TTU131: Mike Kastner, Principle & Co-Founder at Halyard Asset Management

[00:00:06] Mike

It’s clear there are parts of the economy that are in recession. The bright spot is the hiring, the jobs market. If for some reason the jobs market completely slows down, and in fact, goes in the exact opposite direction, you start to see the unemployment rate drift up above 4%, 5%. That could worry the committee, the Federal Reserve committee, and if that happens, they may be vested in cutting interest rates. Given their propensity to take the overnight rate to zero several years ago, that would be a big concern. I think it would be a big mistake for them to do that, but it is on my mind.

[00:00:50] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we will 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 product before you make investment decisions.

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

[00:01:40] Niels

Hey everyone, and welcome to another edition of Top Traders Unplugged, where today, I’m joined by Mike Kastner, who is a Co-Founder and Principal at Halyard Asset Management, which is a firm specializing in cash management for the CTA or managed futures industry. The background to our conversation is that recently, one of our listeners wrote in with a question about cash management after he had heard the first few episodes in our special CTA mini-series that Alan and I are doing at the moment. Since the company I work for has a link to a great firm in this industry, I wanted to see if we can help shed some light on this part of our industry.

With that said, Mike, it’s great to have you on the podcast. Thanks so much for joining me today. I have really been looking forward to our conversation. I hope you’re doing well.

[00:02:34] Mike

Yes, Niels. I’m doing well. Thanks for having me on today.

[00:02:39] Niels

Absolutely. Now, before we dive into the different topics, Mike, that we’re going to be discussing, I thought we should set the stage for our conversation a little bit so that the audience knows a little bit about Halyard’s background, but perhaps also the backstory to what led you to set up the company in the first place. Can you share a little bit of light on your history?

[00:03:01] Mike

Sure. We started Halyard in 2010, Steve Boyd and Adam Cohn and I. We came out of a fund of funds, and basically, for the past 23 years, we’ve managed money for DUNN Capital Management. We’ve managed their collateral. After the 2008 crisis, we found that our services were no longer required at the fund of funds, so we launched the Halyard fixed income group. Since then, we’ve grown to 1.9 billion and we have about 23 accounts. Ten of them are CTAs.

[00:03:37] Niels

Okay, that’s great. In terms of the cash management services that you offer, are all of these within one type of mandate? How customized are the services you offer today?

[00:03:55] Mike

The service is fully customizable. We find our clients have different levels of comfort in their asset classes. So we run everything from 100% Treasury portfolio to 100% investment grade corporate bond portfolios.

[00:04:11] Niels

Okay. Now, in order to give a little bit of a different aspect of the cash management industry, what I wanted to ask you to begin with would be maybe if you could share a history of how cash management has fitted into our industry, because as far as I recall at least, there’s been different ways that we, on the manager side, have been dealing with cash management. We’ve always had the cash so to speak, because as futures managers, we only manage or we only need about 20%, 30% of the cash to have our positions on, but there’s certainly been different ways people have been going about this.

So can you take us back as far as possible in terms of what you’ve seen managers do initially and maybe how they’ve evolved in terms of how they manage their cash?

[00:05:08] Mike

Well, what I’ll do is I’ll go back to how we actually constructed what we call the reserve cash management. It’s a strategy that has a maximum maturity for floating rate notes of three years and for fixed notes of two years. We started back when Steve and I were at Deutsche Bank, and we had a very active vein of business in Silicon Valley. What we would do is the newly minted millionaires and billionaires would come to Deutsche Bank and we would manage their cash before they look to secondary investments. So from that, we developed what I said, the reserve cash management, and it became a natural extension into the CTAs because CTAs want to enhance the cash that they have on hand and at the same time, keep it safe.

