What Investors Need to Know about 2024 ft. Dave Dredge & Cem Karsan

[00:00:06] Dave

Holy shit! How much vega risk, how much negative asymmetry, as a group, are these people taking? We still see it out here. I think we talked about it before. We had that huge surge of private banks in Asia doing accumulator products, in June 2021, on Alibaba, Tencent, Ping An, the big China tech companies, and every private bank in Singapore and Hong Kong doing the exact same thing.

Within three months, the whole thing has blown up, and six months later, you’re hearing rumors of billion-dollar unrecognized losses in bank, after bank, after bank, after bank, after bank. on ticket sizes that were only $50 to $100,000 per ticket. It’s phenomenal the scale of it at all.

[00:00:55] 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 products before you make investment decisions.

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

[00:01:52] Niels

Dave, welcome back to the podcast and thank you for staying late in the office to join Cem and me today for what I’m sure will be a very insightful and fun conversation on a few explosive topics no doubt as we look into the year ahead of us. How are you doing? How’s life in Singapore?

[00:02:09] Dave

I’m good. It’s good. It’s been a lively start to the year, been raining nonstop every day since about Christmas. But other than that, it’s great.

[00:02:18] Niels

What about you, Cem? It’s very early morning where you are. How are things in Chicago?

[00:02:23] Cem

Rainy. Somewhere between snow and rain. The sun is not quite up here yet either. We’ve got David going to bed and me just waking up.

[00:02:34] Niels

Absolutely. I’m the lucky one today for sure. Now, last year, we discussed topics like what about the 40, the Sharpe world, JGBs, and the BOJ, lessons learned from an Indonesian shipbuilder, if I remember correctly, and a few other things. Perhaps I can kick it off maybe by asking you, Dave, if these topics turned out to be as important as you thought they would be, or if one of them, two of them stood out when you think back on 2023 before we move into looking ahead into 2024.

[00:03:12] Dave

Yeah. Obviously, shortly after we talked, the BOJ made their first transition away from YCC, which caused one of the biggest vol events of the year on that day. The whole dynamic around who’s going to own the 40, the central bank policy, the trying to recover their price stability mandates, the impact of who’s going to own the 40. Again, a few months after we talked on Silicon Valley Bank and Credit Suisse, one of 30 G-SIBs in the world going out of business and getting a forced takeover from their main rival.

The impact of the change in interest rates, of the lack of capital in the Sharpe world regulated. The traditional math-regulated financial industry showed its teeth in March. The market strongly reacted to and in anticipation of a knee-jerk reversal of Fed policy, the Pavlovian response to ‘the Fed will always slash rates.’ But instead, the Fed did exactly something we talked about on that call, de facto financial repression.

They went to the regional banking system and said we’ll provide this BTFP, this bond repo, we’ll subsidize you to hold on to government bonds. We will give you even more incentive to hold already zero-risk weighted assets, already non mark to market, already hidden accumulated unrealized losses with maximum unlimited leverage applied to them, we’ll subsidize it even more, so just don’t sell them.

So, all of the stuff we talked about, and inevitably because, Cem and I, we’re always talking about fragility in the system and uncapitalized risk or mismeasured risk. Cem always talks about flows, etc. The positioning in the market, we talked about that, and I’ll talk about all day today if you want to. Still the biggest flow position on capitalized risk in the market is that the financial system (I probably said it last year, I don’t remember), the regulated financial system is allowed to treat government bonds somewhere between riskless and risk-reducing.

So, either you don’t have to provide any capital to hold them, or you can reduce the capital you hold against other assets by holding them, and there is no increase in risk from adding leverage to them. Well, that’s obviously what causes the system to creek. We talked about it last year. I remember so succinctly that the I’d said, listen, you can look at the vol dynamics in the long-dated interest rate markets we were playing in, you can see the thing that eventually is really going to hurt is a bear steepening.

Sure enough, come August, September, October, you saw the pain of that and then the timely reversal of the narrative, and the term I coined on that conversation last year, the much hoped for ‘immaculate recession’ is upon us. As I wrote last month, recession, yay! It immediately took the pressure off the system as interest rates declined and the pricing of future interest rate hots immediately fed through the yield curves. Once the pressure is removed from the system, all that capital is allowed to go out and re-lever up or reapply good correlation to more risk-taking.

So you get the everything rally that we’ve had since November and December. But it comes back to the same thing I always talk about, and Cem and I spent tons of time talking about when we had the good fortune of catching up in Austin at the CBOE this year, just be convex, just be convex. Make money on both sides. Participate, protect. It’s been yet another absolutely sensational year for convex portfolios. A long stream of absolutely sensational years for convex portfolios. So yeah, I thought we lived last year’s conversation and we still are.

[00:07:43] Niels

Yeah, I completely agree. As you rightly say, it’s usually not the things that we think are risky that’s going to get us into trouble. It’s the things we think that are not risky and then we level them up, and then it all blows up, as we’ve seen so many times.

Now, I’m going to throw a question to both of you and then we’ll kick into gear looking more into the new year. But last year when we spoke, and I think this was not just us, but I think lots of investors last year were worried about what was to come in 2023.

Obviously, the year didn’t start out great, but it ended pretty well for traditional assets had you just stayed long all through the year. It feels pretty much the opposite right now, as we start the new year of 2024. The economic climate seems reasonably reassuring. We have falling prices, lower inflation. We have still a strong employment picture. We have lower rates, as you put it, Dave. So I’d love to just ask you both, what are we missing or what’s the market missing from this too-good-to-be-true picture?

[00:08:56] Dave

I’ve been saying for a long time, and I wrote about it probably starting in July or August saying the good outcome is going to be a recession because in a recession, people will buy the bonds. The bad outcome was the scenario that we were staring down the barrel of in October. Nobody’s going to buy the bonds. If nobody buys the bonds, the systemic risk in the system is the lack of capital supporting all the leverage and fixed income in regulated financial institutions.

If bonds melt down, banks, pension funds, insurance companies, wealth management, go out of business. If stocks go down, end equity holders lose money. It’s not systemically risky in a sense, given the structure and nature of the markets now which is far different to what it was in ’08. As you just said or as I always say, banks don’t go out of business taking risks. They go out of business leveraging things they are told are not risky or allowed to account for as not risky. I think that’s still a problem.

We’re in this Goldilocks period of yay, the recession. Now, there’s obviously some things out there that are maybe not necessarily priced like we’re going to have a recession while everybody’s out celebrating forward yield curves and equity markets like this recession is coming and rates will go down. But there’s a lot of credit markets that aren’t necessarily priced like we’re going to have a recession. It’s going to be the default, like I said, the immaculate recession. So it’s that pendulum.

