Cem Karsan and Andy Constan | PNL For A Purpose

[00:00:00] Hey guys, this is Justin. On April 30th, we interviewed 24 guests in a 12-hour live stream

[00:00:04] to raise money for Susan G. Komen in conjunction with our friends at Spot Gamma. Our guests

[00:00:08] were some of the smartest market experts we know covering topics ranging from value investing

[00:00:12] to factor investing to macro and options. We are releasing each of the interviews

[00:00:16] in pairs of two over the week following the live stream to bring our guests' insights

[00:00:20] to our audience in shorter videos and to continue to raise money for a great cause.

[00:00:25] If you are able to, we encourage you to donate using the link provided alongside

[00:00:29] the link to each video. As always, thank you for listening. Please enjoy our conversations

[00:00:33] with Jem Karzon and Andy Constant.

[00:00:35] Just a reminder to everybody, we're here for Susan G. Komen today. If you're watching

[00:00:40] us on YouTube, there's a donate link next to the video or under the video in mobile.

[00:00:44] If you're watching us on Twitter and LinkedIn, you can go to YouTube and you can donate.

[00:00:49] If you get any value out of what we're doing today, you're about to get some breadcrumbs

[00:00:54] If you get any value out of that, please do donate. It's an awesome cause and it's why

[00:00:59] we're doing all this today. With that, Jem, thank you for joining us.

[00:01:04] Hey guys, good to be here. I just want to say my little bit about that as well.

[00:01:08] Obviously, for those of you that don't know, I lost my wife about a year and

[00:01:13] three months ago to cancer. Just want everybody to know there is no higher cause, right?

[00:01:21] The amount of pain and suffering that cancer causes in this world, it's something that

[00:01:25] we are making great strides towards. Hopefully, if we have been able to help any of you over

[00:01:31] the years, any amount, $10, $20, $50, whatever, it's such a worthy cause and much appreciated.

[00:01:40] Yeah, we're so sorry for your loss and it is a great cause. Hopefully, everybody

[00:01:45] will donate if you can. Hopefully, everybody will donate today as we go 12 hours to try

[00:01:49] to raise some money for them. Just briefly to introduce you, I assume our YouTube feed

[00:01:55] is spiking uncontrollably right now so we probably don't need to intro you, but we

[00:01:59] will anyway. You're the founder of CHI Volatility Advisors and you have a very

[00:02:03] unique blend of being able to look at the macro but also being able to look

[00:02:07] kind of in the short-term options world. I'm going to handle the macro today, asking

[00:02:10] you some stuff. We actually have an expert who could ask you better questions on

[00:02:13] the options world than we usually do with Brent here. I'll handle the first part,

[00:02:17] talking about macro, and then Brent will dive in and hopefully we'll get some breadcrumbs for people.

[00:02:21] But first, I just wanted to talk about where we are in general. You've been in the higher

[00:02:26] for longer camp for a long time. Inflation has definitely remained stickier than people

[00:02:32] thought. It's even spiked up a little bit recently. Where do you think we are? Can you

[00:02:35] just give us an overview of where you think we are in the macro landscape? Yeah,

[00:02:39] I think it's important to zoom out. Jack, you and I have talked about this a decent

[00:02:43] amount, so I won't tell that. I can go into 30 minutes just about the background

[00:02:48] where the inflation is coming from. But the core point here is that populism is a reaction

[00:02:54] to 40 years of inequality, and that's a global phenomenon. This is not the first time this

[00:02:58] has happened. You can look back to 100,000 years of history. This is how things work.

[00:03:03] Stratification expands in equality and then you get a reversal. And the reversal

[00:03:09] tend to be quicker than the expansion. The important part is labor. Youth is labor.

