much money. And to put it in context, I think the article I read said, but it still made US$40 billion, or it made US$40 billion and then lost US$15, so not a big deal, but US$15 out of US$40 is a big deal if it’s happening on one bet.

And I wonder (and this is purely speculation on my part), I wonder if, in fact, in some of these firms that are somewhat secretive but have certainly attracted a lot of attention, not least from investors, is there more concentration going on in what we see? Because we hear about it being kind of multi strat and pod shops with hundreds of teams and pods. But still, you could still end up with a concentrated bet even though, so far, they’ve seemed to have very good risk management.

So, that was just one thing I took away from that situation, so to speak. But then the other thing, yesterday Moderna went up 177% in a day. I mean it’s not a small stock and, although I’m sure many people made lots of money from it because it went up, you still wonder a little bit, well, what about those who shorted the stock? I mean, if they were in some kind of long/short equity strategy or just… I mean, frankly, if you were a trend follower trading individual stocks, potentially it could have been in a downtrend and suddenly it goes up by 177%. What does that tell you, from a risk management perspective? Is it actually more dangerous than we might think trading individual equities?

And I think, now more recently, we’ve had single stock equities come out as futures. So, there might be even more people from our industry attracted to that area. But nevertheless, it’s rare we see, for example, normal futures markets a move by 177% in a day. Any thoughts here?

[00:07:06] Mark

There’s no question that the individual stock volatility can be much greater than what you sort of see in most futures markets. Now, when we look at the index level, the futures markets can be much more volatile. And I think a perfect example would be some of the grains markets that have had a big move this week. You see other markets that have seen 20% moves, 30% moves across a month. It’s not that unusual.

But that individual stock movement has been significant for a number of stocks. If you look at the AI area such as Micron Technologies, which has gone from, in April, it was like inside US$400 and then it went up to US$1200. We’re seeing some huge moves in the stock markets. And, going off with our thunderstorm analogy, these are all rumblings that tell us something’s going on. It could be excessive speculation, which is good for the person who is the buyer. But you say, what happens when the markets start to normalize? You’re going to get a reversal in some of these big moves and that’s going to start to harm people.

And the market maker you just discussed is just a perfect example. You had Situational Awareness, but then a market maker is losing US$15 billion in a month. Now, what we find is that the market makers, that we have, that have been very profitable, are very different than the market makers of old because they might be taking speculative positions, they’re taking hundreds of different positions, because they’re looking at the correlation across a large number of stocks, they’re making significant hedging type bets. And if the market starts to arrest, and the correlations that we thought existed in the past don’t exist currently, that could lead to a lot of profit losses.

[00:09:15] Niels

Yeah, absolutely all important things. The other thing I noticed this morning, I think it was, was just a little story where it says Copper Squeeze Draws Biggest Weekly Flow To LME Sheds Since 2020. And as far as I could tell, I didn’t have much time to look into it, but as far as I could tell, it’s not actually the copper price itself. It’s this kind of the spread from spot to three months out or something like that. Or maybe it’s… yeah, again, just bear with me a little bit on this. But anyway, that spread seems to have gone completely crazy in recent days and weeks, although it came back dramatically in the last 24 hours or so, but still at very elevated levels. Is that a story that you noticed or followed?

[00:10:08] Mark

Well, I’m glad you brought that up because one of the issues for when there becomes large moves in commodity markets is when you will sort of say, the inventory levels become very low. When inventory goes very low, then there’s a decrease in what we call the buffer stock.

The buffer stock is there to sort of stop from extreme moves because you could always take something out of a warehouse and make payment, but especially for commodities and there’s a production process. Well, what happens if, let’s say that there’s no available stock in inventory and you need to keep your production line going, then at some point you’re going to pay almost any price for that commodity to keep production moving. That applies to…

And we could talk about the oil market. We’ve had some extreme moves in the oil market because of the Iran, war. But we’re really going to have a problem if, let’s say, the buffer stock or inventory levels get so low so that people will start to pay any price for that. We saw that in the cocoa market a couple of years ago. There’s just not enough inventory.

If you don’t have enough metals in warehouses around the world, well, what happens then is, if you need copper and there’s no copper in a warehouse that you could pull from, where are you going to get it? And so, this is when we truly get extreme moves. This is when we get extreme backwardation, when there’s a reduction in inventory in buffer stock.

And so, when people say, I just need to look at the price trend. Well, let me put this way, looking at inventory levels is critical to understand whether there’s going to be a change from contango to backwardation, or if there’s more whippiness in the front end of a lot of these commodity curves.

[00:12:19] Niels

Yeah, and actually, on that oil you brought up, one of our recent guests, who’s been on a few times and definitely is a listener favorite on the commodities is Adam Rozencwajg. And he really kind of questions the whole thing about the oil situation and what the missing (in his view I think, like a billion barrels of oil) physical oil, what that might lead to. And I think he’s very worried about that it could exactly play out, as you mentioned, into much, much higher oil prices at some stage. But it’s a question of when is that ‘some stage’? So, we may see more examples of this, yeah, sooner rather than later.