Cem is the best about talking about the pendulum, or that everybody’s on this side of the boat and that everybody moves over to this side of the boat, and you get that overshoot on both sides. We were at one side at the end of 2021 and then at the opposite side at the end of 2022 and back to the other side at the end of 2023. At the end of the day, exactly as you say, over the course of 2024, once again, it’ll be what we don’t know that matters.

So have a portfolio that’s optimized to the divergence from the mean of the expectation, not one that’s optimized to the mean of the expectation, because the mean, as it turns out (Cem and I always talk about this when we’re together), the mean is the average of the divergences. You almost never get the mean. The mean, in the long-term path, has de minimis impact on the compounding. It’s the divergences that drive the compounding.

So, it’s just a matter of building a portfolio that’s resilient to the divergences that come back to be convex. But I can’t wait to hear what Cem has to say because he’s more attuned to the current pulse of things than I am.

[00:11:44] Cem

You’re too kind, David. I can listen to you talk all day. I feel like I’m always picking up nuggets here and there. My thought on this is, you said the word Goldilocks, and that’s the perception right now that we have the best of both worlds. The interesting thing is not too far away from the best of both things is the worst of both things. I actually think that’s what we’re closer to. I think we’re more in stagflation.

There’s a structural pressure that used to exist that was deflationary as a function of our ability to send all the money to the top. That deflationary core pressure, for 40 years, allowed us to lower interest rates secularly from 20 to 0 and stimulate, and stimulate, and stimulate, from a monetary perspective, which allowed us to create more Goldilocks for quite some time. I actually think we’re going the opposite way.

There’s a structural inflationary pressure from the rebalancing of inequality and the political pressures that are driving it, and now we’re having to try and manage a much more difficult situation which is to battle structural inflation. That means we’re removing liquidity every time to pull back against that. So what happens now when we get the recession? That’s the big question. What happens when we get the recession? Because now, it’s much harder to stimulate.

You really risk what we risked in 1970, ’71 when William McChesney Martin pivoted into a year and a half long recession, and then inflation, which had been 6 and came down to 2 or 1.5 then went to 12. So my fear is that, actually, this is the worst of both worlds. You’re hearing the word soft landing, Goldilocks everywhere. I think people will be talking and, hopefully when we get together next time, we’ll review what we talked about. But I think there’s an increasing probability you hear the word stagflation going forward, and I think that’s the thing that people are taking their eyes off right now.

[00:14:04] Niels

Cem, since you are getting warmed up here on an early morning in Chicago, where do you want to go next with some of the topics that we want to pick Dave’s brain about?

[00:14:16] Cem

I think it’s best to start from the beginning. When David and I got together, at RMC in Austin, as he mentioned, he gave a wonderful presentation. He does this presentation quite often. This is one of the things he knows better than anybody and presents very well on. There are a couple of items there that I just want to lead off with. You already referred to it, but your broad framework of really the football pitch and cutting both sides.

I’d love to have you walk through, for our listeners, the importance of using long volatility and owning convexity. That sits at the core of both of our views, but I think you do a better job expressing it than almost anybody. If you could even speak to maybe the scale of compounded returns, the difference that comes from that, and also why geometric returns are so important. I think that’d be super helpful to start out.

[00:15:23] Dave

That presentation, which is a format of a form of a presentation I always talk about, it’s my 10 to 15-minute presentation version. I just lead off with a simple picture of the S&P, which over 40 years, 480 months, has compounded from $100 that becomes $2,740. But if you miss the 10 best months, instead of that $2,740, you only get $962.

If you miss the 10 worst months, that $2,740 becomes $10,166. And then we just do some mathematical gymnastics and say, for the total 40-year, 480-month long-term compounded return, the 10 worst months contribute a little over 40% of the return, the 10 best months contribute a little over 30% of the return, and the middle 460 months contribute 25% of the return.

And yet, in what I call Sharpe world, the traditional financial maps of random walks and Brownian motion and normal distributions etc., we’re all taught to ignore the two percentile wings and focus on the expected center of the outcome. And yet 75% of the returns are driven by the two, two-percentile weeks.

So back to what I said just a second ago, the compounding portfolio is the one that benefits from divergence from the means, not one that disbenefits, so, using Nasim phraseology, the antifragility. And then I take the shadings of those percent contributions and I overlay them on a football pitch.

I draw, on that football pitch, the normal probability distribution and say, that’s the frequency of where the ball spends time in a football match. 96% of the time, it spends it in between the two penalty boxes. Only 2% of the time does it spend it inside the two penalty boxes. But the entire outcome of the match is determined inside the two penalty boxes.

So that’s the perfect analogy for investment portfolios. Because our eyeballs are focused on the 460 months, the financial industry, the fiduciary industry wows us with all their incredible midfield passing and movements. All their activity that catches the eyeball and has so much sophistication and flow and beauty to it and has no impact on the compounding path.

In fact, I’ll argue, and you guys know I’ll argue this, is explicitly ignoring the compounding path and focused on the ensemble average of 200 parallel universes in one slice of time and ignoring where all of the impact of compounding comes, which is in the big numbers in the weeks. And then I draw, what we call, an entropy curve, Shannon’s entropy, the inverse of that, and shade the area underneath that curve per the shading of our contribution to the returns of that 480-month path of the S&P.

It’s the area under the entropy curve that is actually the contributor of the compounding. So it’s not the frequency of the monthly returns that matters, it’s the magnitude of the monthly returns. Trying to get people to understand, and you’ll hear me say it over and over again, the biggest flaw in the financial industry, and what I crudely call the Sharpe world, is that there’s not a metric or an incentive for compounding.

Obviously, what should be the end objective of the capital owner, terminal geometric compounding, is ignored by the financial industry and the Nobel Prize winning mathematics and academia all hardcoded in the regulatory construct of Basel I and IAS 19 and Solvency II and etc., that we all function under. In a sense, that destruction of compounding is the destruction of wealth, or, to Cem’s constant story, it’s literally a transfer of wealth from savers to the financial industry.

It’s a disgrace and I rant on and on about it. I’ve probably told you guys this before separately, I wrote letters here in Singapore, like Nasim was doing in New York, for my regulator here to take it to Basel to say we should not embed value at risk in the original BIS regulatory capital guidelines or you’re going to end up where we ended up in 2008. But that fight, you guys know well, I’m not coming anywhere close to winning it.

I’m not making any progress in it except for the few willing and visionary clients investors, that guys like Cem and I have that have, that have caught on, jumped on board and massively benefited. It’s the best five-year history for a convex barbell portfolio maybe ever, and certainly the best relative outperformance over a traditional 60/40 or risk parity or Sharpe world portfolio that’s structured under the misspent belief that correlations and volatility are constant. With that compounding separation, you’ll never catch up.