[00:03:16] The older generation, baby birds in this case are capital. What that ends up doing is it

[00:03:22] creates cycles. We've been entering a cycle of populism. It really started about 12,

[00:03:30] 13 years ago with Occupy Wall Street and the Tea Party. But the millennials had not reached

[00:03:39] political dominance yet, so they were not able to move the needle. It took the bringing of

[00:03:44] not just the left-moving left with AOC and Bernie Sanders, but importantly Trump to bring the

[00:03:50] right left and eventually start passing massive fiscal stimulus and protectionism. Protectionism

[00:03:57] is tied intrinsically to populism. People care about their—countries care about their

[00:04:02] own people. But when we talk about capitalism, we rarely protect our own companies. We're more

[00:04:10] profit-seeking than anything with our corporations. And that creates globalization and whatnot during

[00:04:15] those times. We are in a period of now protectionism and deglobalization. That

[00:04:20] tends to drive global conflict, higher labor costs, less expansive supply chains, all kinds

[00:04:30] of things, commodity scarcity. If you look back at the last time we had that period,

[00:04:35] 68 to 82, which I often reference. That's the last time we saw inflation go bottom left to top

[00:04:40] right and interest rates do the same. We saw the same things that we're seeing now. We saw a

[00:04:46] great society program and massive fiscal stimulus. We saw paired with that a Vietnam War,

[00:04:53] a Cold War that was a massive expansion, and an OPEC crisis and commodity scarcity.

[00:05:01] Any of those sound familiar to anyone? Those sound like some things that we're seeing now.

[00:05:06] It's not a coincidence, right? And so once these things get started, they tend to feed on

[00:05:10] themselves. This is not a one- or two-year thing. This is not a four- or five-year thing. This

[00:05:13] is a 10- to 15-year phenomenon. And that creates structural inflation. Now that doesn't

[00:05:18] mean we're going to have inflation every year. That's going to be high. If you look at 68

[00:05:23] to 82, interest rate inflation went to 7%, came all the way back down to 2%, actually

[00:05:29] below 2%. 69 to 71 took back off when the Fed and stimulus came back to support a recession,

[00:05:40] a multi-year recession. That eventually took inflation to 12%. We then in 75, 76 created

[00:05:49] another recession, a deeper, more powerful one, and interest rate inflation came down to

[00:05:56] 4.5% again. The next leg up was 22% at its peak, I believe. So this is kind of how it works.

[00:06:04] And in my view, if you ask where we are in this, I believe we're in the end of the first

[00:06:10] inflationary push. And we are now in the process of trying to battle that inflation.

[00:06:18] And it will lead to some significant growth slowdowns like we're beginning to see.

[00:06:25] As that happens, inflation will come down. It will probably get to 2%, 1.5%. And we will declare

[00:06:34] victory. We've already tried to declare mission accomplished here in December. I believe

[00:06:43] the Fed will be forced to pivot. This is an election year that's very relevant to the

[00:06:48] macro conversation. It's relevant to 68 to 82 as well. During those election years, during

[00:06:54] that period, we saw greater than 20% returns in markets, double digit every time, 21% on average.

[00:07:01] Those were because of massive fiscal and Federal Reserve support during that time.

[00:07:08] I believe we will see that again. But in the context of that, we saw 0% nominal returns,

[00:07:13] 67% negative real returns over that time period. And I do believe this is a very poor time for

[00:07:19] equities broadly in a bigger macro picture, despite what is likely a positive year

[00:07:28] within the context of that. So we'll stop there and I'll let you ask some more questions. But

[00:07:31] that's the big broad macro framework in five minutes. You mentioned the 70s, which is

[00:07:36] everybody's worry right now. You mentioned some similarities. Do you think there's some

[00:07:40] major differences as well between now and the 70s? Absolutely. It rhymes because of this

[00:07:47] inequality and the populism that's a result of it. But market structure is very different.