[00:05:57] Niels

Yeah, absolutely. But the way I think about it, and maybe you can comment on that a little bit, Mike, I remember at least that when managers were managing cash, including the firms I’ve worked for, back in the day, we wouldn’t even use a cash manager. We would just keep it in treasuries ourselves or we would actually have it in the bank to a large extent before we all realized in 2007 and ‘08 that banks are maybe not as safe as they used to be. So do you have any reference point in terms of how CTAs were doing it back in the ’90s or early 2000s, for example, how they were doing it?

[00:06:33] Mike

Well, part of the answer is what you just said. Some of them would do it on their own in the treasury bill market. Others would leave it in banks and others would leave it in the brokers. Since 2008 and the blow-up of the prime fund, CTAs have been more conscientious about making sure their cash was safe. So the RCM strategy, when you compare it to a 2a-7 money market fund or do it yourself, we’re typically going to be able to outperform those strategies by between 50 and 100 basis points. Certainly, we haven’t been able to do that the last several years when we’ve been in the zero-interest rate environment, but I think that’ll be a good target going forward.

[00:07:17] Niels

Yeah, you mentioned a fund blowing up. That’s also something that I certainly remember because there was a lot of talk about that. I think at the time, certainly, I also recall that we were being pitched a lot at the time by these money market funds. Can you take us back to that time and explain a little bit about what actually went on? I’m not sure a lot of our listeners will be familiar with that money market fund and what actually happened. Also, I’d love to know what you learned from that and took with you on your own journey.

[00:07:49] Mike

Well, first off, the way money market funds are run today is not too dissimilar to the way they were run back in 2008. What the money fund portfolio managers seek to do is maximize their return on portfolio. That might seem like the standard for anybody, but at Halyard, we want to maximize return, but at same time, maintain liquidity and safety, so that when we go into times of panic, we’re actually able to buy beaten-down securities with money that we have on the sidelines, and at the same time, not be forced to sell into a panic.

[00:08:31] Niels

Can you explain a little bit, Mike, about what actually went wrong with this money market fund back then?

[00:08:36] Mike

Well, this money market fund, the prime fund had a large position in Lehman Brothers. When Lehman Brothers went bankrupt, they had to mark their portfolio down. When they did that, all the investors in the portfolio (keep in mind a money market fund is a commingled vehicle), they demanded their money back and as a result, the prime fund had to put up what’s called the gate, they suspended redemptions. So CTAs that were in there weren’t able to get their money to meet margin calls.

At Halyard, we don’t do that. We keep a buffer of treasury bills, as well as our investment-grade paper. As I said before, during times of panic, we’d rather step in and buy the paper rather than have to be forced into liquidation.

[00:09:29] Niels

Yeah, absolutely. I’d love to talk much more in-depth maybe about how you guys do that today. But before we get to that, again, more of a general comment and an observation from your side. Now, in the last 10, 15 years leading into 2022 almost, there wasn’t much interest to be picked up from anything. In fact, if you’re European, it was about trying to avoid negative interest rates. So I imagine that it would have been pretty hard to be a cash manager and make much of a difference really.

But again, you can correct me if I’m wrong here. I’m really curious to know how you think the whole cash management space has changed in the last 12, 15 months now that interest rates are not zero anymore.

[00:10:19] Mike

Well, certainly it’s gotten a whole lot better. We’re seeing very attractive opportunities to invest in short-maturity fixed income. I’d go so far as to say it’s the best investing environment in the last 15 years. For the past several years, it’s been a challenge. We would have to find securities that were trading cheap for one reason or another. In the zero-interest rate environment, we were generating high double digits, call it 25 to 50 basis points, by diversifying in investment grade and municipal securities.

[00:11:01] Niels

Okay. Just talking about your approach to this, we often get asked, as a manager, to talk about our investment philosophy, so to speak. So I wonder if there’s a philosophy to cash management as well and how you think about that in your world.

[00:11:22] Mike

Yeah, there absolutely is a philosophy. We think about it, in many ways, like an equity manager would. We start with the universe of corporations that we like, and then what we do is we buy the cheapest corporations, and then we sell the richer ones as they cycle through the market. Actually, we find quite a bit of opportunity in both the corporate market, as well as in the treasury bill market.

