Yield Storm Ahead: Preparing for a New Era ft. Cem Karsan

[00:00:01] Intro

You’re about to join Niels Kaastrup-Larsen on a raw and honest journey into the world of systematic investing and learn about the most dependable and consistent, yet often overlooked investment strategy. Welcome to the Systematic Investor Series.

[00:00:23] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Cem Karsan and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor. Cem, it is wonderful to be back with you this week, a belated Happy Birthday, I have to say. And it’s been a little while as well. So, how are you doing? Has it been an exciting start for you to the new year?

[00:00:44] Cem

Yeah, thanks for the birthday wishes.

Yeah, I had a wonderful last couple weeks all over the US but I’m finally on the east coast with my son kind of touring boarding schools and whatnot. And that was the best birthday present I could ask for.

[00:00:59] Niels

Fantastic.

[00:01:00] Cem

So, a good start to the year, and a good end of the year for us here at Kai and we’re, you know, really excited for the year ahead.

[00:01:08] Niels

Yeah, absolutely, and we’re going to certainly dive into a lot of really good topics that you’ve laid out today. And it’s not like there isn’t anything is happening in the world right now. So, there’s quite a few things to talk about.

But before we do that, and this could be nothing to do with markets. It could be whatever you have been thinking about. I’m always curious what’s been on your radar for the last few weeks at least?

[00:01:31] Cem

Yeah, I think one of the biggest things is when I was on the east coast recently, I went to an endowment conference. I won’t speak to kind of what endowment was heading it, but it just struck me with, you know, 100 seasoned professionals in the room at a prestigious endowment, how much groupthink there was, how not open to the possibility that the 60 or the 40 might not work. Exposure was going up for private equity, up for venture in a meaningful way. Numbers are going to 65, 35, heavy private equity, heavy venture.

And, it just strikes me as kind of recency bias and a lot of people kind of whistling by the graveyard. Particularly given today, for example, we’re seeing yields spiking 5%, which we thought would be by December 31st. We called that. We were about 10 days late here. But we also see, you know, six and a half this year.

So, I think, I think this is just the beginning. I think it’s going to have massive effects this year. So that’s what’s really top of mind but I’m sure we’ll touch on that.

[00:02:45] Niels

Sure, yeah, we’ll touch much more on that. And interesting, by the way, observations about the groupthink. I think you’re absolutely right. I’m sure we see the same over here in Europe.

You know, two things for me have really been on the radar, I would say, in the last week or so. One is of course the devastating news out of Los Angeles. I mean when you watch the television, it’s absolutely horrific.

I know there are lots of crises around the world. This is, probably, not worse than some of the crisis you see in other parts of the world, but it certainly gets a lot of airtime. And it, I think, for me, not only is it disheartening to see, but it also reminds you how much nature, how forceful it can be.

And of course, you know, in my side of the business where we trade all these commodity markets where, you know, nature plays an important role in determining price action. Something you cannot really participate in unless you have a very sort of rules-based approach because they’re hard to forecast. So, I think that was something that linked to that.

And the other thing, of course, which I’m sure has not escaped your attention either is that we’re certainly lot of news out of the president elect. And as a Danish person, I was particularly interested in the fact or his comments about Greenland.

Not that Greenland is particularly new, but talk about military force, talk about economic force towards a small country like Denmark, which has been a great ally of the US for decades, was, to be frank, pretty shocking.

[00:04:21] Cem

Yeah, I mean it’s rhetoric. I wouldn’t read too much into it. It’s kind of meant to elicit a response, an emotional response by not just the people of Denmark, but the world. You know, I wouldn’t read too much into it. I do think the intentionality of what that means in general, what he’s trying to project is important. I think Denmark is safe.

But, that said, yeah, you know, buckle up. That’s the first of, likely, many more of that.

[00:04:56] Niels

Exactly. I think this is really, for me at least, it could have been anything. Right? It just happens to be something that’s close to our hearts over here. But I think it’s a really interesting indication of what the next four years are going to look like.

You and I have spoken about this a lot, but actually, in my wildest imagination, the number of points that are being lined up before he’s even in office, you know, for good and for bad. You know, I’m not criticizing all of these new ideas, but it’s just kind of shows you that we probably, four years from now, will be living in a very different world to what we’re living in.

And I think investors, as you rightly talked about, you know, group thinking, and recency bias, and all of that, maybe those are the two worst things you could be exposed to right now in a world that might change upside down in the next four years.

[00:05:49] Cem

Yeah, and I think it’s an important thing to step back. I mean, you and I have been having conversations for years now. You know, did we foresee a Trump second presidency? No. But the important part is we’ve foreseen the trends that are driving the rhetoric, driving that populist, protectionist rhetoric and sentiment that we’re seeing. And so, you know, as we’ve said before, Trump is a vehicle for something much bigger than who Trump is, in my opinion.

Now he can be an accelerant, for sure. But much like other periods we’ve seen, we’ve discussed, change is afoot. This does feel, in many ways, like a regime change like we’ve seen in other periods. And that’s what we’ve been saying for years. And that’s what again, the ten-year treasury is telling us today as well.

[00:06:38] Niels

Yeah. Quick update before we get into all these topics, a quick update on the trend following part because it’s very related to what you just mentioned.

Weak bond markets, and especially in Europe, actually, the UK is just hitting some really high numbers in terms of yield, some really high levels at the moment. So, they’re in a bit of a bond crisis, for sure. France also having some challenges. And then, of course we can add to today’s news many other countries, I guess.