[00:07:55] And we've talked about this, but there were no derivatives were just being launched in

[00:08:01] the early 70s. There were no structured products. This market is a very different type of market

[00:08:10] than it was when we had that last similar political reality. So I think that has a

[00:08:17] major feedback loop. We've talked about how dispersion has been driven by structured

[00:08:23] product supply and vol compression. That has a feedback to that equity complex,

[00:08:31] which helps support the equity complex and can extend cycles longer than they used to be

[00:08:36] and reduce volatility. I think that's a critical important point. The other one is,

[00:08:42] a lot of people talk about this. I think this is less important in terms of real returns. I

[00:08:47] think it will affect nominal returns. But I do think that the two other things are very

[00:08:53] important. One, the US debt, right? And how that will play into the reaction functions

[00:09:02] of government. We're at a very different governmental debt level than before.

[00:09:08] And then obviously, we unpin from gold in 71. And so that also had some distinctive

[00:09:18] effects during that period that may be slightly different now that the Fed has

[00:09:22] more experience, more dominance, etc. So I would highlight those three things as probably

[00:09:27] the most important factors that are different. And that will help affect some meaningful

[00:09:33] differences in how things react this time around. For many years, we had these structural forces

[00:09:40] that were keeping inflation down. We had technology, we had demographics, and we had

[00:09:43] globalization. At least that third one seems to be reversing now. But how do you think about

[00:09:48] all those in terms of the structural inflation? Like you mentioned, we're going to have cyclical

[00:09:51] moves up and down. But how do you think about those in terms of the structural inflation we

[00:09:54] might see going forward in a longer period? They're all related. So you said technology,

[00:10:02] globalization. What was the third one you said? Demographics. Demographics. That's right.

[00:10:06] So they're all related, right? Ultimately, if you look at what's happening demographically,

[00:10:13] we have a dominant baby boomer generation dying, right? So that's reducing labor supply.

[00:10:20] That's important. On top of that, we're getting financial support for people, which is allowing

[00:10:29] baby boomers to retire and stop working. Not to mention broadly at large population.

[00:10:37] Globalization, as we talked about, is tied to protectionism or a lack thereof. Populism

[00:10:43] is tied directly to protectionism, and that's leading to deglobalization, which we're seeing

[00:10:47] in global conflict. But technology, which people think is completely divorced from all of this,

[00:10:54] like the AI boom, everything seems like, oh, we've never seen this before. If you think that

[00:11:01] you haven't seen the progress of time or understand how technology and expansion works,

[00:11:07] they happen as a function of investment. If you invest, which we did at 0% interest rates

[00:11:15] in duration, we allowed companies for 40 years to go out and make dough money. If you look at

[00:11:22] Amazon, Amazon would not have existed. It's the biggest business in the world. I would argue it

[00:11:26] would not have existed if we didn't allow the corporation to not make money for 24 years.

[00:11:34] Uber, Tesla, I can go on and on about all of the corporations that didn't make money

[00:11:41] for over a decade and would never have survived in a period of higher interest rates. They just

[00:11:45] wouldn't have existed. Now that they're here, yes, that technology will continue to grow,

[00:11:52] but I believe it'll grow at a much slower pace than people expect because it'll lack investment.

[00:11:57] Much like we saw a boom in 97, 98, 99, 2000, yeah, we had a massive expansion. The

[00:12:04] internet was critical. It was important. It changed the world. Nobody ever had any doubts

[00:12:08] about that, but the irrational exuberance part that Greenfin talked about was the exuberance that

[00:12:13] anybody can make money, that it was just a free-for-all and you just threw money at it and

[00:12:17] you would win because the internet was so important. 96% of internet companies went

[00:12:24] bankrupt in 2000. 96%, the NASDAQ lost 91% of its value. I mean, AI is a critical change.

[00:12:35] Blockchain, critical. It is going to change the world. We will go to a metaverse at some point.

[00:12:40] All of these things will happen, but the pace at which it will happen will slow

[00:12:45] and there will be so much losses profit-wise along the way that people are dissociating

[00:12:53] the importance of technology and the growth relative to the rate and the speed

[00:12:58] and the profitability of those things. So my view is that yes, we're getting massive

[00:13:01] technological innovation. We always have since the time the wheel was invented.