With the Fed raising interest rates, the treasury bill market has gotten a little bit kinked. So we’re actually able to find opportunities where we can sell treasury bills at ridiculously overpriced levels and then buy them at cheaper levels depending upon what the market thinks the Fed is going to do at the next committee meeting.

[00:12:11] Niels

Yeah, which is an interesting discussion on this day where we are recording as we’ve just seen some US jobless payrolls come out. So we’ll talk about that a little bit later I’m sure. But in this construction of your portfolio and the way you try and combine various securities to, as you say, adhere to keeping money safe but also having maybe a little bit of an advantage in terms of the interest you get, and also keeping it liquid.

Let’s start with liquidity, for example. What are the considerations you have? Again, in the context of a CTA where you know what the needs of a CTA typically are, how would you go about thinking about and constructing the portfolio from a liquidity point of view?

[00:13:05] Mike

Well, there’s three perspectives with regard to liquidity. First off, we like to maintain a position in treasury bills, and the treasury bills could be settled on the same day. So if a CTA manager needs a large wire to meet a collateral need, we can liquidate that the same morning and send it out by the middle of the day. Secondly, we look to big, deep, liquid corporate bonds that will trade close to treasury bills (like a little bit of a bid-ask spread, but not too much).

Lastly, what we do for the portfolios is we’ll seek yield-enhanced opportunities in the taxable muni market when we see them. They’re less liquid, but they also offer more of a yield over an investment-grade corporate or a treasury bill.

[00:14:02] Niels

Just staying with liquidity, Mike, because I seem to remember that during COVID, March 2020, even the US Treasury market became somewhat “illiquid”. So I’m wondering, can you talk to me about how you think the whole liquidity (I wouldn’t call it space, it’s not what I mean), but how liquidity, in general, has changed in the last few years? Because also, when I look at it from a European perspective, for example, where interest rates have been negative, essentially, if I look at some of the bond markets, I actually started out in the bond market myself.

My understanding is that today, in many countries, there’s not much of a bond market because there really weren’t any people wanting to participate much in the negative yield environment and therefore, we’ve lost a lot of participants, certainly the ones who were offering or providing liquidity. You can break it down. I’d love to hear more details about how you see liquidity in treasuries, in corporates, in municipals. Yeah, as much detail as you can provide would be great.

[00:15:12] Mike

Sure. March, 2020 is an ideal opportunity to focus on that liquidity. At that time, one of the big money center banks had a run on their short-maturity fixed-income portfolios. They had to liquidate an enormous amount of paper. I’m happy to say that we were actually a buyer during that period. We scooped up some really attractive deals during that March. In terms of liquidity, the Fed provided liquidity back in March 2020. The market couldn’t absorb it all and it was really in disarray.

As a result, we saw some corporate bonds trading in the high single-digit percentage rates. As I said, we liquidated some of our treasuries and bought that paper. It was good quality paper, it was just a completely illiquid market. Now, your point is right. The dealers are better sellers of corporate bonds than they are buyers. They don’t want to provide that liquidity. So what the Fed has done to address that is they’re discouraging money market funds from offering prime money market funds anymore.

What I mean by prime money market funds is they’re funds that do what we do in the RCM strategy, and that’s invest in corporate bonds or bonds that are not US Treasuries. So as a result, the money market fund has become overwhelmingly US Treasury-dominated. About 80%, 85% of the money market space is now positioned with US Treasuries.

[00:16:52] Niels

In terms of corporate and municipal bonds, how has liquidity generally evolved in the last few years in that area would you say?

[00:17:01] Mike

Well, truth be told, you will see illiquidity in the corporate market from time to time when there’s any kind of panic, whether it’s in the equity market or in the currency market. The dealers like to step away. They don’t want to put up their risk capital to take people out of positions. As I said before, what we do is we seek to hold a treasury buffer so that when we see these opportunities, we’re able to go in there and actually be providers of liquidity as opposed to trying to liquidate our holdings into a panicky market.