Long equities, long US Dollar seems to be very constructive for trend followers at the moment. And even smaller markets like (I know most people don’t follow it), but something like live cattle has been incredibly generous when it comes to trend following models. And then of course you have things like gold and silver and even the grains offering some good opportunities.

My own trend barometer is strong at the moment. It’s closed at 59 yesterday. So that should indicate a good start to 2025 for trend followers. And I think that’s correct and I think it’s even yesterday was a good day.

So, the numbers that I have are from Wednesday, and the BTOP50 index was up 85 basis points, obviously for the month and the year, same for SocGen CTA index, up 85 basis points this year so far. SocGen Trend doing a little bit worse, 62 basis points as of Wednesday. Short-Term Traders Index is flat as a pancake so far this year.

And then you have MSCI World, up 66 basis points. And the S&P 500 Total Return, up 62 basis points. But then you have the S&P US Treasury Bond Index for 20 Year Maturity or More, and this is before today’s events, down 1.88%. So clearly something to be mindful of. I don’t think it had a good year last year either.

Now you brought along a lot of interesting topics, Cem. I’m going to try and guide us through this and I’m going to ask you some additional topics relating to these themes. But let’s start out with some of the more geeky stuff. And I love when you use these terms that I have to always remind myself, what exactly do they really mean?

Anyways, Long-Term Skew in Vol Markets Are Well Bid At The Moment. So, let’s start with that and see where we go.

[00:09:03] Cem

Yeah, I think this is a really great indicator that people who are in the kind of systematic quantitative world should be aware of. You know S&P 500 skew, it’s not the only skew we’re looking at. But that, as a proxy, has been very bid in the back of the curve.

You’ve had a skew… And to be clear, what a skew is, it’s the downside options; you know, how high that volatility is relative to the upside options, and obviously, always, an equity index is higher to the put side because it’s downside insurance. The steepness of that is really what we’re looking at.

You can measure skew in different ways, but the important part is once you get out to two, three, four months that skew has continued to be very sticky and steep. It really started pre August meltdown and was exacerbated at its initiation by not only a SEP quarterly options expiration that has had a lot of open interest and a lot of structured product demand, but most importantly, the election, and after the election the December OP-X and all the structured products are at the end of the year. All of that skew demand has played a huge driver, which we discussed here, in that August decline.

The August decline looked very different than you would normally see. It reversed quickly because it happened early and there was a lot of skew supply in the front of the curve. But what that did is, when that relief happened, that skew (which people got washed out on and really lost a lot of money on) we had a historic breakdown between short-term and long-term skew involved, given the size and speed of that move. But what we’ve seen is that has remained sticky on the back.

And as we’ve gone through December, I think a big thing that we were looking for is, after the election, after we get through the end of the year, will this calm down? Was this just a function of that end of the year supply/demand imbalance? And the answer is it hasn’t.

And it hasn’t, and now it’s really focused on March and April, and it’s continued to push further out. And the reason that’s an important sign is what that tells you is that the market is stuck, that there’s a supply/demand, there are people out there who are really short the skew on the back end of the curve. And, you know, entities had to sell more of that to get back what they were short in December, to fund it basically. And that’s a typical response. To sell longer, further out of the money skew and keep trying to cover your shorts that are closer. The problem is when you get a structural decline, a real longer term structural decline, that can exacerbate and lead to a longer term decline.

Okay, you know, we saw this in ‘07, leading into ‘08. We saw this in, you know, ‘99, ‘98 prior to the bigger structural declines. It doesn’t mean there’s a short term spike coming because, again, short dated skew is relatively well supplied and you can cover your margin risk. It’s really a function of, kind of think long term capital management of the short end of it. If the long end of the curve goes higher, it’s a mark to market issue. You just can’t get it back, and everybody starts chasing, and then it can go higher, and higher, and higher.

So, we had a huge vega response, last time in August. We continue to see more vega response relative to gamma in the market. And that can really exacerbate not just a vol event, but, again to reiterate, a longer term (meaning year, multi-year) type decline. And so, we’re much more watchful for that kind of a coming opportunity given that structure in the market and the risks of exacerbation.

So, I think it’s something that people aren’t watching that much. That’s very important to watch. You know, there is a structural supply and demand imbalance on the downside options further out in the curve, and that can lead to, again, a reinforcing down structural down move.

[00:13:08] Niels

Yeah, so, as far as I’m aware, the CBOE has something called a skew index. And is that different or…

[00:13:17] Cem

It is. It is meant to be a representation of skew. It is at near highs, and has been structured going higher. So, you can see the trend there. It is not a good measure of skew. And the best measure for skew, without getting too wonky, is a delta sticky measure. Something that’s probabilistic as opposed to money in the space.

[00:13:41] Niels

Yeah, one of the things that’s so wonderful about having you on in the very first part of a new year is that that you’re also open to giving your sort of thoughts and opinions about what’s going to happen sort of both in the shorter term, but also in the longer term. I think maybe we’ll deal with the shorter term right now. We might come to the longer term a little bit later in our conversation.

But of course, last time we spoke you were looking for some weakness. Maybe it’s already started. Maybe we still need to go and touch some fresh highs before it happens. But tell me a little bit about how you see that. Because we’re coming up to an OP-X again in January. So how, how does that all fit together?