[00:13:08] Mark

I think the oil market is a perfect example because when you think in terms of the geopolitics, okay, we can look at, we’ll say, there’s the immediate geopolitics. You read news about the Middle East, or you read news about what’s going on in Ukraine. But the more interesting stories are floating around underneath that. And when you look at this inventory buffer stock, the demand for oil by China was significantly reduced.

So, basically, they started to pull from their inventory reserves to stop the oil prices from going, we’ll call it exponential. And in an attempt to do that they say, well, we can be able to stabilize the oil prices because if let’s say that we have a huge spike in oil prices, that’s going to have an impact on economic growth around the world and that’s going to stop our trade surplus engine. So, they said we’re going to cut back and use our buffer stock, we’re going to use our inventory to sort of smooth out a little bit of the oil price shock.

Now, at some point as you draw down your inventories, and this is also in the US if we have our oil reserves, then you don’t have any more buffer stock. Then what? Then you have the real big blow-off price in oil or in the underlying refined products, and that’s what we should be really worried about.

[00:14:50] Niels

Yeah, absolutely. Okay, good stuff. Let’s move on to a quick trend following update. We are now just about 10 days away from month-end and so far August has been okay. It looked a little bit better a couple of days ago. We’ve had a couple of days of, I would say, corrections in the trend space but yeah, still positive for the month for the most part, I would imagine.

My own trend barometer has cooled off a little bit in recent days. We’re down to kind of a neutral level of 43. Again, that just means that in terms of the breadth at the moment in the portfolio that it tracks, you know there’s about what to expect in terms of number of markets that are trending. Not too few, not too many so to speak. I’d love to hear your thoughts, maybe, if there’s anything that has stood out to you from the trend space over the summer since we last spoke. But other than that, I’ll just update on the performance where we stand.

[00:16:01] Mark

Well, Niels, you know that I’m a VUCA guy, so, I always have got to put it every day in terms of a context. And the thing that’s interesting that we have is that we started out talking about rumblings, but we looked at volatility, in terms of the VIX index or V VIX index, is relatively low. So, for all of the things we’re talking about are all these rumblings, volatility has been relatively low. Uncertainty has come off its high, from the Ukraine war.

I think that when you focus in on complexity and ambiguity as the next parts of VUCA, there are some complexities going on that is going to lead to trends. Let’s look at the yen carry trade which being unwind, the intervention is supposed to stabilize the market but what it tells us is that there’s a macro imbalance in the currency markets currently that has not been fully played out.

Similarly, we’re seeing a lot of fear concerning the bond markets. Again, since we don’t really know where Fed policy is going, given that we know that there’s some treasury finance moves that are going on. There’s a lot of ambiguity. And ambiguity means that people are going to be cautious that they’re going to have to adjust their expectations and that’s going to lead to trends. So, I think that there’s a lot of opportunity for trends going forward in the fall, given the fact that we started out with these, call it, thunder warnings.

[00:17:44] Niels

That’s fair, that’s fair. That may definitely be the case. We’ll certainly see as we go through the autumn of this year.

But on that, from my vantage point, I think generally speaking, the last week or so has been fairly quiet. As I mentioned, a few good days and then the last couple of days it’s been correcting somewhat, especially from some of the action we’ve seen in the fixed income area. We’ll get to that in a second.

Anyways, as of Tuesday this week, which is the 18th, we have the BTOP 50 up 1.78% for the month of August, up 9.87% for the year. SocGen CTA index up 1.47% for the month, up 9.7% for the year. The Trend index up 1.69% for the month, up 9.73% for the year. And the Short-Term Traders Index having a good month, up 1.37% for the month of August, up 4.6% for the year.

If we look at the traditional world, also doing well. MSCI World up 2.63% as of last night, so the 19th, and up 12.3% so far this year. If we strip out US and Canada (so we look at the MSCI EAFE (I think it’s pronounced) up 1.45% for the month and up 11.39% for the year. US Aggregate Bonds up strong 72 basis points, given the intervention we’re seeing or whatever we call it in the treasury market, and up 0.39% only for the year. And then the Total Return, S&P 500 Total Return, up 2.97% as of last night, up 12.65% so far this year.

But as I alluded to, Mark, there is one other rumbling that we are seeing taking shape at the moment and it is happening in, I don’t know if this is the biggest market of all, but it’s probably one of the biggest markets and that’s the US bond market. It’s not that I’ve spent too much time reading up on the details of what’s been announced, but clearly we are now seeing some form of, well, maybe intervention is not quite the right word, but it’s certainly some action from the authorities in the US in terms of what they would like to see happening, especially to the long end of the US treasury curve. So, I know you can explain this much better than I can. So why don’t I just hand it over to you and we’ll see where we go with this.

[00:20:37] Mark

Well, I think let’s start with the US Treasury head. He has said that he’s the number one salesman for US bonds around the world. So, his job is to make sure that there are buyers for US treasuries, because what we’re seeing now is that, on a weekly basis, and so especially during refunding, we could be auctioning off close to US$800 billion in a given week, which is an astounding number. Now some of that is refinancing. So that’s rolling over of existing bonds, but that’s a huge number that has to be auctioned.