I have this conversation right now, Cem, you probably have the same all the time, with people telling me how pension funds or endowments or family offices, they did okay last year with their mid-single digit returns, and they avoided all the risk that was out there. Last year was just a blind layup to be up 30% in just a simple barbell strategy of long equities long vol. And you just missed a 30% compound that your end capital owner will never catch up on.

So that’s the lead into my presentation and then I show some simple hypothetical examples on the impact of compounding of the relative concavity versus convexity of a portfolio against a benchmark, and then show some real-world examples of how you construct that and how you do it. Now, easier said than done. This is, maybe, the number one conversation I have in email, or Twitter, or LinkedIn, is guys saying, well, how do retail guys do this?

For whatever reason, they don’t want to let the retail guys do it. They don’t want to let me be an ETF. They don’t want to let retail guys invest in a strategy that protects capital. Now, out here, and increasingly as Cem talks about all the time, over there, they’re more than willing to let guys short volatility in structured products that expose them to unbounded ridiculous risk with incredibly negative asymmetric return dynamics. But the inverse of that is very difficult for the retail to access it. I wish somebody could explain that to me. So that’s that presentation.

The whole presentation, again, I was telling Niels before you jumped on Cem, I’m sick of central banks so I’m trying to be mathy in the December presentation and write another version of convexity bias and volatility tax and that sort of stuff. So yeah, it’s what we’re passionate about and we just want to help the whole world have a better retirement. It’s a constant fight to get that.

[00:23:21] Cem

Yeah, I wanted to highlight that up front, because, like you said, it’s the most important thing but is rarely talked about anywhere else. So I just wanted to really give you a platform to highlight that.

[00:23:33] Dave

That was the title of it was “One Thing” and then I lead off with the City Slickers clip of Curly saying, “The secret of life is one thing.” We all innately know that because where you have skin in the game, we know that it’s a non-ergodic path that we have to avoid bankruptcy, we have to avoid the car crash, in my race car analogy, we have to avoid the solvency barrier in our investment paths.

While, in that ensemble average of 200 parallel universes, in one slice of time, it may seem very unlikely that you get your two-percentile outcome. But in your path of your life, of your investment path, I guarantee you get your two percentile outcomes by definition, and it’s those two percentile outcomes that will drive your terminal capital far more so than all of the rest.

[00:24:26] Cem

Yeah, and you mentioned an important word there, path. So in the end, entropy always wins. But in between there, we can have periods where things don’t work, and that’s the reality of just randomness. But some things are not necessarily random over shorter periods of time. Someone highlighted another thing that you brought up in your presentation, I just want to talk about that a bit as well. You brought up a wonderful graph of history going back 800 some years.

Rarely do we get to look at the world in 800 years of actual data as it relates to things. This was the UK’s 20-year average inflation versus inflation volatility. It really highlights how unique the period 1997 to 2016 were. There was really, really, incredibly low inflation relative to all the other 800 years of history, and particularly low inflation as a function of the volatility of inflation. I have several ideas and thoughts of why that has been the case, but I’d love to hear your thoughts.

You also expressed a regular refrain that you believe the genie is out of the bottle at this point, that the nature of unprecedented historical volatility suppression is coming to an end. So I’d love to hear your thoughts on both those things, how they may or may not be connected. Why do you believe we’re in this type of period and why do you think we’re normalizing, potentially, to the long-term path?

[00:26:15] Dave

Yeah. I think as much as you talk about it, Cem, I think we went through a very similar complexity in the ’60s, and that led to a structural change: the 1971 release from gold, and launched us into a decade of volatility, of divergences from the mean where, imagine, a highly convex investment strategy would have been a lot better in the ’70s than just your standard 60/40. It would have been a lot, lot better.

You’ve got the double whammy of the defeat of inflation or the restoration, the Paul Volcker restoration of price stability. Let’s fight it. And then you have the Greenspan era of the modern era of inflation targeting. They call it inflation targeting, I would call it price stability.

I hate the blending together that inflation is the CPI index. Inflation is the growth of money and credit and a measure of the impact of that is the CPI index. Now the nomenclature is you just call that inflation. But they targeted that. They violated Goodhart’s law. They took a measure and turned it into a target and it became useless as a measure. It’s that picture of those dots that I know you guys have seen on my right.

It’ll be in this month’s write-up again because it drives my argument. Hey, look how important a convex, anti-fragile, resilient investment strategy has been for the last 10, 15, 20 years. Imagine what it will be when this dot starts going up. I show in all my pictures, you can see, that we’re in a regime shift in the last four to five years now, where that dot starts moving higher and to the right.

So, inflation is going up and volatility is going up. And the benefit of a convex resilient investment strategy, the separation to the traditional strategy has been exponential. Poof! Off you have gone. Because you’re capturing these divergences.

I feel strongly, and Cem knows, that that’s a great proxy that foregoing of the suppression of price stability, the Minsky stability begets instability, flows through the entire system with high nominal GDP volatility, which is what we’ve seen: unbelievable third quarter nominal GDP. Who would have predicted that eight years ago? Nobody. That means high interest rate volatility because the central bank has to now react, right or wrong. It’s written into their mandate that they have to respond, and so they do. That creates interest rate volatility, which then creates all kinds of volatility such as commodity market volatility, as Cem and I are happy to talk about, but it’s probably boring if we go too far.

The whole thing creates a whole bunch of sociopolitical volatility the world over. The application of this volatility suppression of price stability, and the impact of a period of productivity growth and on-lining of globalization, that should have led to declining prices. It was offset by a mass input of money and credit into the system through monetary policy, which resulted in massive asset inflation (which they don’t measure, ergo inflation), but is obviously the root of wealth segregation and fragility in social systems the world over. This inevitably has led to the Arab Spring and the proliferation of sociopolitical instability that’s now gone from being internal revolutionary Civil War instability to cross border and cross continent.

That somehow needs to be stopped because, as in Neil Howe’s fourth turning, we know that the last time we went through this problem, in the ’30s, and factions of the world printed money to avoid their version of the depression, it didn’t end very good. So, hopefully, there are more rational heads around and, at some point, the forever proliferation of government debt, forced into the hands of in-savers through badly incentivized and regulated financial institutions in the form of financial repression, stops.

I think I heard Cem or Niels, one of you guys talked about this on your group call. It’s the largest election year in the history of the world. There are more people voting this year than ever. We’ve gotten a taste from places like Argentina and the Netherlands of the directionality of that dissatisfaction with the voting process. So be convex.