[00:14:28] Cem

Yeah. Just to rewind recent history. You know, when we were talking in September or so we were pretty adamant that, you know, into the end of the year, particularly starting in late October, should really be a constructive period. Obviously, it was. The best-case optimal turnout, given looking in September-October, would have been to rally into mid-January. That’s kind of the idea that we highlighted. That would be the most likely as we’re not on frequently enough to get high frequency updates.

But I was pretty vocal on other platforms in the middle of these OP-X, two, three weeks before the end of the year that, given the strength of the flows that we were amidst at that time (both Vanna and Charm flows) that we talked about, the rebalancing/releveraging effect at the end of the year that the market was not strong enough. And this was before any decline came. So that was a real reason for concern. We highlighted that.

We said, this rally could end early, similar to, kind of, how we talked about September being unlikely to decline after the summer, and it happened in August. We were very, very adamant that there was a very good chance for some vol and some decline. And sure enough, we got that starting during that, generally, unexpected window of like Santa Claus. But again, we foresaw that publicly. So, that was the beginning of the decline.

So, it ended early, much like August before September, and other things we’ve seen, because people are increasingly aware. You know, I’m not the only one out here talking about this. Others are as well.

But that is, because it happened early, it has a little bit different path. But basically, the market is looking for, and we said this since the middle of December, something like a 10% type decline here, peak to trough. We don’t see this initial decline as the… We do see it as the beginning of a bigger decline, to be clear. But, we do believe that after this initial decline there will be a counter trend rally, and that counter trend rally will be sold eventually, and will, in our view, lead to a bigger decline here as the year goes on.

Will that be a bottom here in the next couple of days? Potentially, we could get a real big decline today into Monday. So, I would be very hesitant on when this is going to be out. It might already be too late. But we’re sitting here on unemployment day.

I was talking to you before the show. If we had just been on a day earlier, we actually really foresaw this. in my notes I said to you, this potential decline, on a strong unemployment number, on a Friday, very few people want to jump in front of these things.

You know, with the 10-year hitting 5%, people are going to try and probably get out of the way here. OP-X next week; OP-X Fridays into Mondays are usually the strongest day 95% of the time, but when they’re not, they’re incredibly violent because there’s a lot of open interest in that big monthly OP-X in January and that can exacerbate into a convex move. So, it’s important to watch today. Again, I’m not calling for a crazy crash, but I we could see 150 to 200 points in the S&P, potentially, in the next two days.

[00:17:48] Niels

And neither would you be surprised if the weakness lasts into sort of end of Q1. I mean it doesn’t have to be related specifically Jan. OP-X in terms of finding a low.

[00:17:59] Cem

I agree because there’s a skew that’s high and not well supplied in March and April. I do think that we will get a re-decline. I don’t think it’s going to be sharp. It’s going to continue to be stair steps. Why? Similar to what I said about the skew, if you have short dated vol and short dated gamma, you know, the most painful trade (which is the most likely trade) is if that’s well supplied. And a long-term skew bid is for a stair step down because then your short dated puts don’t protect you and the long dated puts continue to get higher, go higher and higher, and people are forced to cover with band aids again, that don’t fix, that eventually lead to a bigger and bigger painful trade that eventually forces people to buy back long dated skew.

And so, it’s not just the only thing in the market. I realize that. But that would make the most structural sense given market structure.

So, I do think that today, tomorrow, in a couple days, again, I’m not sure when this comes out, maybe too late, but it could be an interesting decline. The market could be looking for a short-term bottom. Meaning, we’re talking weeks or a month bottom and I could really see us see a counter trend rally that would be pretty painful for shorts to try and shake the shorts that are in the market rebuild sentiment. But I could really see after that another decline that really is kind of Feb OP-X to March OP-X.

To remind you, Feb OP-X March OP-X, that one may sound familiar. We may have talked about that important cycle before. That’s the Covid crash cycle. It’s not a coincidence that these declines happen cycle to cycle, that started the day after Feb OP-X ended, the day after March OP-X.

The reason that was so painful and so violent, yes, Covid was the catalyst but the amount of open interest and risk in the market as an accelerant, in options and structured products, really created that 30% option cycle to option cycle decline.

Quarterly expirations are the biggest risk. Structured product issuance is bigger than ever. Positioning is bigger than ever. So that March OP-X represents a real risk in the market. And I could see a big rally back shake others, much like we saw during Covid. We knew about Covid. We rallied till the day after Feb OP-X and then, you know, saw a sharp decline. So be watchful for that.

Again, knowledge is vol dampening. If I go out there and start talking about it too much, it becomes increasingly unlikely. But I do think that’s an important path to watch here.

I could see a rally that eventually… a pretty violent rally off of a violent-ish bottom here, in the next couple of days, that could really try and… That said, long-term vol should hang in into that rally given the volatility that we’re seeing. And, as I mentioned about a month ago, vol was really cheap in December and was likely to rally into and throughout Q1. And so, that’s still our focus on how to play this.

[00:20:57] Niels

Yeah, it’s funny, as you were talking about this and reminded us about the Covid situation, I was kind of thinking (maybe completely unfounded), well, maybe the Fed is fully aware of these cycles and that’s why they waited until the 23rd of March to come out and do all of that stuff right after March OP-X. But who knows what goes on in that…

[00:21:18] Cem

They’re aware of the risk and open interest in what’s happening and are increasingly likely to have an understanding of the calendar cycle and why it’s happening.