So, you say, I have to ensure that the borrowers are going to be able to find their money and there are going to be lenders who are willing to commit to ensure that these auctions go well. And one of the big problems that comes in is that the market for treasuries has actually, I don’t want to say gotten too big, but there’s a tremendous number of outstanding issues in the bond market.

And what that means is that we’ll issue 30-year bonds on a quarterly basis, on a 10-year basis, and then as interest rates move, then the next auction will have a new coupon, it’ll be a new bond, and we call that the on-the -run bond issue. And then the old bond will become off-the-run. And so, what happens is that we have a lot of these different, we’ll call it, orphan bonds that are away from the benchmark on-the-run issue.

So, if you issue a 30-year bond, you might have a number of bonds with different coupons that have a 26-year maturity, a 27-year maturity, a 22-year maturity. Now, what we find is that there starts to become a difference in yield between that 30-year bond and the 28-year bond. Now two years difference in maturity or duration is not that much. But what happens is that if you’re holding that old bond, you’re going to get a different price than if you’re trading the on-the-run.

And so, everybody wants to get rid of those off-the-runs and get it in an on-the-run. So, there’s less liquidity that’s associated with the off-the-run bond market. Okay, so what the treasury announced is a buyback program. And the buyback program, this has been done in the past. So, we’ll go back to the first buyback program was in 2000, 2002, and at that particular time, if you could believe it, the US Government was running a surplus in the government account. So, there was a talk and there was research that was done and say, well, what happens if we run out of long-term bonds because we just don’t have enough of them?

[00:24:00] Niels

Yeah, I remember that.

[00:24:02] Mark

Now, let me put this way. It seems like that’s ancient history. It’s like 25 years ago. But in an attempt to do that, they said, let’s start a buyback program to try to ensure that we have liquidity for any more of this on-the-run issue or to increase liquidity for off-the-run. Programs were stopped, when rates were fairly stable. Then they started up again, but now they’ve been increased from about US$2 billion to about US $4 billion a month.

Now, in the process of doing this is that the rumblings which we talked about, the Treasury Secretary is basically signaling to the market that we have a liquidity problem with off-the-run issues so that we want to use some of our financing ability to be able to buy back these off-the-run issues and then reissue the on-the-run. So, there isn’t going to be a change in the amount of debt, it’s just going to be a change in the composition of the debt. So, in that sense it’s going to add liquidity, it’s going to provide stabilization. It’s probably a good thing.

But what it really tells us is that there isn’t enough market making power to be able to ensure that these off-the-run bonds have enough liquidity. And that’s where the real problem is. That leads us to a bigger issue about the treasury market in general and we’ll call it the ‘plumbing problem’.

But I’ll stop there for a second.

[00:25:55] Niels

Yeah, just before we go to that.

Now, if I understand you correctly, and as I said, I’ve not had time to look into all the articles, and all the news flow, and so on, and so forth. If I understand you correctly, it’s not about buying back long-end bonds per se, it’s about buying back some and then issuing some others, Right?

[00:26:24] Mark

Yes.

[00:26:26] Niels

But, the timing of it, kind of the day after the treasury long bond hits 5.34%, which is like the highest we’ve seen in God knows how long, seems a little bit suspicious in the sense that you could, I think rightfully, get the wrong impression, maybe that, oh, this seems like a yield curve control kind of thing. We don’t really like long bonds to be yielding too much. And I think we hit the pain point of the Treasury. I mean, is there anything in that?

[00:27:10] Mark

Well, let me put this way, nothing is as what it seems to be when you deal with governments. If the government tells you not to worry, that’s the time to start to worry. So, we’ll use that as a basic premise. Now I don’t want to say that I’m a conspiracy theorist, but generally you sort of say there should be some concern. Is there something else going on?

Now the important part to say that this is from the treasury, this is not from the Fed. So, the Fed has done operation, there have been operations where they say like, well, I’m going to not buy as many when they were doing QE, I’m going to switch from bonds to bills. What I purchase is going to change in an attempt to try to sort of stabilize the yield curve based on my behavior for my balance sheet. So, that’s really not what’s going on here.

It’s not like the treasury is also saying I’m going to try to change my average maturity of the debt. So, we’ll sort of say during the Yellen period there was a tremendous amount of focus on issuing more treasury bills as opposed to bonds. So, even though he had very low interest rates, when Yellen was Treasury Secretary she said, let’s try to issue more bills because there was more demand for short-term instruments. But they sort of say we don’t want to sort of push long-term interest rates up. So, we’re going to change the financing needs. So, it brought down the average maturity of the overall treasury holdings.

So, we’ll say, there’s different actions to take. That’s not what this buyback program is. But you could sort of say that, okay, if I’m going to buy back 27-year bonds or if I’m going to buy 14-year bonds, to reduce that supply, well, then their question comes in, I’m swapping these out for some other bonds, what am I going to swap out for?

Is it going to be just for the 30-year or am I going to now issue bills as an alternative to take off all of the pressure on the long end? So, this is the start of something. The size that they’re talking about is this sort of a drop in the bucket. But all of a sudden you sort of say that if off-the-run treasuries start to get prices that are out of line with what we think the curve should look like, well then the treasury could step in and be able to buy those cheap bonds that they think is cheap in an effort as part of this buyback program. So, they’re actually acting as bond market stabilizers, albeit it’s a very small program.