[00:31:36] Cem

We completely see eye to eye on this stuff, not surprisingly. The word for me is control. The Federal Reserve had complete control over that period. They were able, as I mentioned before, to do unlimited monetary policy because of the deflationary regime that was set up before them. There are two mandates – price stability and growth. If you have slight deflation or deflation, and you can stimulate into it to continue to generate growth, it is a perfect machine.

Why wouldn’t they do that forever? Pretty easy, right? Do more monetary policy, put more oxygen in the system, just create bigger dinosaurs. But the problem, as you know, is inequality. And that’s the thing. You can’t reduce a system to two elements and run the whole economy based on two because guess what? It’s not that simple. We have human beings in this system and those human beings don’t just care about GDP maximization.

They feel that it is important, because we are human, for something that is fair or more just. When things are unjust and politically, as a people, we decide to maximize median outcomes as opposed to mean outcomes, there are subtle difference, major differences in outcomes. Now we have to give people money. We have to take money from the top and rebalance. All of a sudden, things look a lot more like they used to: a machine where sending money to people, demand-side economics, matters again.

So we’re moving out of a period of pure Federal Reserve central bank control because they can’t control it anymore. Because the political forces have now come up that say, you know what, there’s another thing that’s important. You can’t just do this game anymore. You have to worry about us, the people in the system. So I believe that’s the big difference.

Greenspan, in 1996 (it’s not a surprise that this starts in 1997), realized that the natural state of unemployment could be lower without pausing inflation, and so they did more, and the experiment, the grand experiment, began. But as you always mention, you can kind of push things into a direction. You can assume that things will go great because in front of you, they seem to be going great. The volatility is low.

I think this will lead us into the next conversation, but what you’re really doing is you’re creating more and more pressure in a system the more you do to generate more growth with a natural means. You create, what I would call, a sumo market or these tectonic plates. At the end of the day, that system is not the same as no pressure. Yes, it may mean no volatility. Two equal forces pushing against each other may mean no volatility, but it’s not the same thing. When those plates shift all of a sudden, you get an earthquake.

I think that’s what’s happening here. We’ve been building up pressure in the system and operating in a very simple system because we could during some period of time say, “Well, we’ll deal with the consequences later, if there are consequences. We’re not even sure if there are,” but there are always consequences. There are always consequences and that pendulum swings.

But we created, arguably, a 30, 40-year period of growth, peace, cooperation; the growth of China, globalization, and unwinding that is very difficult. It’s not a coincidence that in the 1970s, the last time we saw this, we saw the growth of a Cold War, Vietnam in a hot war, that was kind of an extension of that, a proxy of that. We had OPEX and commodity scarcity and flexing of muscles in any way you could, deglobalization broadly during that period, and of course greater and greater fiscal spending.

All of it is happening again. But now, with all the malinvestment, all of this mean reversion from a very off the graph spot, I think that’s what people have to be broadly aware of in terms of the path. Entropy always wins. But when the path goes one way, particularly far, that entropy can be very fast. and sudden. and dynamic, and even more convex. Anyway, that’s my extension of what you’re saying.

[00:36:43] Dave

Yeah, it’s Minsky. Stability begets instability. It’s self-sabotage. This is the propping up of the sandpile, just keep propping it up, and you’re just creating more fragility. It’s the forest fire analogy. You put out every fire, you create so much fire risk that you can’t control it and, eventually, you get the fourth turning. You get the reset dynamic punctuated equilibrium in evolutionary biology.

That’s how the world evolves. It doesn’t evolve gradually. It evolves in big jumps with long, long periods of stasis in between. I had the joy, I don’t know if I ever told you this, guys, I got invited to a Greenspan breakfast. I think it was one of the preeminent investment banks that invited me shortly after he’d retired. Somebody asked him the obvious question, how do you deal with the dichotomy of the dual mandate? And he said roughly what you said, Cem.

He said flat out, we remove, from our measurement of price stability, assets and then we use our monetary policy to inflate assets. So, we get the wealth effect of growth through the asset inflation, and we have stable price stability because our policy is directed at asset inflation, and we don’t measure it. This was Greenspan. This is 2000 something. When did he retire, 2006, something like that?

So we’ve solved the dichotomy. We’ve solved it. I’m the great maestro. We drive growth through the wealth effect, and we don’t count the asset inflation as part of our price stability measure. Now the two objectives are complimentary.

[00:38:29] Cem

Amazing, right? Again, we’ve seen these things in the past, but the pressure and the extent to where we’ve gone along that path this time, I think that makes it particularly out of statistical historical precedent, at least in recent historical precedent. I think that’s the part that’s particularly interesting.

[00:38:49] Dave

I don’t know if we talked about this last year, but we talked about a lot. There’s a lot of comparisons to the ’70s. Cem, you do comparisons to the ’70s in terms of the behavior of markets. But the obvious difference, and this is a difference that was pointed out on a group email chain from an old friend – a famous hedge fund investor in New York, there’s the obvious big difference.

Paul Volcker was dealing with 20% of debt to GDP when he decided to fight inflation. Jay Powell is dealing with 120%. Not just in the US, but in Japan, Europe, UK, the entire world has blown through the rubicon of 100% of debt to GDP. This is a big problem. So, this gets to the whole conversation. A lot of what we were talking about last year, who’s going to own the 40 – fiscal dominance.

The concept is that there’s only so much the central banks can do before they have to start buying the bonds again. As we saw from the treasury borrowing advisory committee, just before Janet shocked the market by reducing her duration issuance, they said we can’t buy any more duration bonds. Stop it, we’re full. This is the big challenge, and this is the loop that everybody, when you start talking about it, that you say, “Wait a minute.” This is why I say the recession is the good outcome.

The bad outcome is, I titled (two months ago) my write up “The Hunger Games.” Janet Yellen is Katniss in The Hunger Games. She’s going to get hers. Trust me, she’ll fund her deficit, but she’s crowding out everybody else. If you want to argue that the prognosticators are right and that we’re going into recession, I would argue that the most obvious sign of that recession is the declining lending in the US banking system, in particular, the regional banking system who have been incentivized to hold on to their treasuries, that they can repo at face value, and not make any loans to anybody else. It is explicitly crowding out.

That crowding out isn’t just relevant in the US regional banking system. It’s relevant in bond markets and capital markets all around the world. If the banks who have held all of these bonds as zero risk weighted assets, and hold to maturity, and accumulated, in the case of Bank of America, the famous $130 billion of unrealized loss, and they don’t want to buy any more, obviously, you get into a loop that the outcome is really hard to resolve. It’s what I dubbed, at the Jim Grant conference, the ‘great stop loss’.

People start saying, “Well, I’ve had enough, I’m getting out before everyone else gets out,” even though I’m sure that CFO of Bank of America, he doesn’t have to mark those to market. He says, “I’ll just wait till they mature at face value.” It’s a one hundred and thirty billion unrealized loss because you have got a trillion dollars lent out at 1.5% when the current market rate you could be lending it to your clients at six or seven, there’s somebody on the board saying, “I’m not sure that’s a good business model.”