[00:21:28] Niels

Sure, very interesting, actually. The other thing, I don’t know if you’ve looked at this, but I’m sure you’re aware that when we ended last year the S&P had its best two calendar year performance I think since 1988 or something like that. And I don’t know if you’ve studied what tends to happen the following year.

[00:21:50] Cem

Yeah, not pretty. I won’t give you the exact numbers but this did come up at the endowment conference. We’ve talked about it with others. Two years back-to-back, positive like that, has an expected negative return the following year, which you don’t see in many data sets, and a very poor winning percentage. We’ll leave it there.

I will add to that in a reminder, again, you and I have talked about this but, you know, in structurally inflationary periods (which we’ve called for and we are seeing), driven by populism and protection, (which we’ve called for and we’re seeing), I think hard to debate either of those things at this point. The last time we saw this over that 14 year period, ‘68 to ‘82, incredibly poor equity performance, 67% real negative returns over 14 years.

But importantly, and the reason I bring this up here, is that during election years the average performance was 21% over that same period. So, the non-election years during that cycle are pitiful. I think it’s about 10% nominal loss or 8% nominal loss, real loss, over that period. And without those years it’d be almost 100%. So, it is important to note that that 26% or, whatever percent, 25% return we had last year is completely in line with history.

And again, all of the populist elections, all five, if you include the last two, have a very similar… They’re 100% up double digits. The average return up 22% now, and consistent, huge winning years. You take those out of the data set. All other elections only yield 5%. So, it is a big… It is an outlier to its own years, it’s an outlier to other election years, and it falls in line with everything we’ve said and the reasons for it. So, I think when that happens you probably should pay attention to it.

So, it’s not just the two years back-to-back. I really think there’s some give back here (for lack of a better term) given, what I would say, is bringing forward equity market performance, and spending ,and other things that helps boost the market during an election year which are likely to have to be given back.

[00:24:09] Niels

Yeah, absolutely.

Now, I do want to talk a little bit about inflation and interest rates and all of that but before we do that, you had one of these other topics for me to guide you towards, again, one of those things where I had to just remind myself exactly of what does vanna and charm mean. But I have done my research.

So anyways, you talked a little bit about that as well. And you’re expecting maybe that it’s going to fail?

[00:24:37] Cem

I’ll be brief about this because it kind of ties into what I was just saying. A part of the reason why I think a counter trend rally… You know, this market’s probably likely to try and find a counter trend rally here sometime in the next few you days, not weeks, after a bottom. You kind of need some cathartic action for it to happen.

But the reason that would make sense is because we do still have this last push. There’s this push/pull that happens with vanna charm if the gamma event isn’t big enough, or it moves, and then there is some slowdown of that decline. The vol, which is now expanded, now compresses. And that compression, much like we saw in August – sharp bottom, other situations, Covid.

Those reversals of the expansion lead to equally powerful rallies and there’s still a ton of open interest in January because it’s the primary, the biggest expiration for single list equities. So, I would be very watchful of a potential counter trend rally as I kind of highlighted before. That’s one of the big reasons we’re looking at that, as well as the fact that this is likely to be a stairstep because of other issues in market structure.

It doesn’t mean the decline is not going to be longer and bigger at some point here, I want to be clear. But in the very short term I would be very watchful of that, and market structure in that regard.

So, you know, a decent amount of positive flows coming after something that would look like a vol increase cathartic drop here potentially today, Friday and into Monday.

[00:26:14] Niels

Sure, sure, sure. Oh, by the way, I forgot to answer you. You said I don’t know when this episode’s going to come out. Well, it’s coming out tomorrow so it’s very fresh news. What people will be listening to tomorrow, Saturday, will be fresh from the oven. Some, some fresh crumbs, I think, is what we refer them to be.

All right, we’ve talked a little bit about it already, but I think this is important. You certainly also highlighted that in your notes about what’s happening in interest rate markets. It’s not just today but things, as you call it, are getting harder to hedge. And before you maybe give your sort of thoughts, some of the headlines that I’ve just been picking up in the last few days are that one, you have record issuance of corporate bonds. They’re estimated of being at around $200 billion in January, according to Bloomberg. So, I wonder if other people are realizing that it might be a good time to get rid of their… or get some borrowing done before everything goes haywire.

Another thing, I mean generally, I guess you could say that there might just be fewer bond buyers, and in an overleveraged system that’s obviously a very bad combination you could say. And then on top of that you hear someone, and this might be something that actually could come to fruition as far as I can tell, Trump saying that actually NATO countries should probably spend 5% of their GDP on military which again, you know, we were stunned when we heard 2% but that actually did come to pass.

Now 5%, maybe not as crazy as one would think but it means more deficits, it means more issuance and we know that when interest rates move like this it’s a game changer for economies, for markets. So, tell me what your thoughts are and to remind our listeners, you have called for a lot higher 10-year yields. We’re well on our way for that. But just talk me through your sort of big picture here.

[00:28:26] Cem

Yeah, absolutely. So, you know this, but I can’t emphasize enough interest rates, the cost of money is everything. It is the most important thing by far. The economy can be incredibly strong. Output and sales could be through the roof for companies. But performance of equity markets and assets, writ large, can be very poor throughout a very strong economy. That is counterintuitive to most people.

‘68 to ’82, I just use that as a reference because the last time as interest rates went up, bottom-left to top-right for a long time, the stock market did 0 nominal percent return, 67% decline. GDP grew above trend in real terms, in real terms, and it is counterintuitive. It was a much stronger economy than we’ve seen the last 20 years. That’s why we had inflation. But the actual market asset returns were negative in real terms, dramatically. So, again, it’s counterintuitive. Why does that happen?