[00:30:26] Niels

Yeah, I mean, from time to time we hear the description of the bond vigilante, so to speak. Not that they’ve been super active, as far as I can tell, in recent times, even though you might think that at some point soon it’ll be warranted given the debt levels, and so on, and so forth. But nowadays, I mean, a lot of things have changed.

I mean I started out as a bond trader, about 40 years ago, and a lot of things have actually changed since then. In your mind, who… So, there’s a big difference between who controls the short end and who controls the long end. Who do you think ultimately has control of the long end of the bond market?

And actually, this is also where obviously we, as trend followers, we don’t mind if we have a long-term trend in the short end where we can see the path of interest rates going higher or lower for a while, consistently, that could be a great trade for a trend follow. But of course, once you get out in the long end there could be some real massive moves from a price perspective if interest rates really do change. But who do you think, nowadays, controls this – Fed, treasury, bond markets?

[00:31:56] Mark

Well, I sort of say that there’s been a lot of research on what we’ll call treasury plumbing. How does the treasury market operate? And it’s always been somewhat opaque. And there’s always been the view that well, whatever it’s doing, it seems to be working fine and that we’ve got a good process in that everyone will argue that treasuries are the safest asset in the world. And the reason why they’re safe is because they have a tremendous amount of liquidity. Don’t worry about it.

And in reality, we’ll sort of say that the Fed is concerned about it, the Treasury is concerned about it, and the market should be concerned about it, and every trader or investor should also be concerned about it. And let’s start with some of the mechanics and then we can talk about who are the players, who are the, say, vigilantes, but are driving the bus?

So, there is no exchange for treasuries. Then we do have the futures exchange for futures, but the rest of the cash market is over-the-counter, is driven by a set of primary government security dealers. These are dealers that have responsibility to and are managed by the Fed. In fact, probably one of my research [projects], that I was working on back in the ‘80s, was how does the Fed survey or, how is their surveillance of the risk of the primary government securities done, and how do they choose who is a primary government security dealer?

So, these are designated individuals. They’re there to sort of make markets. They’re also serving as a conduit for treasury auctions. And the system is working pretty well, albeit is somewhat opaque.

But as the market has gotten larger and larger, the amount of capital that’s available from primary dealers, relative to the size of treasury and the size of treasury volume, is out of proportion to what we might think. And part of this is that because of regulations from the Fed, such as the supplemental liquidity ratios, there may not be enough capital, at primary government security dealers, for them to do their job to make markets.

Okay, now this starts to get back to this treasury buyback program. If they can’t make markets because they can’t serve as a financial intermediary (so there’s someone who wants to sell treasuries but there may not be a buyer to match that sale), then you say the dealer will make a market, they’ll quote a bid/ask spread, they’ll then take it onto their balance sheet and then they’ll try to find another buyer for that bond.

So, what happens if let’s say there’s a less liquid treasuries? Well, then you’re going to either have to increase your bid/ask spread because it’s going to be harder to find that buyer, and you’re going to have to hold that on your balance sheet longer, which means you’re going to have to finance that and you may not have the capital to do that.

Now if that’s the case, they say like, well, we want to sort of like improve the liquidity for the off-the-run, so that we could help dealers because they don’t have enough capital to do their job as market makers in the treasury market.

[00:35:54] Niels

And I ask out of ignorance here, but since you’re in the US, you may know. The basis trade that we hear talked about in the news flow, is that part of the problem/solution? Meaning for example… Well, I don’t know. I mean, if banks can’t provide the balance sheet and the regulars don’t want hedge funds providing it, where are we left?

[00:36:27] Mark

Well, you’ve now sort of touched on who are the vigilantes or who are the marginal buyers and sellers in the treasury market? So, we’ll sort of say in the old days we had the primary government security dealers and then you had mutual funds; we’ll say, unlevered buyers of the treasury market. So, Fidelity or a large mutual fund would say I want to buy treasuries. They would call up the dealer. The dealer would make market. And so, those bond funds were not levered funds.

Okay, now we probably sort of say that you look at the amount of holdings or treasuries right now in the US, hedge funds are holding and are some of the biggest holders. They may be larger than mutual funds in terms of their holdings in treasuries. We’re looking at 9% plus of the total marketable treasury bonds.

So, what you find out is now the vigilantes are the hedge funds, but they’re a different type of vigilante because instead of being, we’ll call it, real money accounts, they’re levered accounts. And we’ll sort of say that they’ve done some studies (this is coming from the Fed) of what is the breakdown of the type of trades that are being done by hedge funds these days? And the number one trade is the basis trade.

So, the basis trade between the futures and cash, and you’re looking at the differential between what we’ll call the cheapest to deliver and the futures market. So, the futures market, we will probably say, is the single largest source of liquidity, but that’s going to be benchmarked against what is called the cheapest to deliver.

And so, to keep the price of the treasury futures in line with the cash, there are people who engage in the basis trade between cash and futures. So, if you trade in the futures market, you’re probably trading against someone who’s doing a basis trade because they’re looking at the differential between the futures price and the cash price. So, how what you do in the futures gets distributed in the cash market is through the hedge funds who are basis trading.