[00:17:39] Niels

In terms of all the factors that I’m curious about when you construct these portfolios, we’ve kind of touched upon it a little bit indirectly, but what about credit rating? Where do you draw the line in terms of what is safe and what is not safe? I imagine as well that there are probably some restrictions in terms of what managers are willing to accept in terms of the percentage holdings of different categories of fixed-income instruments. How do you construct that to meet your mandate, so to speak, all of your mandates?

[00:18:13] Mike

Well, for the RCM strategy as it stands, we have a minimum investment credit rating of A for the overall portfolio. We will invest in triple B paper, but when we’re investing in triple B’s, we want to see a company that’s actually improving their financials and is at risk of being upgraded. With that said, we don’t invest in all investment-grade paper. US banks, we do like. Canadian banks have an unusual provision where they can be bailed in.

What I mean by that is, if for some reason or another, the company was to become at risk, the fixed-income paper could be converted into equities. So we do not buy any Canadian banks. For European banks and Japanese banks, while their credit rating is investment grade, we don’t like the credit quality in the riskiness that they hold in their portfolios, so we avoid them as well.

[00:19:25] Niels

Now, another thing that has come on the radar of most investors in the last few years is ESG. I imagine that there’s also some considerations, of course, maybe depending manager by manager, I don’t know. But can you talk a little bit about what you see managers do in terms of approaching ESG through the cash management that you do?

[00:19:51] Mike

Yes, we are ESG-compliant in most of our portfolios. The good news is most of the big corporations in the United States have moved in the direction of being ESG-compliant. So while at one point it was a very narrow universe and made it difficult to achieve diversification, it’s gotten much more broad now. So the vast majority of our portfolio of approved corporations are ESG-approved.

[00:20:25] Niels

Okay. Of course, me not being an expert in your field, are there any other considerations that you need to take into account when you construct a portfolio for a client like a CTA? Is there anything else you put into the equation?

[00:20:42] Mike

Yeah, you hit the nail on the head with liquidity. We’ve talked about it on several different occasions. Basically, when we buy a security, if it’s going to be a material holding in the portfolio, we want to have a good idea that it’s going to be liquid. Our target for the RCM strategy is to be able to fully liquidate the portfolio in three days, although in most cases, that can usually be done in a day.

[00:21:10] Niels

Okay, yeah, that makes sense. Now, another thing from a practical point of view, I guess, certainly, that’s something that we deal with on our side is (of course, and I’m sure many CTAs do), is that there are different currency classes in a fund. Some people will invest in euros or Swiss francs or pounds or whatever it might be. So that’s obviously another angle on all of this. How do you deal with the fact that there could be many different currencies in the fund that you are asked to manage the cash for?

[00:21:43] Mike

We do manage two UCITS funds out of Dublin, Ireland. They are both ESG compliant and they also require us to do foreign exchange hedging for them. Our approach to foreign exchange hedging is to avoid period ends. So month-end, quarter-end, year-end are the times when corporations will come in and hedge out their P&L.

So you can never really be sure which way the market is going to go. But during those period ends, there’s a good chance that there could be market dislocation. So what we found is that the sweet spot for hedging is to do our hedging on a one-month basis and do it to the middle of the month to avoid those busy times of hedging.

[00:22:34] Niels

Yeah, that makes sense. I seem to remember having something similar many years ago when I was more involved in these things. Okay, one thing that we talk a lot about, on the manager side, is this thing about number of markets. Now, I know it doesn’t fully apply to what you do but it does to some extent because it has something to do with maximum risk in any one single instrument, etc., etc.

So, how do you decide in terms of how many instruments and “positions” that you want to have or need to have in your portfolio in order to balance most appropriately the mandates that you have?