The two main drivers (there are three or four), the two biggest are one, you know, if you can get a 20% yield on a 10-year bond, you’re not going to pay a 25 PE for the market, multiple contractions. So, the multiple was approximately 25. The PE multiple was 25 or so in ‘68 and it was four and half, four and a half in ‘82. Why four? Because four is about a 20% earnings yield, you know, it’s not a coincidence. So that’s the biggest one.

The second biggest one is margin contraction. We are sitting at record margins or close to it still, similar in ‘68 at 4 relative to its time, in ‘82 margins had collapsed. I think you can look for that to begin to happen if interest rates continue to go higher for a secular period of time.

So, interest rates are everything. And so, we better focus on is that happening, is it not happening? And I think it’s also important to understand the mechanism with how these things get going. It’s not like, oh, they’ve gone in, and they’ve gone up, and so everybody’s now into the trade or they’re hedging it so everything’s okay, like some other markets.

The structure of the yield curve is critically important. If the curve is inverted, you’re getting paid to hedge your interest rate inflation risk. And we had an opportunity to do that. That’s why we were screaming, literally screaming about how this trade was.

You should lock it in 10x as much as you can because you’re getting paid for a hedge. You never get paid for hedges. That never happens for big structural risks. The opportunity was there, and it was there for a long time. And the response from people was, the market’s saying it’s not going to happen. Well, guess what, there are things bigger than the market. The market can be very inefficient at times.

So, the problem now is it’s hard to hedge. The curve is now upward sloping. It is getting increasingly difficult. If you didn’t do it already, if you didn’t put that bet on big enough. And by the way, sizing of that trade matters because I think some people put it on. But as a trade, the problem is that trade affects everything. It literally destroys the value of every asset, and as people know (well, not every asset, many assets), and the reality is most people don’t realize or appreciate that.

Again, back to that endowment conference I was at, the majority of people, when the question of inflation came up (these are very seasoned professionals, owners of investment firms, etc, CIOs), the majority of the people, the majority, were suggesting equities as a hedge to inflation. That is a complete misunderstanding of what equities do during structural inflationary periods. And again, that’s different than a one-year bout of inflation or a two-year bout of inflation. We’re talking structural, and I think that’s a big difference.

So right now, with curves upward sloping, it’s very hard to hedge. And when it’s hard to hedge, guess what? Much like we’re talking about options markets, the risk of, of the pain trade… And there’s a reason the pain trades end up generally working, the pain trades generally work because that means people are stuck. That’s a sequestered demand or supply that needs to come back to the market, that needs to get out. That’s why pain is the most likely outcome 90% plus of the time.

And in bond markets you better believe that if people are stuck, which they are based on everything I’m hearing from everybody else, and it’s now hard and expensive trade, so they’re not moving fast enough, more pain is to come. So, I really want to highlight that fact.

You know, it’s not going to be a straight line, much like it hasn’t been a straight line from when we started talking about it two, three years ago to now. But the trend will continue and at some point it will accelerate because it will become more painful and people will get stopped out.

They are not stopped out. They’re not even close yet. The pain is not enough. And there are enough big entities that are leveraged with bond exposure in all kinds of way across the market. It’s just too much exposure relative to what the market can handle.

And to your point, there’s issuance in Europe which is just one of the many ways entities are “stuck”. Right? And they will have to come to market and there’s just not enough. And at some point, you know, the bond vigilantes will start pushing on it and that’ll just make it worse.

[00:34:01] Niels

This is one of the things that I find very interesting. I mean, I actually started my career out in fixed income trading government bonds.

And you know, one of the things that concerns me in what you’re saying, because I tend to agree with it despite, by the way, my outrageous call on our group conversation which went completely against this, but that was just to be outrageous. Anyways, the thing is that when we talk about a structural change in interest rates, and I do believe in these cycles, and we’ve had 40 years of interest rates coming down. I’m not saying we’re going to have 40 years of interest rates coming up, but I think they’re certainly going up for a while. The thing is most of the portfolio managers out there have never experienced an interest rate increase or hiking.

[00:34:49] Cem

It’s that recency bias again, which is what we highlight at the top.

[00:34:51] Niels

Yeah, and maybe are of the, how should I say, opinion that, well, the central banks can still control and force the long end of the curve. But you know, when, when things decouple, which I’m not saying they have done that yet, but if they really do decouple, which we saw maybe a little bit of tendency to in the UK, you know, things can go completely against…

[00:35:16] Cem

Interesting, absolutely. I have an interesting point to illustrate how much people are in long-duration. They don’t even realize it.

I have a client who has 40% of wealthy individual net worth in municipal bonds – a pretty common thing here in the United States. The average duration of his bonds are 15 to 17 years. When he goes to his muni bond manager and wealth advisor and asks him about this exposure and the risk, the response is well, your bonds are callable and your effective yield is actually only, you know, five years.

And so, to him he’s like, well, I don’t have that much duration risk – 5 years, etc. But the truth is that people don’t understand that call, the second you move away from it, you know, the call essentially means that if yields go up, 1% or 2%, all of a sudden the call comes off the table. It’s just premium that you’ve collected. Now your effective duration goes to 15.