If, let’s say, that there are more treasury bonds outstanding for different prices, well then there’s a likelihood, and not often, there are going to be switches in the cheapest to deliver. So, then that means that there’s more opportunities for basis trading profits, but also for risk. So now, if you’re a hedge fund and you’re trading in the basis or you’re trading in treasury market, you’d say like, well, okay, these hedge funds are fairly large. Well, the actual amount of cash that they have on their balance sheet, we’ll say that capital, is relatively small. So, they’re leveraging up through the repo market. So, they’re financing all of these trades, these basis trades.

So, you’ve got a tremendous amount of financing going on, a tremendous amount of leverage because with the basis trade, you’re looking at just a few tick market that you’re trying to make because the market is fairly liquid. So that means the only way you’re going to make any money at the basis trade is that you’ve got to use a tremendous amount of leverage on what you think is a fairly low risk, low return trade that you lever up like crazy.

So, now you then say is, holy smoke, if all of these hedge funds who are sort of the marginal buyer of treasuries on the long end (there’s the providers of liquidity through basis trading), they’re the ones who are sort of driving the market more so than real money accounts. Well, and they’re all highly levered and they’re all sort of financing in the repo market. Well, then you got to sort of say, whatever happens to the repo market is going to spill over to the bond market in ways that we’re not really sure of.

[00:41:21] Niels

Yeah.

When you talk about it like that, it certainly reminds me about the Swiss franc/euro trade that lots of people loved and felt certain about until the day where the Swiss franc was let free, so to speak.

[00:41:39] Mark

Yeah, and this whole issue of repo financing has a tremendous impact because we’ve had, again, this research that I was doing in the ‘80s, we had not primary, but we had sort of secondary dealers in treasuries, that were highly financed, that went under in the ‘80s. And so, this is why we then started to do research on the primary government security dealers because what’s the risk that they might face?

So, you’d sort of say that, well, that has an impact, especially if, let’s say, that the Fed wants to sort of cut its balance sheet, okay, then that’s going to have an impact on repo financing or even if they raise rates in the short end, it’s going to have a tremendous impact on repo financing. And so, well, what might happen in the short end of the market for overnight funds might have tremendous reverberations into the rest of the market.

And then finally, when you look at the over-the-counter market and treasuries, the primary dealers, while they’re one source and they usually have been the drivers of market making, we have like the HFT, the high frequency traders, like at Citadel and other places, that are active in the treasury market. But they’re all electronic trading. They’re not reporting to the Fed. They don’t have specific market making responsibilities.

So, they could be able to be very active. But if they say, yeah, I don’t think this is a really good time to be involved in treasuries, they could just turn off the computer and that’ll have an impact on the rest of the market. And so, the reason why we’re so worried about this is that when you look at March of 2020, there was a shortage of liquidity in the market. So, we expected that the treasuries would act as a safe asset and it didn’t act like the safe asset.

So, this gets to another issue which, probably, we can start in a whole different podcast, is the Treasury, which has always traditionally been the safe asset, still the safe asset? ‘Safety’ is because you’re going to get paid. But ‘safety’ is also the fact that when I want to sell an instrument, I’m going to get the fair price for that instrument.

And if, let’s say, that if the price is going to be discounted when I need liquidity, then I’m going to say, well, that’s not as safe as what I thought. Maybe I should sort of avoid that market.

[00:44:44] Niels

Yeah, and I think you bring up a good point. It’s definitely too long to go into this time, but for a number of years, not often, but from time to time I bring up this issue that, I think, is what’s kind of going on and has been going on for a few years. And it’s probably a cycle, by the way. And that is this thing about trust. And maybe the easiest way for us to see that is the institutions we tend to trust. Well, that changes.

Maybe at the moment, there are certain institutions we don’t trust anymore as much as we used to, and so on, and so forth. And I think, certainly in the financial markets, once you lose the trust of the market, then all hell breaks loose. And although I worry that we could get to that point in some markets, we’re obviously not there right now, but I think that’s something to watch.

Now I want to switch gears because we’ve got a long list of items which we probably won’t get to all of them. So, we have the luxury of picking and choosing. One of the things, just to remind you, was that there are a macro themes. There’s something about commodities, which we’ve touched a little bit on. There’s China as the swing consumer, and so on, and so forth. So, where do you want to go next, in the last sort of 15, 20 minutes that we have together today?

[00:46:26] Mark

I want to talk about two things. One is a piece of research that I found very interesting, which is associated with trend following because oftentimes we talk about trend following on the podcast.

[00:46:37] Niels

As long as it doesn’t involve any trick questions for me, Mark, then we’re fine.

[00:46:43] Mark

Okay, no trick questions. And then I want to talk about someone who died in the last month that, I think that a lot of people may not remember or may never know that person. I’d like to sort of say that as a tribute to him, I’d like to end with talking about a person that was influential in my life, in terms of reading his research. And that’s Victor Niederhoffer.

[00:47:14] Niels

Before we get to that, there’s something else.