[00:13:09] It seems like it's faster and more ridiculous than ever, but it's constantly that way. We're at

[00:13:13] increasing rate of change, but that has always been the case and I think that's important to

[00:13:19] note. So I think technology and the advancement of technology will significantly slow as

[00:13:24] interest rates increase over time. Just one more for me before I hand it back to Brent

[00:13:28] for the breadcrumbs that everybody I think is looking forward. But I want to ask you about

[00:13:31] the Fed because they are meeting tomorrow. They seem to be in a tough position right now. You've

[00:13:35] talked about them being in a box. What do you think the Fed is going to do going forward

[00:13:40] and what do you think they should be doing? Well, what I think they should be doing and

[00:13:44] what they are going to do are different things and what the Fed is going to do and what

[00:13:48] they're going to say are also probably different things. It's important to remember

[00:13:52] that the Fed has now said the word transitory three times since 2021. In my opinion, not

[00:14:00] because they actually thought inflation was transitory. I don't think the Federal Reserve

[00:14:04] is stupid. I think they know they need to use their power of their verbiage to try and

[00:14:13] control as best they can the outcomes. And in telling one of the biggest problems with

[00:14:20] inflation and these things is that it's self-fulfilling. There are expectations of

[00:14:25] inflation that pulls forward demand, right? And that increases inflation. If markets reflect

[00:14:30] an inflationary environment, then you can invest and you can buy things real assets

[00:14:37] with cheap interest rates and it doesn't allow the Fed to keep interest rates lower.

[00:14:42] So there are natural consequences of admitting that we are in structural inflation. So

[00:14:49] the Fed won't admit it. It's not incentivized to do that. They're incentivized to play

[00:14:55] Pollyannaish and stupid. They are fully aware of the circumstances. Now, when you're in a box

[00:15:02] and when you are no longer just – the way things were set up before, we had structural

[00:15:08] deflation caused by zero percent inflation. Again, we used to send money to what I call

[00:15:14] Planet Palo Alto. We used to keep sending money to supply and that would create all these goods

[00:15:19] back onto our shore, right? We would get Ubers and Teslas and Amazons and those are

[00:15:24] deflationary. And so we were able to – the Fed was able to stimulate with monetary policies

[00:15:30] cyclically, right, to battle that. And so it was very easy in a deflationary period. They

[00:15:34] had one mandate, which is to just make sure growth come along. The cost of that was

[00:15:39] inequality, right? And we could keep doing that forever. It's a great system if people

[00:15:43] weren't in the system and we could just keep sending money to the top 0.1 percent.

[00:15:48] But we're not in that situation anymore. Now, we have a dual mandate that the Fed has a dual

[00:15:51] mandate they have to battle. And so they have to choose at any one moment. And that is a very

[00:15:57] – at the high wire act. That's something we haven't seen for 40 years. The Fed is

[00:16:04] in an unenviable situation. At any given time, they're going to have to go from one side

[00:16:08] to the other. And it's probably most driven by politics because there's no right answer.

[00:16:13] What's worse, inflation or recession, poor growth? It's a political question.

[00:16:21] And so ultimately, when the political whims push towards growth as they are during an

[00:16:26] election year – this is why we get positive election years in the context of what otherwise

[00:16:29] is structurally weak period for equities and risk assets – but in these periods,

[00:16:35] you'll get stimulus and they will favor growth over inflation. And I believe that's what they

[00:16:39] will be doing this year. And that's what they've told us as of December of last year.

[00:16:42] They were pretty clear. Took a lot of people by surprise. That's what they're going to do.