And, you know, it’s a pretty simple idea for us who are quantitative and systematic in the markets, but the majority of people have no idea. And that’s just one of many ways that people have dramatic duration in the portfolio. Never mind the private equity, private credit, private… If you hear the word ‘private,’ run, run. It’s not just duration risk, it’s liquidity risk.

The last thing you want is locking up your money for 10 years in equity or things that are tied to credit, like equity, just when interest rates are about to take off. So, there is a tremendous amount of, again, in terms of just looking at supply and demand, an incredible amount of demand for things to buy back if things start to go higher. And that’s why it becomes a self-fulfilling prophecy.

The last thing I’ll say about interest rates going higher and why it becomes a cyclical kind of self-fulfilling prophecy is it actually is a feedback to inflation itself. If the cost of things go up, you know, the interest rates go up, you know, the cost of goods go up, you know, the cost of money is a driver itself to inflation for multiple reasons. Not to mention, as we know and is well publicized by the Fed, what the causes of the ‘60s and ‘70s, definitely not the only cause, but causes of inflation were in the ‘60s and ‘70s is that people were pulling forward demand, demand because the expectations for inflation had gone up.

So, the more inflation expectations go higher, the more people pull forward demand, try and buy inventory, try and lock up goods, try and borrow to buy anything pinned down, et cetera. So, it is not a linear function, and the more it gets going, it becomes exponential.

So just again, I think people, again, have that recency bias. Again, when asked, that muni manager set showed a graph going back to 1990 saying that municipal bonds have never gone above 5.25%. So, why would you be worried about your 5% coupon muni bonds?

[00:38:34] Niels

At times like these, Cem, wouldn’t it be nice to have an extra set of safe hands in the Fed? Or maybe that’s what he’s planning to do, our new president, I shouldn’t say our, your new president.

[00:38:51] Cem

I’m not going to tell you my political leaning.

[00:38:53] Niels

No, no.

[00:38:55] Cem

You know, my president or not my president, he is America’s president.

But yes, the Federal Reserve is, in theory, the one entity, if truly independent, that could, in theory, serve as almost an academic or rationale (whatever that means) actor, to try and help do what it was intended to do, what it was created to do, which was to smooth the business cycle and to smooth the risks in the market. Unfortunately, they have the dual mandate.

That was easy, it was easy for the Fed to be dominant, and as we’ve talked about in the past, really drive outcomes almost one-to-one when deflation was structural because they could push, use their tools to help counteract inflation while spurring demand. And now that they’re contradictory, now that they have to manage price relative to GDP growth, they’re really in a box. And that’s true without a Donald Trump.

Donald Trump is intent as, as all politicians are, but even more so to exert his power and exert his influence on things in any way he can to improve his political outcomes. And my belief is that he will, and, by the way, it’s not just his political outcomes (I want to be more fair there too), really try and improve America’s outcomes not relative to the rest of the world. And if he does what I think he intends to do, this is not a Greenland type situation, this is real like what he intends to do. He wants to use any means of power possible. And the Federal Reserve is the most powerful entity in the world. It is like a superpower for Donald Trump. And he is not going to sit back and let them do whatever they want.

He is Nixon on steroids. And you better believe, we know how Nixon turned out in terms of Federal Reserve policy. So, I strongly believe that he is trying, behind the scenes right now, as all presidents do to some extent, but particularly trying to pull the levers at the Fed. If Powell does not play nicely or if the Fed generally does not play nicely, I 100% expect him to put in a “shadow Fed”. That sounds more nefarious than it is.

What is that? He will appoint his next Federal Reserve chairman for next year very soon, if that’s the case, and they will just tell the market what their policy is and that will discredit Powell and the Fed and force Powell to play ball. And my guess is Powell’s a smart guy. He knows that there’s a pressure, that that would be the alternative. And so, he’s going to do his best to play ball and make and play nice so it doesn’t get to that. We will see.

But the point is there is real political influence on the Fed. You can act like it’s independent. It’s not. That’s not how the world works.

Even if they were truly independent and there was a political pressure, they coordinate because they need to because the two cannot work independently for one outcome, which is their shared desire to smooth the business cycle and improve the outcomes of the American economy. So, I think it’s a really important thing to watch. Again, we talk and highlight interest rates and how it’s so critical. Well, you know who is in charge of interest rates, at least on the short end the curve? The Federal Reserve is. So, you better be watching that very closely come inauguration time.

You know, what the Fed says and does, that’s part of why I highlighted this Friday is so important. It’s the first big number, given all the uncertainty, that really will influence Fed outcomes and the ability to control narrative, et cetera.

So, this is a much bigger number today, as will the CPI number be, than we’ve seen a long time given what is about to potentially occur with the Fed and the new administration, but also the Fed, broadly, in terms of monetary policy.

[00:43:23] Niels

Well, there are a couple of things that spring to mind as you were talking. I think, of course, the Federal Reserve as an institution is very, very important and some uncertainty, within that institution, certainly is really worth taking note of. But you know what, when I’m thinking about other big institutions around the world right now, we’re in a vacuum in a sense of leadership.

A lot of these big institutions have, in many ways, failed. And whether it’s the WTO bringing China in, and then that completely kind of going not in the direction that they thought it would. We have, on health, the WHO coming under lots of criticism. But then you also have something like the EU. And even now, I think you and I discussed it last year when maybe I did it with Alan when the Draghi report came out, but it seems like now they’re also now officially acknowledging that the whole project of EU, that I’ve watched from the beginning, maybe it’s not really working, if you know what I mean. And that’s a big statement.