[00:42:09] Niels

I wanted to maybe just step in here with a thought that I’m not sure I’ve completely thought this through. But I’m curious and I can’t imagine anyone better to think about this and give some views.

So, when I got into the financial industry in the ’80s, even though we had already started this path of globalization which essentially led us to this extreme carry regime, everything was super stable just as Cem pointed out from the chart also on inflation, back in the ’80s, the world was not the same.

So, the Far East could be doing well, Europe could be not doing great and the US could be in a recession or whatever. We were kind of moving in different directions. Both of you talk about, at the moment, that we see these pressure points building up. But at the same time, I think we can probably agree that globalization is not where we are heading right now and haven’t been for the last couple of years.

So I’m just wondering, is there something good about deglobalization that might help take off the pressure between what is going on in different parts of the world? For example, as an example and maybe not tied directly to globalization or not, the Bank of Japan has engineered something interesting with the bond holdings because they took them out from the banks, which we now see in the West are full of them and that’s not a great situation, but they seem to have not only done that, they’ve re-liquefied the JGB market to some extent. So even though we’ve kind of been pooh-poohing the Japanese model and what they were doing for decades, maybe there’s something we can learn from them. I don’t know, this is thinking out loud.

[00:44:16] Dave

Well, I don’t know what we learn. I think we might learn that a period of not driving inflation has created a stability and homogeneity that doesn’t exist in most other cultures right now. Now, obviously the demographic problems there are a different problem to solve.

You know I spend most of my time looking at Japan and China and what’s going on in the second and third largest economies in the world that too many people, I think, aren’t looking at most of the time. Instead, they are calling Cem to find out whether the VIX is going up or down tomorrow.

So, Japan, I think, is really interesting. We talked about it last year, and I’ve been saying for a long, long time, is the most dangerous peg in the world. In a sense, they’ve eliminated the YCC peg. It took them three stages and steps, over a quarter, effectively, and it’s gone now. There’s no more line in the sand. There’s a reference point. They’ll buy bonds when they need to. Meanwhile, they’re still at a negative policy rate and they’re still doing full QE. They still bought a trillion dollars worth of JGBs last year, and they’re still buying on their regular schedule, and they’re still there to buy more should they deem it necessary.

But by stepping away from the original line in the sand at 25 basis points and then 50 basis points and then 1 to let the pressure out of the system. I thought Grant Williams described it great when we did a chat a couple of months ago. He said it’s like The Matrix where they fired the bullets, and they were coming slow enough that you could dodge them as they came. So, it let the system kind of clean up that. Now, that’s the 10-year part of the curve.

They still have negative front-end rates, and there’s still some problems in how they make subsequent adjustments and challenges. It’s not easy and straightforward. But as you said, Niels, I’m a huge advocate. You guys know I don’t have a view. But you can see some sharp differences between Japan and the rest of the world. Higher interest rates don’t hurt the private sector in Japan. Notoriously, corporates and consumers don’t borrow. They’re not levered up.

The corporate sector in Japan has done the opposite of the financialization of equity markets and balance sheets that’s gone on in the West. They’ve gotten all of their profits through efficiency. They’ve squeezed costs. All of their profitability comes from margin efficiency and the market assigns no price multiple to that whatsoever.

Higher interest rates would, in general, be a benefit for the private sector in Japan, be much less of a scary risk to the banks. Again, the Bank of Japan taking over 50% of the JGB market was almost a direct transfer from what the banking system used to hold. So, pension funds and insurance companies, their share of the market remains constant, and bank share collapsed as Bank of Japan took it over.

Much like GDP growth, C plus I plus G, GDP growth was constant for 30 years, and the share of that of consumers was constant, and there was an inversion of government in investment. So government took over and crowded out all investment. So I said this, I think I said this maybe with Grant the other day. To me, I have this idea in my head that Japan looks like the US coming out of World War Two. The US had been through the Great Depression, which is simply just the total destruction of private sector debt.

Private sector debt in the US, which was the depression, went to zero. And then you had another five years, four to five years of austerity as the only borrower in the system was the government to fund the war. Then, when you came out the other end of that, you had this massive (at the time) highest ever government debt, and they shrunk.

You had a completely clean private sector balance sheet, and they crowded the whole thing in, and you had this long, sustained period of stable growth until the credit went too far and the government started borrowing aggressively again in the ’60s. Then you got inflation, and they released the gold peg, and the inflation accelerated, and you got the other end of that cycle.

As Cem would say, everybody moved to the other side of the boat. Japan has that sort of look right now where you can make an argument that such a significant portion of the private sector benefits from higher rates. But I still think it’s the most dangerous peg in the world because what does that mean when that whole private sector has been the largest net foreign investor, net foreign creditor ever who says, jeez, our opportunities are better now back home.

[00:49:15] Niels

But at the same time, I’m sure I’ve heard you say it’s not the most dangerous peg for the Japanese, it’s for the rest of the world.

[00:49:22] Dave

Yeah. That’s it. The reversal of those flows, I think, is a very logical and rational thing (again, I don’t know anything). My positions are all about what I don’t know. But Dave Dredge is a guy who sat around and paid attention to a lot of economies and markets in Asia for the last 35 years. You can make a pretty good argument that this could generate a reversal of flows, and that has implications because Japan, for a long time and really right now, is the last provider of liquidity to the Hunger Games.

Everybody else, with the shutting down of QE by all the other big central banks, banking balance sheets are full, the available capital because it’s been overextended through the application of leverage in 60/40, risk parity, bank balance sheets, liability-driven investment strategies, is unable to absorb more and add more leverage to that because it turns out that correlation is a dis-benefit not a benefit now.

So the last guy putting an extra trillion dollars of liquidity into the system, and to Cem’s point, forcing interest rates to zero in the front end, and incentivizing the continuation of this carry trade, if he says, I’m going to flip over and join the other side of the Hunger Games, it’s a problem for the system. The extension of that, and I’ll talk about it as much as you guys want to, China is the other big part of that story.

China was by far, firstly, the singular credit impulse creator for a decade post the GFC. Now they’re going through their own post-excess hangover in some spectacular fashion. If you want the opposite argument to the Magnificent Seven are ridiculously expensive, go and look at a few Chinese stocks in Hong Kong.

Hang Seng Index is back to the 1997 level. There’s cheap value, but there’s all kinds of arguments why it’s cheap. It’s not obvious that it’s a great opportunity. Funnily enough, I think when we talked last year, everybody was all now’s the time to get back into China and Hong Kong. You had this massive rally from November to January, and then everything is down another 30% from last year’s lows despite global stock markets having a really, really good year.