[00:47:17] Mark

And one of the more interesting pieces of research is the new version of The Art Of Trend Following paper. It’s been kicking around for a number of years. And I think that it’s always one that, I think, anyone who listens to the podcast should read, albeit there’s a lot of mathematics to this.

[00:47:44] Niels

What’s the name of the paper you’re referring to?

[00:47:46] Mark

It’s The Art and Science of Trend Following. It’s by Artur Sepp. And he’s at LGT. And he sort of said, well, let’s look at classifying different trend followers. And he said that there are three classes classifications, we’ll call it the European, American, and we’ll call it Classic – so, what I call the academic, which would be time series, momentum type. Now, he defines European as those people who look for high signal to noise trades and look at constant adjustments in their positioning. I call these Europeans the pragmatists.

[00:48:40] Niels

Then when you say constant adjustment, it’s kind of dynamic adjustments, right?

[00:48:46] Mark

Yes, dynamic adjustments. There’s a constant adjustment or dynamic adjustment to position sizes. Then there’s the American, which we’ll call it the breakout trend followers with, we’ll call it, digital positioning. Which means you look for a breakout, you take your position, and then you put your full position on, and you hold. You don’t do the, we’ll call it, dynamic adjustments…

[00:49:16] Niels

Yeah, and maybe to clarify here, Mark, sorry to interrupt you, but just maybe to clarify because I think it’s doing a little bit of a disservice to the listener if people get the impression that that’s how American managers do it today. I think there are a few people who do it continuously, for sure still, but it’s probably more where the industry got started. Right?

That’s kind of how we started out where we didn’t have all the tools to do dynamic position sizing. So, we would size at the time of entry. As I mentioned, there are still firms that do this today and there’s nothing wrong with that. But I think, also, there are a lot of firms based in the US today that uses dynamic position sizing, including the firm I work for, that’s why I want to mention it, so to speak.

[00:50:06] Mark

Right. And when he uses these terms European and American, it probably is more classic historically. And now, the important part from a due diligence perspective or someone who’s a listener is to say, if you start this as a baseline, then the question comes in, how do you differentiate one manager from another? So, you could have a classic American which would be breakout with which we’ll call digital positions.

But then you say like, oh, but someone else might say, yes, I do breakouts, but then I dynamically adjust it. So, I’m a hybrid European American. Or I use both models at the same time, and I sort of correlate between the two. And then the third, which we call time series momentum, where I look at classic momentum across time and then just scale between high positive returns to negative returns and then do the adjustment.

So, now the important part is this, they actually are fairly similar in terms of their Sharpe ratios, their drawdowns. There might be differences between each one of these. They all do very well during periods when there’s a lot of trends. And so, what happens is, the one takeaway, you could sort of say, well, you need to have trend followers no matter what style you have. And if there’s a big move, it doesn’t matter, you’ll do well.

[00:51:51] Niels

Sure.

[00:51:53] Mark

But second, you’d sort of say, well, there are nuances between the two and that might affect when you’re going to do better or worse. And so, you need to at least understand or appreciate the difference. And I think that when they talk about trend following, sometimes people lump it all together. And yet you could say you can actually differentiate further based on some of the characteristics of position sizing and how you take signals and looking at signal/noise ratio.

[00:52:25] Niels

The funny part is, Mark, that I completely agree with everything you’ve just said, but I also think about this idea of, well, it’s good to know what kind of manager you are. So that makes it easier maybe to understand when you should be doing well and when maybe you should be doing less well, so to speak. But the thing is, I don’t know that necessarily picking one over the other, as an investor, makes a lot of sense because we simply don’t know the future.

I think this is an interesting debate when I get asked, and that happens on a frequent basis, about how do you construct a portfolio of managers? I usually say that it’s probably a good idea to start by looking at people with structural difference. Now, this could be one structural difference, right? It could also be the number of markets they trade, the speed they trade at, for example, things like that.

But it is interesting that we love these classifications. Oh, are you an American style classic? Are you time series momentum, whatever. But at the end of the day, we’re all just, looking at something where we don’t know what the future path will look like for the market and therefore we don’t really know which one we should pick.

[00:53:46] Mark

That’s fair.

And if anything, what it tells you is that, while they’re similar, you may want to choose a portfolio that has more than one trend follower and have a little bit of different style. And they say like, whatever style you’ll have, in the extreme move or the real positive years, you’ll all do well.

But it also tells you that you should diversify across some trend followers. But you don’t have to have a portfolio of 10 different styles. So, you don’t have to have a large portfolio of them. There’s an optimal number and people have studied this. So, we’ll sort of say, relative to some other hedge fund style, the number of trend followers you need to be able to replicate a benchmark or replicate is probably less than for some other hedge fund styles.

[00:54:51] Niels

Yeah, I completely agree with that. I just wanted to intersect one thing and that is I don’t know how widely this is, but it’s something I’ve seen on our side, and that is this kind of process of evolving from being maybe wedded to one style to actually increasing the styles or the methodologies you have in your program. And I think that makes a lot of sense, actually, that you don’t necessarily have to go and find four different – one time series momentum manager, one moving average crossover manager, one price break.