[00:23:19] Mike

Well, our comfort is right about 2%, 2.5% per position. So, our portfolios will have anywhere between 50 to 60 different line items if you will. Again, the diversification is imperative because even with the best financial analyst, you could miss something and see a little bit of credit widening if a corporation misses when they release their quarterly financials.

[00:23:51] Niels

Yeah, true, which actually also turns on to my next question, and that’s more the area of risk management. Now, again, this is another topic that we talk a lot about on the podcast when it comes to managers. But what about in the cash management world? What are the risk management metrics you use if I can call it that? Maybe you can explain. I know some of it is maybe a little bit taken from earlier points we’ve talked about today. But overall, if you should frame your approach to risk management, how would you frame it?

[00:24:27] Mike

What I’ll say is we don’t do it the way the CTAs would do it. We’re not looking at value at risks. The way we view risk management is in construction of the RCM strategy. We’ve been doing it for 25 years and we’ve been through a number of financial panics, so for us, the stress is really liquidity, diversification, security selection, and the ability to move in and out of markets when needed.

[00:24:59] Niels

Absolutely. I’m just curious. Obviously, you work with a number of different CTAs. Do you see there’s a big difference in what they want from you or are we all more or less the same when it comes to our cash management nowadays?

[00:25:13] Mike

Every one of our clients is different. They have different mandates, they have different risk tolerances. We have one CTA that only wants to use treasury bills. So basically, we build out a portfolio of treasury bills holding between 10 and 15 of them. Interestingly enough, we do see opportunities to trade around those treasury bill positions, to actually add value over and above what would be earned by just buying and holding the treasury bills to maturity.

[00:25:44] Niels

Okay. That brings me to my next question, and that is, how should managers (and of course, therefore, their underlying clients), think about the expected returns in cash management? Maybe even I would go (and I’d love to hear your thoughts more broadly as well), if I was going to throw in this active versus passive type investment approach (obviously, you’re active, but a lot of people would be pretty passive in this area of finance), how do you see those forces, and then as I said, what do you think about the expected benefits or returns in one versus the other?

[00:26:24] Mike

Well, for our strategy, we’ve been able to outperform money markets since we’ve implemented it. When you think about the CTAs and the hedge funds, in general, they have a philosophy that they eat what they kill. By leaving their cash passively managed, they’re leaving opportunity on the table. So if we can earn between 50, 75, 100 basis points over the treasury bill market, that’s real money, and that’s real money that they’re leaving on the table unnecessarily.

[00:27:02] Niels

Yeah. Absolutely. Now, it kind of ties in a little bit with one other thing, which, again, has been a big point of discussion in our industry. Unfortunately, there’s been a lot of pressure on this, and it’s the fees. I can imagine that your industry would have also met some of that as interest rates sat around the zero level. So maybe you can go back a little bit, a couple of decades, perhaps, and just tell us a little bit about the evolution of fees in your industry and where they kind of are today. You don’t have to disclose any specific fees, but where they are generally, and how you see that evolve going forward. That would be really interesting.

[00:27:46] Mike

The fees have certainly compressed along with all investment management compensation. But I think it’s a mistake to look at the fee only. Right now, if you go out, you can take a look at some very large money market funds and they’re charging 35 basis points, which is and was quite large given the environment we were just in. There’s others that are very low fees, some of the ETFs. But in looking at the fees, you should follow up by looking at the performance of the portfolio, and not just the overall performance, but the portfolio performance during times of stress. That really will tell the tale about whether you’re getting what you need for the fee that you’re paying or if you’re actually getting less than you should because you’re paying a cheap fee.

[00:27:46] Niels

That sounds very similar to our side of the business where we also think people should look at the net return when they look at the cheapest options for sure. I think that’s a pretty good overview. Is there anything else you want to talk about specifically, in terms of that it’s important for the audience to know about cash management, where we are today, before we shift to another set of topics that I’d love to hear your thoughts about? Is there anything that I missed asking you about?