China’s doing everything they can to manipulate and hold their currency steady to create the impression and the benefit of suppressed volatility of the currency and try to keep flows coming in and not scaring away and are absolutely insatiable in their appetite for inflows. And yet, registered famously, I’m sure you guys may have seen the chart, the first net outflow FDI month, since they opened the market FDI flows sort of thing.

So there’s all kinds of interesting challenges and interesting opportunities out here. Cem knows, we’re all sitting around the drink table in Austin with Cem, and Noel, and Devin, and the other professionals in the US volatility markets. All they want to talk about is what I’m doing in Asia, in China and Japan. They’re so bored of talking to each other about VIX and S&P vol. They’re like, Dave, come on, tell us something.

[00:53:02] Cem

Yeah. I don’t want to stop talking about this. This is the really interesting stuff as far as I’m concerned. I’d love to dive a little bit more into that. As you mentioned, very astutely you highlighted the last two times we essentially had a clearing of the debt. You call it a debt jubilee or whatever you want, but it was a subtle one. The de-pegging of the dollar from gold was essentially a debt jubilee.

I think this time, yes, we’re at 120% of GDP, and it’s almost, I would say, inevitable that we’re going to have to somehow monetize that debt or get rid of it. Japan did it, as you highlighted, by just buying a greater and greater share of their debt. They were able to do that, to a large extent, because of the carry trade and because their currency rate wasn’t affected.

Much like in the US these days, anytime we have some volatility, or we have some increase in QE, the dollar gets stronger. We have the exorbitant privilege. That’s what allows us, in your Hunger Games model, to be Katniss Everdeen, to crowd out everybody. Japan did that for a while. It took them a while and it was painful to growth, in some ways, but maybe for other reasons, as you highlighted there, that are somewhat different.

I’m curious to hear, is there a monetization that’s relatively allowed by the world? One of the best things for equity values of entry was the US de-pegging from the dollar. It allowed that , much like World War Two did, for a new run in the US. Is the US going to get away with that and could Japan just keep doing this at this point? Yes, they’re at 260% of GDP, but if they own all their own debt, does it matter?

If we just hit a button one day, 10 years down the road, and say, okay, we’re going to take the Fed in Treasury and they’re just going to wipe it clean, does it matter? I know that in between here and there, there can be lots of unforeseen circumstances, lots of volatility. I agree with you. It’s the unknowns. There is a lot more unknown than ever right now. But I just would love to hear your thoughts about where do you think this goes?

I know you don’t know, and nobody knows. But if you had to guess, where are some of the pressure points and where you think some of the greatest risks are? As Niels just mentioned, maybe it’s not in Japan specifically, but maybe it’s the effects Japan has on other funding markets. I would love to hear a little bit more of your thoughts, and specifically how you think that plays out.

[00:56:02] Dave

Yeah. I think, again, the answer comes from Japan. The core of my belief is they have a huge opportunity. Key to that opportunity is the government crowding in the private sector. So it means they have to get their head around that deficits need to shrink. In fact, I say all the time, in these big global Hunger Games, the winner will be the first guy to shrink their deficit. The guy who reduces the supply of bonds is going to be a big winner in this process.

Japan has the biggest overhang but is in a unique situation that it might be easier for them to shrink supply than just about anybody else because their private sector doesn’t get hurt by higher rates, in that sense. Whereas it’s really difficult in the US because of this sensitivity to higher rates, and as you’re trying to restore price stability.

I think the analogy is post World War II in the US. You can imagine post World War II in the US, I assume you guys know, you know, they did YCC. They pegged the 10-year treasury at 1.5% and allowed inflation to run hot. But while that was happening, they shrunk government debt and that brought in private sector debt which resulted, arguably (call me Frederick Hayek biased), bringing in for more efficient investment and productivity growth over the next decades than if the government was the one spending that money.

I think Japan, very much, has that opportunity. So, what I would imagine, the good outcome is that they keep 10-year (which has currently come all the way back down to 60 basis points having been up to 1 when it was the red flag, and the bull was a hard line in the sand), keep it below 1.5% and tolerate (which they’re obviously showing they’re willing to do), tolerate 3% or 4% inflation for a little while, and while you’re doing that, shrink the deficit, shrink the bond supply.

Yet, all of that entails that you have to stop doing QE. You have to stop buying all the bonds because then you won’t keep inflation steady above 2%. That means, again, this transition in the banking system, those bonds inevitably have to find their way back onto the bank’s balance sheets, the ongoing issuance in rollover of debt, etc. Which then raises the question, how do the banks make space for that? Now, I don’t know what’s going to happen or whatnot, but I do know that Japanese banks are notoriously large investors in synthetic credit products all over the world.

Obviously, particularly in Japan, but not unaware in CLO structures in Europe and the US. They are the largest single investor in almost every single thing of significance. So, you can imagine those things which are complex risks and have arguably mis-measured or undercapitalized risks in them, because of the utilization of Sharpe world mathematics and how the risks are calculated in the tranching and correlation assumptions embedded in those synthetic structures, is a place that I think people should be concerned about.

We’ve seen, in the past ,when Norinchukin decides they’re going to, for whatever reason, reduce their CLO purchases in one year has massive implications on US CLO markets. Imagine if they decided to bring money back out of those markets because they’re happy to own JGBs. So, I think those implications on how those flows shift, the obvious implication in dollar-yen, if that were to come to fruition every time there’s been a global unwind of carry, that has direct implications on the directionality of dollar-yen, it goes down because the yen is the funding currency of the world.

Now, arguably right now, more so relatively but maybe not on as a large and absolute basis because I don’t think there’s as much FX carry in the world as there once was, but on a relative basis, the yen’s role as the dominant carry currency for obvious reasons as everyone else’s interest rates went up, and dollar-yen in this process since early last year has gone from 100 to 150, now 145.

Well, all of that is that outflow as they were the last guy providing liquidity, and the reversal of that as obvious potential implications. And then that has implications again, the feed on effect to China, because China in itself is fragile because of their own credit overhang. Their role in the world is fragile. Their sensitivity to outflows is fragile. Japan is a significant, significant both financial investor and real economy investor.

Japan has a lot of manufacturing. They were the first to expand manufacturing into the emerging market world. Japan’s a major trading partner with China. And then, of course, the other thing, and I think Jasper talked about this with Brad the other day, something that I think is really under talked about is Japan’s role in a security sense out here. Everybody’s well aware of the frenemy relationship frictions right now between the US and China and China’s clear aspirations to re-assume Taiwan.