I think they kind of came out today acknowledging that maybe it’s actually not working as they intended, and they need to completely reform in order to become somewhat competitive again because they’ve lost the competitive edge completely.

[00:44:53] Cem

Yeah, I think, to step back from that big picture, we have discussed this and I think it’s important to keep this framework top of mind, in a world where the Fed, with a fiat currency where the US Dollar is the reserve currency of the world, the Federal Reserve has the ability to linearly control volatility and drive and drive money to corporations. That also drives globalization and historic peacetime. And so, we had this wonderful, long, 40 year peace, and growth and relative stability.

So, if things during that time weren’t working so well, you know, the pressures that have existed in Europe, which we’ve seen problems with throughout that period, NATO, other things. If those pressures were existing then, buckle up, because without… What’s happening here is there’s more realized volatility because there’s less stability. We gave this analogy in some way or another, a metaphor, I think a year or so ago. I think it still incredibly applies and people should be aware of it.

It’s, when an incredibly strong, big, powerful person, that’s all powerful, dominant in a room, there’s peace. There’s peace because nobody’s going to…, what that person says will go, period. The second that there is a vacuum of power, or power itself is questioned or can be questioned, now you have everybody trying to pull a lever and you get some form of chaos. And you know, this period we’re entering is naturally chaotic because the Federal Reserve can no longer be all-powerful. That sits at the essence of what’s happening.

And then you take all of the issues that have built up over this time, and the resentments of that all-powerful person who’s been in the room doing all the things right. And, you know, there can be a lot of particularly volatile outcomes, but everybody is going to be, every country, every institution, corporate, public are going to be pulling the levers of power to try and improve outcomes for themselves. They always try to. But in an environment where they were less able to exert that influence, they were less willing to do it.

And so just expect more global conflict. That’s not coming to an end. Expect more breakdown of institutions, you know, big and small. So yeah, I agree Europe has its problems, challenges, but it’s not just Europe. It’s global at this point.

[00:47:58] Niels

So, we’re going to pivot soon to another powerful individual. But before we do that, let’s talk about something where you could certainly say they’ve had their challenges, but you’re seeing some, maybe early signs of some improvement. And I’m talking about China here. And so…

[00:48:18] Cem

That’s counterintuitive.

[00:48:19] Niels

Exactly. So, let’s talk a little bit about that.

[00:48:21] Cem

So, I think that’s important. Tied to the bigger, longer-term picture, China, we’ve highlighted through other macro conversations and what not they have massive structural problems. Right? But when you start to see everyone abandon an asset and give up for the long term, and meanwhile something like US assets, and the dollar, and everything that the other side get, we’re seeing a 50-year type dislocation relative to assets. And that’s not new. It’s gotten worse. But it’s not something that’s brand new. And we’ve seen it.

The question is always, in that scenario, can you get a catalyst? Is China going to become a Russia, which is, you know, just dead money forever because of the rule of law and all the other issues we’ve talked about, or is there a potential, maybe it’s only for a few years to be clear, for something else to happen? So, we are always sitting here, not dogmatic, and saying this is what’s going to happen.

The reason I keep repeating the things is because they keep happening, and with all the causes, I have yet to see a contrary argument that is meaningful except on this one issue. And I think this is critical to highlight, and I’ve highlighted it more recently in the last month or two as something to be watchful for. But it’s increasingly something that I’m watching.

A Trump administration is thought to be really tough on China. Why? Because last time he was president he was really tough on China. But important to note that the last time Trump was president, he was really, friendly is maybe the wrong word, but really productive in his willingness to listen to Russia and to work with Russia.

You know, contrary to what many other people thought was rational or made sense, he has continued to put people in his administration that are still willing to be really helpful to Russia. He’s mentioned that his first thing that he’s going to do is solve the problem in Ukraine. Well, what does that mean? He’s going to force Zelensky to give into Russian demands for the most part.

Interestingly, in 2020, when Trump left office, Russia and China were not allies. They weren’t allies, not publicly, at least in any way. In ’22, they came out very publicly in February, before Russia invaded Ukraine, with a joint communique to announce that we, at the time, highlighted. That is a critical document that everybody should read and know about because it is a statement of a change in the world. And Russia and China are now connected at the hip. I mean, at the hip. They are relying on one another and they are allies in every sense of the word right now. So, can Trump, who is very, very pro Russia (for lack of a better term), be super strong against China? Maybe, maybe, maybe we should be thoughtful about maybe that Trump is not going to be as strong on China. He keeps talking again, and again. He’s already said a couple things.

One, he said, well, if Taiwan wants us to defend them…

[00:52:00] Niels

It’s going to cost them.

[00:52:01] Cem

It’s going to cost them. And basically, not even saying, we’ll defend you, but you better pay for the stuff or we’re not going to send it to you anymore.

There have been several clues that his tariffs are not going to be focused on China, but instead on Canada and Mexico. I actually think that all the Greenland rhetoric, all the Panama Canal rhetoric is a clue. It’s not worthless. It’s a clue that he needs to show strength and that he is the tariff man, that he is protectionist in the face of potentially making a deal with China, acquiescing to China. Acquiesce is a kind of, I guess, I shouldn’t use that word, right? I’m being political.

The truth he, and by the way, here in the US there is an isolationism happening. America first. It’s not just about making America first. It’s about not messing around with all the other stuff. Like, we don’t care about the other things. We’re no longer going to be standing up to Russian or Chinese aggression. Now, maybe that’s a good thing for China.