[00:16:45] Now, do they have to still kind of – when inflation continues to be hot five times in

[00:16:49] a row, do they have to kind of back off of that a little bit? Sure, it's a political

[00:16:53] story and they can't be seen as ignoring inflation. But you better believe their

[00:16:59] interest as soon as they can is to try and continue to stimulate and make sure this economy

[00:17:04] continues to rumble along. And if not, be hotter than it would have been in other periods. So

[00:17:11] I believe that's where they are this year. Now again, the next bout of inflation will lead to

[00:17:15] a abandoning of growth for inflation. And again, I think that will eventually come,

[00:17:21] but it's probably for next year. Yeah, thanks. So nice to meet you officially.

[00:17:27] Sam Brutt. There's been a lot of conversations about

[00:17:30] call overriding. Let's just say fairly low equity volatility or the impacts of zero DT,

[00:17:36] whatever it is. But Decibel pointed out that globally, vols are pretty low if you look at

[00:17:43] cross-asset and global vol. And I'm curious – that was particularly the case

[00:17:48] in the end of April – excuse me, end of March, start of April. And now we're starting

[00:17:52] to see rolling bouts of vol picking up. Like yen was going crazy, gold going crazy,

[00:17:59] FX. So vol seems to be having these spasms, whereas let's just say over the last year,

[00:18:07] things were fairly quiet. Do you think that's a trend that's going to kind of continue here as

[00:18:11] we move to the election and as things are changing with FOMC and those types of things

[00:18:15] tomorrow? Or is that likely to get smoothed out into the election this year? Is there

[00:18:20] a changing of regimes, I guess is the question.

[00:18:22] So if we zoom out to two and a half years, not just the last year, right? We have had significant

[00:18:30] dispersions in volatility, not just dispersion in equity markets, etc. That is, in my opinion,

[00:18:38] partially because interest rates as they went higher, increased risk premia,

[00:18:43] and are naturally supportive. And not to mention we have rotations due to changes in

[00:18:49] the world right now. Those are naturally, interest rates increase is naturally supportive

[00:18:56] for that volatility. How I've described this is, and again, I know, Brett, you're familiar

[00:19:00] with this, but the structure product issuance in the move away from equities into bonds,

[00:19:07] right? It used to be just a one-way street just into bonds. Now it's a move into bonds

[00:19:12] plus bonds plus collateral that you can then use to compress risk. The interesting part is

[00:19:18] that compression risk through structured products and other similar vehicles is going to the center

[00:19:23] of equity indexes primarily. That vol supply is really pinning S&P vol and central.

[00:19:35] The FX world, right? That world, for example, is not as deep and does not have this type of

[00:19:43] supply. And it is really on the fringes, but at the epicenter of this deglobalization

[00:19:51] reality and the move of money. So FX, if you look at 1968-82, what vol did the best on a realized

[00:19:58] basis and an implied basis, it's not what people would think like oil and commodities.

[00:20:04] It's not equity vol. It's definitely, it's not even bond vol, which did quite well.

[00:20:12] It's actually FX vol. It's gold vol. The currency vol, the dollar vol was incredibly high, right?

[00:20:20] Those are the volatilities that are less likely to also be pinned by this supply.

[00:20:25] And we argued for this about a year ago when gold was on its lows and that vol was

[00:20:29] compressed in gold while oil vol was through the roof, right? Commodity vol actually did,

[00:20:35] like oil vol and other commodity vol did very, very poorly in the 60s and 70s despite

[00:20:40] it being very strong because it was underpinned. Instead of the Fed selling puts, which really

[00:20:46] reduced the volatility of the dollar and bonds and all these things for 40 years,

[00:20:50] now you have commodity producers able to sell puts at an underpin price.

[00:20:54] So vol in those centers was actually very compressed over that time period. I believe

[00:20:59] that will also be the case in this time period that whether it's oil or copper or

[00:21:04] other industrial metals, the volatility of those are a sale. You should be selling puts

[00:21:08] in those, best way to benefit from the uptrend there much like it was good to sell puts broadly

[00:21:15] over the last 40 years and very profitable trade. And equity land, I do believe equity

[00:21:20] vol will not do that great. What it did in the 60s and 70s, which I believe it will do

[00:21:24] again is you'll have spasms like you were saying, you'll have short-term volatility.