[00:29:17] Mike

I don’t think so. It’s a fairly straightforward business, but it’s important to view the overall business in terms of the diversification and liquidity. Our CTAs need their money when they need the money, so we have to be adept at being able to liquidate portfolio and wire money when they need it.

[00:29:41] Niels

Yeah, actually, that’s one good point that you just mentioned there. I would imagine that this is something that people may not realize, but technology plays a role because you’re dealing with things where sometimes money needs to be in a different part of the world, more or less on the same day. So having that overview and the ability to manage all of this, I would have thought is quite important.

The other thing that I wanted to maybe ask you to comment on, because I think it’s important on our side of the table even though we are quantitative strategies, but I would imagine that maybe on your side, it’s even more important or equally important, and that’s just experience. You mentioned earlier, you’d seen a few things in your career. So is there anything you could share in terms of things where you were surprised, “Wow, could that really happen in this liquid market,” and where you learned some lessons, maybe good, maybe bad?

[00:30:42] Mike

Well, as I said before, I think the lesson learned was really building out a solid portfolio where there are not going to be any surprises. What we do is, on an ongoing basis, we’re looking at the companies we invest in. So on a daily basis, we’ll look into their balance sheets, we’ll look at their monthly performance, and we’ll try to evaluate what we should anticipate when they release their quarterly results. We don’t like surprises. We like to be plugged into the company. So, in that sense, we operate more like an equity manager than a fixed income manager.

[00:31:27] Niels

All right. Well, let’s shift gears, Mike, because I wanted to also spend a few minutes on how you see the world. Obviously, you’re a fixed income specialist with decades of experience. This space continues to surprise, and of course, it’s a lot in focus at the moment because it seems like the whole world is just watching what the Fed is saying. I’m not necessarily saying they’re listening to what the Fed is saying, but they’re watching. So talk a little bit about how you see the world right now. We’ll just walk through your outlook and expectations, maybe as much as we can.

[00:32:08] Mike

Sure. I would say prior to this morning’s employment report, I think the vast majority of investors assumed that the US was in recession. The reason I say that is because of the deeply inverted yield curve. What that means is that long bonds are much more expensive than short-maturity fixed income, about a 75-basis point inversion between overnight paper and the 30-year. I don’t think we’re going to slip into a recession and the reason being is because we have such a strong employment backdrop. We have, basically, a shortage of workers in the US. As a result, there is going to be continued expansion of the workforce and that means more money being earned.

With that said, certainly, housing, manufacturing and autos, to a lesser extent, I would argue, are in recession right now. Services are hanging in there and seem to be the counterweight to those industries. But the long end just doesn’t make any sense at the current yield levels.

[00:33:23] Niels

You mentioned the unemployment numbers that just came out. You and I are recording on Friday, February 3, and of course, they were somewhat surprising. Through your updates, etc., etc., you talk a lot about (and I’ve seen other people talk about) this fact that, yeah, maybe the markets are listening to the Fed but they’re not really hearing what they’re saying. What do you think the Fed really is saying at this time? Because also, I think part of the optimism that came into the early part of 2023 was this sense that maybe the peak of rates won’t be 5.5%, it’ll be closer to 5%. So there have been signs of maybe not as hawkish as we kind of thought three months ago.

Where do you think we’re heading, and then once we get there, what do you think is going to happen?

[00:34:17] Mike

Well, you’re right. Just three months ago, the target from the Federal Reserve at the overnight rate seemed to be 5.25% to 5.5%, and then at his press conference on Wednesday, Chairman Powell sounded a lot less hawkish than he did at the end of last year. So, at the conclusion of that meeting, I anticipated they had maybe another 25 or two 25 basis point moves and that they would stop at 5%. With that said, the long end is so overvalued relative to where inflation is running. I think that we would actually see the curve re-steepen as the Fed pauses their rate hikes.