There is no doubt that Japan is the number one key security relationship for the US in the Pacific. Nothing else is even close. And yet it gets almost no attention on the matter. The US is by far the number one most important economic relationship in the Asia Pacific and gets little press about that. Japan has, by any measure, the most high-end sophisticated manufacturing technology capability in the world.

When the US needs really, really, really high end, sophisticated defense stuff built, it gets built in Japan. I’m obviously here. I’ve been doing nothing but Japan, off and on, for 35 years, but people need to pay attention to Japan. It matters in the world in all the geopolitical stuff.

I don’t watch any US TV or news but I’m guessing that you hear about Europe and the EU and Ukraine 24/7, with the occasional dig at China, but you probably hear about Japan something in the vicinity of never. Even on CNBC you don’t hear about Japan. You might hear about it today because Nikkei made a new 35-year high today. Like I said, that equity market, is not so uninteresting.

[01:03:11] Cem

Yeah, I couldn’t agree more with all that sentiment. I do think Japan, whether you think of them as a proxy or just as a one-two punch, is the West’s proxy in the east. I think all the activity in the volatility is going to bubble up in the East. The primary beneficiary, the greatest beneficiary over the last 40-year Federal Reserve experiment has been China. That’s the biggest thing that’s unwinding.

How do you put that back in the bottle? You don’t. That ends with a step function, and that’s what we’re beginning to see, I think. Japan, on the other end of that, has gone through its rebalancing period and is in a position to be a counterweight there. It’s a dynamic bitches brew, if you will. Who knows which way it’s going to bubble up? But I have some ideas, and some of them are related to everything that you’re saying.

[01:04:26] Dave

Cem and I both say all the time, Niels, volatility and liquidity are just opposite sides of the same coin, literally the same thing. We go back and forth saying we’re value investors in volatility or we’re just a big asymmetric store of liquidity. But liquidity suppresses volatility.

The biggest provider of liquidity in the globe is Japan. So if you think about where I’m looking for cheap volatility, it’s where that liquidity is going, because that is the cheapest volatility and the thing that has those conditional Bayesian tails, should that liquidity reverse. In a sense, simplifying my day job, all I have to do is go and follow that liquidity.

Now, conveniently, the Japanese are the original, original buyers of structured products with embedded short volatility to create yield. They are the original levered short-vol, carry trade, global investment strategy in the world when it comes to banks, pensions, insurance companies. I just have to wait for the phone to ring and find out which banks got vol they want to sell me that’s coming out of that activity.

Now, in the good old days, that was coming out of Korea and China and Singapore, everywhere. Increasingly, it’s coming out of Japan. Korea is not so enthusiastic.

[01:05:06] Cem

And the US, now, actually. Interestingly.

[01:05:48] Dave

Now the US, which is great. I think I told you this, Cem, that everyone’s whining out here because now the CBOE and CME have opened up overnight trading desks on VIX and S&P vol. All of the volume has shifted that in Asian time instead of the behemoth they used to be. It used to be that we traded more KOSPI vol and Hang Seng vol and Nikkei vol out here today than the US traded S&P vol.

But now, because you’ve got this global market of S&P vol, with the structured product activities going on, you say, well, let’s just do S&P, it’s easier.

[01:06:31] Cem

Yeah. I think that the last thing I want to really dive into with you, and I think it’s so important. You get that being out east. But the structured product phenomenon has become so critical to the vol compression story. Again, it used to be in Korea and Japan and Singapore because of the retail component and everything else that exists out there in a different form of investing.

But here, it’s getting greater and greater dominance. The interesting part is the reason. Here it’s not as much because of retail. Mom and Pop buying out of call vols and doing the whole thing. Here it’s because interest rates, actually, ironically have gone higher.

[01:07:19] Dave

Yeah. It’s weird.

[01:07:20] Cem

This is globally the case. If you think about structured products, derivatives didn’t exist until the 1970s and structured products globally didn’t really get going until the ’80s and ’90s. So we haven’t had an inflationary period yet where derivatives have been around, where structured product issuance has been happening to the extent that it’s happening.

If you look at year over year growth, it’s off the charts. It makes sense. There’s a value proposition there. Because derivatives are capital efficient, you can get your 5.5% in the US or wherever you are, you get your higher yield and now you can stack your structured product on top of that. That yield is very appealing, particularly in a world that’s increasingly scary and volatile, where markets in two years at least in the US haven’t gone anywhere.

Other places have gone down. So there’s a clear value proposition relative to several years ago, and that’s driving this demand. It makes sense. It makes logical sense. But the great irony is that money, during inflationary periods, used to go from the stock market to the bond market and liquidity used to come out of the market. Now we’re pulling money out from the stock to the bond market but also into selling volatility, which is now compressing the indexes at the core.

What we’ve got (we talk about this a lot, and you and I talked about it at RMC as well) is massive dispersion. You have the constituents of the non-vol centers still moving with idiosyncratic risks. If you’re away from the center, liquidity is being pulled out of the system so volatility is increasing. But if you’re in the center, it’s still becoming more and more pinned. It’s like a donut.

I’d love to hear your thoughts about that, being out east in particular and having a different perspective, because this has been a thing out there for quite some time. How do you invest in that environment? When does that break? If interest rates are secularly going higher and we’re seeing greater and greater inflation, we’re going to see more and more structured product issuance as that goes and continues to provide vol to the center of the indexes, where do you go? How do you play that? How does that break? I’d love to hear your thoughts.

[01:09:34] Dave

Yeah, that’s a great one. Maybe this is a good way to sort of wind it down, Niels. In my note back to Niels, I mentioned this, that you and I talk about this. You’ve got the early-stage dynamic where the vol selling is in the front end, is gamma, is delta, selling short-dated puts or whatever. It plays in very well to your active market making trading activity because you’re getting cheap gamma and the ability to express short-term directional views on the other side of the short flow imbalances around that. But it’s really concentrated, as you say, in here, not out here.

Now, what we saw in Asia, over decades, as vol came lower as interest rates came lower, as real yields came lower, as the appetite and the comfort with doing these things went up, those products became more and more complex, more and more long dated, and started embedding much more, what I would call, leverage as opposed to underlying and realized risk. I always think of vol selling, or option selling, as providing non-recourse leverage.

The big risks in the big unwinds isn’t per se your delta exposure or gamma exposure to a pickup in realized vol or a decline in the underlying index. The big risk is you have got to go and buy back the non-recourse leverage. When that non-recourse leverage has evolved over year, after year, after year, of this work, so I’ll do something more complicated, more levered, longer-dated, more embedded third and fourth-moment type risks, and that starts to get recycled in the system.