I think we need to be mindful of that, again, Trump is a Nixon like character. It took, and we’ve mentioned this in the past, it took a Nixon to open up China. Nobody else could go, in this scenario and make good, make a deal with China. But, you know, Trump could play the “ art of the deal” and then go make a deal with China. And, in the short term, that would be very economically supportive. It would manage some of the inflation issues that he’s probably going to face. There are arguments for it in the short term, but it’s probably not a good long term play for the west and the United States, my opinion but, you know, to be seen. But that’s not what we’re talking about here. We’re talking about prediction, markets, and possible outcomes.

So, I think people are missing that there is a potential. And again, this is not an up down call. There’s an asymmetric trade off there and it’s about probability times magnitude. I’m saying some people I think this is a 2% chance. I’m saying it’s a 30%, 40% chance and that the magnitude of the trade is so big, if that’s the case, if we see reversion to the mean on that trade, it could be the biggest trade that we’ve seen in a decade.

So, the point here is not to like go put your money all in Chinese stocks, but it is go buy calls and get asymmetric convexity, barbell, all the things I’ve been talking about, the inflationary pressures, and everything else, with a bit of a hedge or some convexity in China. And I think that’s something really to be thoughtful of.

Again, people will be, if it doesn’t happen, people are going to say, well, you call for Chinese stocks to go up. Well, that’s not what I’m saying.

[00:55:07] Niels

Sure, sure.

[00:55:08] Cem

What I’m saying is there is incredible convexity. You know, some mean reversion to that trade could be, it could be cause for a dramatic opportunity and the odds and probabilities of it happening are higher that people are whistling, by was a changing macro environment. And actually, if you listen, if you listen really closely, the clues are there.

[00:55:31] Niels

Yeah. What I like… Well, first of all we should always remind people that even though we talk about this, we are not offering investment advice by any stretch of the imagination during these conversations.

But what I like about what you’re saying is something that I often think about in very simple terms and that is, you know, and I started changing my sort of view on this a few years ago and this is that we need to go back to ‘expect the unexpected’. We were living in such a stable, predictable, as you said, world of peace and all of that stuff. So anyway, that’s one thing.

And when we think about ‘expect the unexpected’ there’s one person that springs to mind, besides Trump, and that’s his new friend Elon Musk, who also seems to be very interested in German elections these days and far right policies. So, you actually had it as a point. So, I’d love to hear your thoughts about that.

[00:56:31] Cem

Yeah, I won’t spend too much time on this, and again, I’ve highlighted this briefly before, but Elon’s been a little quiet lately, I think do not expect that to continue, I think as soon as Trump’s in power here.

Trump himself, remember last time around, was getting fact checked and not allowed to tweet X, or Y, or shut down on different social media platforms. He is going to have the microphone times 10 this time. Not only is he…

[00:57:07] Niels

And Facebook.

[00:57:09] Cem

I was just about to say Facebook has like stopped… You saw it before the election. All the major institutions refused to endorse anybody. Everybody is going to bend to his will this time around. And it’s not just bending to his will now. Elon, you know, is his strong ally and runs the town square. So, if you think that, you know… And Elon will be, as he did leading up to the election, pushing narratives. That’s what he’s done. He’s done it successfully.

You know, you could argue Tesla never would have made it this far if he wasn’t able to squeeze all the calls in the market, you know, seven, eight, nine, 10 years ago. He has again, and again, shown himself, and understands, importantly, the ability of narrative to move outcomes. And so, these guys are going to use narrative in every way possible. Understand that Elon’s incentives are also different than Trump’s and may may help push Trump’s incentives in a certain direction.

That’s another reason to be thoughtful on China. I think there is a lot more pressure inside the administration to make good on China in the short term, to fix the China problem in the short term. Not a long term solution, but a short term one. And I think Elon will potentially change that narrative.

He’ll be at the point, and he can talk about it if it happens, but when that narrative starts changing, you better believe Elon will be at the point of the spear there and helping push it. So, that’s the one point I want to make with Elon. Yeah, just pay attention. He’s going to be at the forefront of this narrative story. But that will create more volatility, and more dispersion, and more of the issues, you know, rotations that we’ve been seeing.

[00:59:01] Niels

Okay, cool.

Let’s leave it for now, here, because the great news is that you and I are going to be recording again next week with our mutual friend, Dave Dredge, where we’ve had this now annual tradition of kicking off the year by sitting down and talking to him. So that’s going to be recorded next week.

So, we’ll continue, I’m sure, to touch on some of these topics and expand into some other really important ones, and there’s no one better to do that with than Dave. So that’s going to be super interesting.

Now, for those of you listening who feels that this is super interesting and appreciate all the efforts that Cem is putting into to this, why don’t you head over to your favorite podcast platform and leave a rating and review just to show some appreciation for Cem and all the work and input that you get from him.

Next week I’ll be back with Alan, so be sure to send me some questions if you have some for Alan as we kick off the year more from a maybe a trend following perspective, so to speak. As usual, you can email them to info@toptradersunplugged.com.

So, for now, from Cem and me, thank you so much for listening. We look forward to being back with you next week. And until next time, take care of yourself and take care of each other.

[01:00:28] Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoy this series, go on over to iTunes and leave an honest rating and review and be sure to listen to all the other episodes from Top Traders Unplugged. If you have questions about systematic investing, send us an email with the word question in the subject line to info@toptradersunplugged.com and we’ll try to get it on the show.

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