I mean, I think there is some mileage in when managers (and of course you have to find really good models within each category for sure), but where managers start to blend different types of trend following as long as it’s “pure trend”. So, you’re not deviating from that. But I think there is some mileage in diversifying these kinds of methodology within your overall program.

And now that we’re talking about it, something I haven’t really thought about before, but it strikes me that managers can probably be a little bit conservative in the sense that if they started out doing one style of trend following, they kind of stay with that forever. Which I know that’s probably being very human about it because we don’t like to change as such. But I think that actually could be one kind of way we see trend following evolve.

So, it’s certainly something we’ve done, on our side, where we find really good ways of doing trend but they are not necessarily how we started out doing trend. And if you blend them together you get perhaps a stronger overall package.

[00:56:49] Mark

Well, let me put this way, we’ve argued that, okay, if you have a single trend follower style that maybe that you need to diversify across other firms but then the firm itself could be able to do that. And we’ll call it (and I’ll create a new word) the podification of trend following. So, we know that multi strats, they’re looking for a combination of pods to give you a smoother return profile. And then of course you’ve got to deal with each one of the pods and the personalities and such.

So, the nice part about it is that the advancing trend following style would be to say I run different trend following models almost as if they’re different pods. And then what I could do is I can blend those together. And so, what I can do before I execute, I could be able to say I have pod one, which is the American style; I have pod two, that’s the European style; pod three, that’s time series momentum. Then I can run those all separately.

Then when I want to issue signals into the marketplace and trades, I could aggregate those so that then there’s just one set. I cut my transactions costs, but I still will be able to track each one of my trend pods separately, internally, and I know exactly which model is doing better or worse.

[00:58:26] Niels

Exactly. So, I think that’s one very important part. Even though transaction cost, generally, at least in my view, is not the biggest hurdle we face in the long-term trend following trading on exchange futures only because transaction costs are low. But there is one other big advantage, compared to going out finding three or four or five different managers, and that is you get netting of the performance fee because it shows up as just one return stream, as one product return. And I think that, actually, is not insignificant and that is a really great advantage, by the way.

So yeah, for sure. Anyway, I’m not entirely sure where we’re going to go with this but…

[00:59:14] Mark

The only thing you need to do is figure out how to employ a pass-through model so you can pass through all of your costs to the investor.

[00:59:24] Niels

Then you have true costs, right? Yeah, absolutely.

[00:59:29] Mark

I’m going to save my comments about what I want to do. There’s been some interesting research on short-term trend following trades and I’ll give a sort of like a little teaser. And the research is that, well, what we found is, or what the market has found is that short-term trend following just doesn’t really work that well. So, what these researchers did, which is very interesting, is they said like, well, what’s the cause for that?

And the cause that they find is that it has to do with actually the tick size. When tick sizes are very small, so that then you could have more high frequency market makers in the market. Okay. Well, then they could be able to pull and add orders very quickly which actually can offset the gains that you’re trying to make in short-term trend following. And that if you look at futures contracts that have large tick size, you can still make money from short-term trend following. Those that have very tight or small tick size, it is very hard to make profits in those markets. Which is…

[01:00:49] Niels

And we’re talking about vol adjusted tick size, right? It’s the vol adjusted tick size. It’s not the tick size itself, as far as I recall.

[01:00:55] Mark

I’m just using a tick size as a generic. There are things you have to do to sort of make this all work. But it’s very interesting. So, we’ll say that the one thing that we constantly sort of… that I spend more of my time on is not so much there’s the modeling, but then there’s, we’ll call it, understanding the plumbing of how markets operate. And plumbing does matter. So, tick size matters. Who are the players in the market and treasuries matters. Who’s getting to finance, this all matters. So, the plumbing matters in terms of all of this.

[01:01:40] Niels

It really does. It really does. It’s not so much just about whether you’re using 100-day breakout or 50-day breakout. I completely agree. It’s even down to the data, what you do with the data and all of that stuff. So, I completely agree.

I know we’re going to move on to Victor Niederhoffer, but before we do that, I just want to maybe leave the audience with the sense that I’m not so sure, personally, that it makes even sense to talk about short-term and trend following in the same sentence. I really don’t think it is quite the same and I don’t know many firms that really employ trend following techniques, truly, in the short-term space. It’s more like a vol breakout and then they get out with completely different rules, not from a reversal of price, and so on, and so forth.

So, I’m a little bit cautious about calling it short. I mean, I know it’s being called short-term trend following, but I’m not even sure and we’re not even capturing the same things probably. So, it’s a little bit of a confusing thing for me.

Anyways, I’d love to hear what your thoughts are on Victor Niederhoffer. As some people may know, we’ve had his younger brother Roy on the podcast a couple of times. I’ve never spoken to Victor Niederhoffer, I’ve only heard anecdotes. But I know you followed him much more closely, so, I’d love to hear your thoughts.

[01:03:19] Mark

Well, I like to say that he was actually the one of quants quant, and probably one of the earliest true quant traders that we had in the hedge fund space. And he’s probably, he’s done some very significant research which I’ll talk about in just a second. He wrote the book, The Education of a Speculator. You know a lot of traders have written books. This is probably one of the better books from a trader, explaining what they do and how they view the market.