I think I’ve talked to you about this before, in ’08 when S&P sold off in the aftermath of Lehman and etc., you had the big sell off and you had a spike in VIX, but 12-month S&P vol hardly moved, relatively speaking. But out here, because there was so much of this non-recourse leverage around that risk of the sell-off, the guy can’t just buy back his one-month puts. He had to go and buy back two-year, three-year variants, whatever the accumulated end of that provision of third, fourth moment risk, vol of vol convexity risk.

We’re trading multiyear KOSPI and Hang Seng in the high hundreds. Now, the asymmetry of that obviously is much, much higher than the asymmetry of gamma and delta.

So I think what you’ll see evolve, meanwhile, to get from the early stages of people selling gamma and applying very little leverage to the structure but starting this compression of vol that you’re seeing every day right now, that took years to spread out to those products becoming highly complex with multi layers of leverage, and two year, three year, four year five year, ten year structures, where the big, big, big payoff, when the unwinds came, was owning something five years out on the convexity surface.

That’s where the big payouts, really, really big asymmetric payouts came. But it took a long time and there was a whole lot of vol suppression and (your term, we didn’t use that term back here in the ’90s) pinned. But if you want to see pinned, go look at KOSPI and Nikkei and Hang Seng during that period pre ’08, that was pinned and there was no vol. The vol selling was astronomical. But the good news was that there was a zero-convexity premium. Vol of vol was priced at zero in the wings.

I don’t have to be a clever investor to know that if I buy something zero, it’s bounded to zero, my asymmetry could be pretty good. I can buy that for 5 years, 10 years, and I don’t really care if there’s no realized vol for 5 or 10 years. I’ll get there eventually. I was saying this to Niels earlier. This is a little bit what I’m trying to write about for December.

What we’re trying to do in that environment, and we were talking about this last year about how we’re trying to build distributions, what we’re really trying to do, Cem, we’re not trying to project a probability distribution, we’re trying to project a possibility distribution.

So we’re trying to measure that entropy outside the probabilistic and then saying, well, geez, if I can own something that implies zero vol of vol two years, three years, four years, five years out, the possibility of a Bayesian conditional shifting of the existing probability distribution has enormous asymmetric impact on the pricing of that option, variant swap, skew structure or whatever. That’s really what we’re sitting out here doing.

So I’m fascinated. In fact, I’m probably spending more time talking about S&P vol than I ever have in my career because that’s what the banks want to talk to me about, because that’s what they’re doing (maybe some Nikkei as well because Nikkei is hot right now and so that’s attracting some flows). But yeah, the China market, nobody will pick up the phone if I call them to talk about China. So yeah, it’s a great story.

I want to talk to you guys more because I don’t pay enough attention to it, and yet I’ve spent my whole life doing nothing but paying attention to that stuff. So to see it coming in the US, it’s such a big market, such a sophisticated market, and yet, as you know, it will overwhelm everything else. Nothing else will matter.

When Korean retail traders were full-flow, autocallables, every market in the world’s volatility was driven by Korean retail investors. It wasn’t just KOSPI, but Nikkei, Hang Seng, Euro stocks and S&P. It’s phenomenal. You back it out (and I know this is what’s going on in your head every time you’re thinking about it Cem), holy shit, how much vega risk, how much negative asymmetry, as a group, are these people taking?

We still see it out here. I think we talked about it before. We had that huge surge of private banks in Asia doing accumulator products in June 2021 on Alibaba, Tencent, Ping An, the big China tech companies, and every private bank in Singapore and Hong Kong doing the exact same thing.

Within three months, the whole thing is blown up, and six months later, you’re hearing rumors of billion-dollar unrecognized losses in bank, after bank, after bank, after bank, after bank, on ticket sizes that were only 50 to $100,000 per ticket. It’s phenomenal to scale of it all. So yeah, please keep me informed, Cem, on all that stuff.

[01:15:05] Cem

We have a lot to learn. This is all a brave new world, relatively speaking, out here. So if it turns out that KOSPI…

[01:17:24] Dave

I’ll try to get some of our guys to share some of the stuff and try and see if we can start tracking down the way we looked at KOSPI, the way we looked at Eurodachs, the way we looked at the stuff we started looking at and see if I can see what the in products are and what kind of stuff people are doing.

I have got to believe that the margining requirements in the US are more attuned to the potential risk than they were back in ’08 in Asia, but I’m not sure. It all gets hidden. It all comes down to some basic value at risk distribution, 10-day margin period of risk stuff that really misses the tail.

[01:18:08] Cem

Obviously, we talk about it, we know about it, but I think very few people are looking at or understating the scale of the effects that are coming from that world. I think it’s important. I think doing that deep dive, and we’re trying to do it too, will give you a broad edge and does represent a significant opportunity.

[01:18:31] Dave

My guess, just looking at it from afar, is that it has still not done the duration extension that we eventually sought here. Otherwise, the fixed term structure wouldn’t still be like this.

[01:18:42] Cem

No, it hasn’t. It hasn’t.

[01:18:44] Dave

You go back and look at Asian index vol term structures, and even more so skew term structures, in the pre-GFC period or even pre-COVID, you’ve got inverted term structures everywhere. That inverted term structure is simply supply-driven. So, think about the scale of what that supply must be that it’s beaten down traditionally positively sloped vol term structures to be persistently inverted in vega, in skew, in convexity. The scale of the flow is just phenomenal. So who knows? S&P can get there.

[01:19:28] Cem

It’s particularly interesting in the context of expanding volatility in other ways, like FX vol, Treasury vol. All the other areas are particularly dangerous and during inflationary times have for great reasons a significant uptick in vol. So you could really see a bifurcation of vol, in some ways a dramatic bifurcation, that’s not just dispersion within the indices but across the markets. We already started to see that, honestly, in the last couple of years. My guess is that that continues for some time.

[01:20:05] Dave

Interest rate equity vol relationship is, if you asked anybody two years ago, geez, if interest rates blow up and interest rate vol blows up what’s going to happen to equity vol? Obviously, it’s going higher. It’s an odd pair. Apparently, it’s not. The markets will forever fool you.

[01:20:23] Cem

Yes, they will. Yes, they will.

[01:20:25] Niels

I think that’s a good place to end this conversation with that statement. But I also have a feeling that we may have to increase the frequency a bit and not just make this an annual event because there’s just so much stuff to cover when we get you two together.

Dave and Cem, this has been an unbelievable, insightful, fun conversation. Thank you so much for doing this late at night in Singapore, early morning in Chicago. I have thoroughly enjoyed listening to both of you going back and forth and I’m very sure that all the listeners will as well.

Before we go, let me just encourage everyone to follow, subscribe to the amazing content that Dave and Cem produces because as you can tell from today’s conversation, we are living in a truly global macro driven world, and it is perhaps more important than ever before to stay well informed.

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

[01:21:33] Ending

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