[00:35:05] Niels

Given the number we’ve just had today, I know it’s maybe a cheeky question to ask you with such short notice, do you think it’s still 5% after what we’ve seen this morning? Also, you talk about that overvaluation of 30-year bonds. Can you explain what you mean by that and how much of an overvaluation that equates to?

[00:35:28] Mike

Sure. To address the first question, I was shocked and I think everyone else was shocked because, since the end of last year, there’s been a lot of announcements of layoffs from big corporations. So we expected to start to see that first in the unemployment insurance, and then secondly, in the monthly payroll report. As a result, this morning’s number came right out of left field. It didn’t make any sense. With regard to valuation, the bond market typically values the inflation premium as being inflation plus 1.25%. Our anticipation is that the Fed will be successful in getting inflation down, but we don’t think they’re going to get it back down to the 2% level. We think it’s more likely down to a 3.5% level.

So if you add the 125-basis point premium on that, the fair value of the long bond is 475. If you put those numbers into a bond calculator, that shows that the 30-year bond is overvalued by 15% right now. So as a result, we think that there’s a pretty good chance of a significant downtick in the long bond price.

[00:36:55] Niels

Yeah, that wouldn’t surprise me either, of course. In terms of the wider economy, before we wind our conversation down, in terms of the wider economy, US economy, clearly, that’s something you follow very closely, much closer than I do. Because I think to some extent, we’re all affected by what happens to interest rates, both short-term and long-term, and what happens in the US to a large extent, of course, spills over to other parts of Europe. I would love if you have a view on what’s going on in Europe. I would love to hear if you have a view on what the Japanese have going on in their yield curve or control just to get your thoughts on these things?

[00:37:49] Mike

We take a very negative impression of yield curve control. We think that the Fed, they controlled our yield curve for years and that created the distortion, and I would argue, quite frankly, that also caused the inflation problem that we’re going through now. So, I don’t like yield curve control. With that said, I think that the US market is going to go through a slow period until we get reacclimated to the current level of interest rates. For instance, right now, the housing market has basically completely dried up because no one’s going to refinance their mortgage at a 6% when it was just 2.5% 18 months ago. It doesn’t make economic sense.

But ultimately, people will have to buy houses, buy and sell houses, and they’re going to have to come to terms with mortgage rates that are between 5% and 6%. But until they’re able to come to terms with that level, we expect that the housing market is going to be on hold, we expect it’s going to be difficult for the automobile market and difficult for corporations in general to refinance their corporate paper.

[00:39:05] Niels

Okay. Just one final question on that before I have just a couple of final questions, Mike. I heard maybe about a year ago, some people say that, well, if interest rates go back to the levels they were in 2007, corporate America would be spending half of their profits just servicing debt because of the huge corporate debt once they had to go out and refinance at much higher rates of course. That may be true, but I’d love to hear what you think about that. Actually, another thing, once we were talking about servicing debt, what about central banks? How high can rates go and maintain before they find it difficult to service their debt, in your opinion?

[00:39:53] Mike

Well, to answer the second question first, the central banks have been very clever in their activities in terms of debt management, so they would find a way to manage that debt. We’ve basically watched the central banks print money and spend it. So I’m not worried about them. To answer the first question, corporate America was rewarded for issuing debt and buying back their own stock. It created an upward trajectory to their profits, and their CEOs were compensated for doing so. But as a result, the balance sheet of many corporations has deteriorated.

Your point is, yes, as they have to refund this debt, it’s going to become more of a drag on their P&L and the CEOs, quite frankly, will be criticized for that.

[00:40:51] Niels

Yeah, absolutely. This is something I’m learning as my daughter is starting university, and that is this thing about the rule, I forget the number, but it’s a specific rule that from 1993 onwards in the US meant that compensation of these top CEOs had to be linked to the profitability or whatever it was, the value creation of the companies and therefore, essentially the share price, and maybe that’s not a great way of giving them proper incentives. But anyways, I don’t know if you have a view on that or not, it doesn’t matter.