[00:21:28] But again, I want to remind you 60 to 82, 14 years, the market went nowhere.

[00:21:31] What does that do to long-term vol? Right? Yes, you had a lot of declines,

[00:21:35] you had a lot of rallies. But at the end of the day, those were short-term spasms and long-term

[00:21:42] vol did not perform. And so one of the best trades you could have done, 68 to 82, was to

[00:21:47] sell calendars all day long and just keep selling them because it would mean revert and it kept

[00:21:52] me in reverting again and again now. And that way you'd have the gamma, but the Vega

[00:21:58] would not perform. I do think that's likely to be the case. I also think SKU, which we've seen

[00:22:02] at very low levels lately, right? That's actually efficient. I think SKU is overvalued

[00:22:09] in this regime. I think you'll see a much flatter SKU going forward despite these short-term

[00:22:15] spasms. I think it is because long-term vol and long-term SKU is the most overvalued of all.

[00:22:23] You'll begin to see a significant reduction of SKU I think structurally going forward.

[00:22:29] So I think somewhere related to that may be the upcoming election. And I just wanted to

[00:22:34] get your insights on volatility into and around the election. There's obviously a bunch of kinks

[00:22:38] and kind of term structure if you start to look at that. What from a volatility

[00:22:42] perspective do you think the election impact is? I mean, people are obviously anticipating

[00:22:47] more volatility around the election. I remember in the last election there was some pretty

[00:22:53] wild movements or something two years back of the Trump election. What are the effects? Are

[00:23:00] there knock-on effects that we can start to look at now? Are we still a little bit too early

[00:23:04] before the election period and how vol may impact things? How do you start or when

[00:23:08] do you start to think about those? Yeah, so in terms of the event vol tied to elections,

[00:23:14] it's still pretty far out, right? It's not nearly as liquid and hard to make any money now,

[00:23:21] nor do you need to be positioning for that now in my opinion. That said, elections and event

[00:23:27] vol are critical part of microstructure and drive short-term or one of the biggest inputs

[00:23:34] to short-term moves. The world hedges for events. Time is not linear in the sense that

[00:23:43] a second is worth the same amount of volatility. Basically we can have weeks where vol is very

[00:23:50] compressed and there are no hedges and there's no big structural buyback of some of the deltas

[00:23:59] tied to that in the equity market. Then we can have a massive day or two where months of implied

[00:24:05] volatility come out of the market. So the election is always a hedged event, a watched

[00:24:14] event, which means dealers take naturally massive insurance on it and there are short stock

[00:24:21] in the absence of some really unexpected outcome. A largely unexpected outcome is not

[00:24:29] the same thing. It's hard in an election where there's two people to have a dramatically

[00:24:34] unexpected outcome. It can happen but it's not just the president that matters. It's

[00:24:42] the government and everything that comes with mandate. At the end of the day, those tend to be

[00:24:47] positive events. People get bearish, get scared but again there tends to be very positive support

[00:24:53] coming out of that. I think over a short period now it doesn't mean that positive for the next

[00:25:00] year or three months even. It really coming out of that maybe for that option cycle in a

[00:25:07] month or so. Now a squeeze out of that period into the end of the year. It's in early

[00:25:12] November. Then we have some of the most seasonally positive periods that also bring supply and other

[00:25:17] you know we had December expirations are always the biggest expirations. They have a lot of

[00:25:21] other positive flows coming out of it. So I would expect this year, you know the post-election

[00:25:28] to be very positive. Particularly in an election year there'll be some exuberance. Now

[00:25:34] to be clear, you know my view on after this year how this market looks is it you know it's

[00:25:41] set up for potentially after a big rally. A very dangerous setup here structurally and when you

[00:25:47] zoom out to a more five, ten-year picture. So it makes sense after a big rally this year to

[00:25:54] start to see something I would expect in January or February of next year as a potential

[00:26:00] target. If we do rally like I expect to really be placing hedges and thinking about the next move.