And he viewed it more as an evolutionary biology in the sense of an ecosystem. So, it’s not so much markets are efficient but you have to look at the ecosystem of markets and how they behave, which we called it plumbing now but he would call it the ecosystem. He also wrote the Daily Speculator blog. A lot of other people have written or been guest writers for that. It’s still out there but not very active. And I think for a lot of people, 15, 20 years ago this would be one of the go-to places to talk to.

So, he was a very powerful researcher. I think that he had some great pieces of research that were pathbreaking at the time and some of them were coming out in the ‘60s. He was not an academic, he was more of a trader. So, this is unusual that he had the academic chops but at the same time he was a trader.

So, he was one of the first people to come up with the headline, Overreaction Anomaly. He did some path breaking work in stock price clustering which we called a round number effect. He did some extremely good research in short-term mean reversion that went after large moves. He did some of the first insider trading anomaly research by just following what executive behavior did. So, if executives are buying their stock or selling your stock that’s telling you something about what they think about the underlying company. But he probably is noted, when I say he was a quants quant, he always sort of had the view, if you cannot count it, you do not know it.

So, he sort of rejected unverified financial advice, intuition, or media speculation in favor of that he was a strict empirical data person. So, he said, if you say something, prove it with the numbers. And when you think about that, that should be the mantra of everybody who’s a quant or trend follower. His view also was test everything. You run vigorous statistical backtest, and historic price behavior, look for an anomalies. And you’re only as good as the quality of your testing. And he embraced mean reversion and patterns.

Now, at the same time, he was well known for his blow-ups in the late ‘90s and sort of made a second comeback. He’s not the first person that we’ve seen who had made fortunes in trading, lost it, and came back. And it was because he always had an inquisitive mind to say okay, how do I get better? How do I admit that I’m wrong and how do I then be able to sort of say improve my process?

So, he’s probably also best known for those sort of ongoing battles with Nassim Taleb. So, we’ll sort of say that if Victor Niederhoffer was the true empiricist, Nassim Taleb was the skeptic. So, you had the quants quant who said like let’s just look at the data and follow the numbers versus the skeptic who said that history and statistical data could be misleading. So, he represents an extreme view. But for many of the quants today he should be sort of an example of someone you should emulate. An example of someone who followed a philosophy and stayed true to his philosophy and lived and died by the numbers.

But I think that it’s something, as I saw the obituary, I was moved because here’s someone that I you know was influential in how I thought and I think that many people have forgotten him or don’t remember him.

And I’d like to end the podcast by saying, remember Victor Niederhoffer, and go out and get his book, The Education of a Speculator. And I think that you’ll be rewarded for reading a piece that has been somewhat forgotten but was important for many quants 20, 30 years ago.

[01:08:52] Niels

Yeah, as I mentioned, it’s not someone that I follow specifically. I have been aware of him. I’ve seen the headlines, usually the not so positive headlines with these blow-ups. But there is something that is also very important and that is that a lot of very interesting people and very successful people came from his firm, people like Toby Crabel who we recently featured. I believe also Monroe Trout, super secretive but someone who became a highly, highly successful quantitative manager for sure, and others. So, a long list of very interesting people came or were influenced by Victor Niederhoffer, including your good self.

Mark, anything else you want to bring up before we bring it to a close for this week?

[01:09:50] Mark

No, we’ve had an exhaustive hour here. We’ve covered a lot of topics. Hopefully we’ll sort of say that, as we said, we’ve got our rumblings of thunder clouds and I’m not sure when I’m scheduled next, but I’m sure that I think that we might have more than rumblings from the next time I’m on this podcast.

[01:10:13] Niels

Yeah, you could be right. Yeah, it’ll be a couple of months and then we’ll see what the world looks like for sure. Let’s leave it there for this time. Mark, thanks so much for your prep and for coming on.

I will suggest, of course as I always do, that people listening should go and show their appreciation for Mark and all the other co-hosts by going to your favorite podcast player and leave a rating and review.

Of course, there’s an extra incentive at the moment to leave a rating and review and that is the competition we have running for another couple of weeks until the end of August, where I mentioned, on the episode a couple of weeks ago, with Dave Dredge and Rich, that I will put up one of these very nice (if I have to say so myself) TTU vests that I’m actually wearing today. I did remember to wear it today. It’s not so hot where I am today.

Anyways, that is up for grabs for the best review. And of course, in order for me to notice the review to be sure, please send an email to me telling me what you wrote, where you wrote it, when you wrote it, and I will bring it into the competition. We have some really good ones so far, but I’m sure there are some people who can maybe still find time to do so. So anyway, it’s out there.

Also, next week I’ll be joined by Alan, so if you have any questions for Alan or me, you can email them as usual to info@toptradersunplugged.com. By the way, that’s the same email you should send your review to and we’ll do our best to bring up your topics. If there are any questions or something you want us to discuss.

You can of course always go to the Top Traders Unplugged website to follow along on the trend barometer and all the other things that we’ve got going on that, including the weekly trend following report that Rich and I do, and lots of other resources.

From Mark and me, thanks ever so much for listening. We look forward to being back with you next week and as usual, and as always, take care of yourself and take care of each other.

[01:12:28] Ending

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