But I will want to ask you just something we ask trend followers in our series on the CTA industry is, what’s the one thing you’ve heard about trend following that you disagree with the most? I wanted to, again, maybe a little bit cheeky, ask you the same, if there’s something you hear about cash management that you really disagree with. Is there anything that springs to mind?

[00:41:51] Mike

That I disagree with. I can’t really identify anything that I would disagree with in cash management. I think that, as I said several times, I think it’s important to position high-quality corporations in the portfolio and avoid those that are somewhat questionable.

[00:42:14] Niels

Yeah. I just want to make sure you heard my question. I know we have a little bit of an audio issue, at least on my side. But my question was not whether you disagree with cash management is whether there’s something you hear people say about cash management that you disagree with.

[00:42:29] Mike

Yeah. I think what I disagree with is the idea that it’s easy and you can do it yourself. In my experience, I’ve been doing this for 35 years now, when someone that’s inexperienced in the market says that it’s easy and they can do it themselves, they’re going to have trouble at some point down the line.

[00:42:50] Niels

Yeah, I think that makes sense. That’s actually also some of the things that we kind of hear from time to time, that trend following is so easy that everyone can do it. But I certainly disagree with that.

Final question, Mike, before we round up our conversation, and that’s just summarizing what we’ve talked about maybe into a question. When you look into 2023, what are you most excited about and what gives you cause for concern when you look into the coming year?

[00:43:19] Mike

Well, what I’m most excited about, I said at the beginning, this is the best time for my market in the last 15 years. I think listening to the Federal Reserve, it’s going to stay that way for all of 2023. What concerns me most about this year is the possibility that the Fed panics; that the economy does tick down; that the stock market isn’t as buoyant as it’s been and the Fed panics and cuts interest rates and does so in a significant fashion. That’s a worry that I have.

[00:43:57] Niels

What do you think might actually happen if they do so, if I can just follow up on that?

[00:44:02] Mike

Well, as I said, it’s clear there’s parts of the economy that are in recession. The bright spot is the hiring, the jobs market. If for some reason the jobs market completely slows down, and in fact, goes in the exact opposite direction, you start to see the unemployment rate drift up above 4%, 5%, 5.5%. That could worry the committee, the Federal Reserve committee. If that happens, they may be vested in cutting interest rates and given their propensity to take the overnight rate to zero several years ago, that would be a big concern. I think it would be a big mistake for them to do that, but it is on my mind.

[00:44:52] Niels

Okay, yeah. Just again, for me to understand, Mike, I understand that you are afraid of that. But what are you afraid will happen if they do it? That’s what I’m trying to find out in terms of is it just that inflation comes back or is there something else you find? Could it be that your concern is that markets will lose confidence in what they’re doing in the first place, which, if they don’t have confidence, that can lead to bigger problems, I guess?

[00:45:19] Mike

Yeah. I think that’s the concern, that they lose confidence. They lost a lot of confidence when they were identifying the inflation rate as being transitory. They got their confidence back by being so aggressive in 2022, so much so that the stock market is off to a decent year this year and feels like that will continue. But should their confidence be lost again, you could see stock prices take a significant hit. After the dip they experienced last year, that could be very problematic for the economy as a whole.

[00:45:59] Niels

Mike, this is a good place to end our conversation for now at least. Thank you very much for your time and your insights and your thoughts about this. This is an area which of course is very closely linked to what we do in our industry, but it was the first time we’ve had a chance to really dig into this area, so I really appreciate that.

To all of you listening today, I hope that you were able to take something from today’s conversation onto your own investment journey. If you did, please share these episodes with your friends and colleagues. From Mike and me, thanks so much for listening and we look forward to being back with you on the next episode of Top Traders Unplugged as we continue our deep dive into the many facets of the CTA industry.

In the meantime, go check out the show notes for this episode, as well as all the other resources you can find on our website. As usual, not least, take care of yourself and take care of each other.

[00:46:58] Ending

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