[00:26:07] As we wrap up in the couple minutes we have left, we have a standard closing question we're

[00:26:11] asking everybody today which is what is one interesting thing you're seeing right now that

[00:26:15] you think others should be paying more attention to? And it could be inside or outside investing.

[00:26:19] Yeah I think there's so many interesting things going on right now but I think the

[00:26:24] thing that people really aren't talking enough about is skew and how flat and how you know

[00:26:31] compressed skew is in the market. As we talked about I think structurally that makes a ton of

[00:26:35] sense but there's also some very important reinforcing realities of that circumstance.

[00:26:43] It means it's very easy to hedge any tail downside and it makes declines in the market

[00:26:51] easier to buy. That doesn't mean that we are going to turn around quickly into whatever decline

[00:27:00] or swoon we've seen but it does mean that the decline is likely to not be structural

[00:27:07] and at some point also not meaningfully catastrophic or a ball event. I think that's

[00:27:13] very important. It is way too easy at this point to get hedges in the market and I think

[00:27:21] that's a very very important thing that people are missing. Now to be clear a lot of times

[00:27:27] when skew is flat declines can last a bit longer than expected because you don't get

[00:27:33] that impulse, that fear impulse and you don't have that ball of spike that then leads to

[00:27:38] that buyback that we've talked about from the Vaughn and Charm flows. So ironically if you go

[00:27:44] look at the timeline 2015 we had the Yawanda evaluation, big vol event, screens went black.

[00:27:55] That was a big vol event not a very big decline all in about about eight nine percent

[00:28:01] followed by Feb 16 which was the opposite right a very vol compression skew flat decline.

[00:28:07] That was the biggest decline we had since 09 and it was 12.5 percent right but not of all of them

[00:28:13] much more tick tick tick tick. Similarly you know you roll forward to 18 we had the volpocalypse

[00:28:19] not that deep a decline right you know but very very meaningful again about nine percent

[00:28:26] decline and then we you know but quickly responded what happened in Oc Nov Ds 2018 skew

[00:28:32] flattened you know people were hedged because of the last event and what happened we had a 19 percent

[00:28:38] decline. People talk about the volpocalypse and the fear of it was less than half the decline

[00:28:42] of the Oc Nov Ds decline in 2018 so you can get bigger declines with a flat skew

[00:28:49] because you don't get that vol reaction and that feedback loop to feedback but ultimately they

[00:28:54] do they do tend to be viable dips and do tend to eventually resolve themselves it just

[00:29:01] may take a bit longer so I think I think the skew out there is telling you something I think

[00:29:05] if you look at history and in the circumstances of that skew you'll have a better clue about

[00:29:09] how this next several months will play out. Well Jim thank you again for doing this we

[00:29:14] really appreciate you taking the time and coming out to help us support Susan G. Komen.

[00:29:19] Couldn't think of a better cause and couldn't think of two better people to do it with so

[00:29:22] I appreciate you guys having me take care. We picked the perfect time to talk to you we've

[00:29:25] got the fed this week we've got the QRA which to be honest before you pointed out on twitter

[00:29:30] about a year ago I didn't even know what that was but it turns out it's a very market moving event

[00:29:34] so we're gonna cover a lot but before we start I just want to intro you you're obviously you're

[00:29:39] Andy Constan the founder of Damp Spring Advisors and you have a perfect background to talk to

[00:29:44] today because you've got kind of a mix of the systematic and the discretionary on the macro

[00:29:48] side you were Bridgewater you were Brevin Howard you can kind of come at this from

[00:29:51] from different directions so we really appreciate you taking the time and just a reminder to

[00:29:56] to benefit Susan G. Komen if you're watching us on YouTube there's a donate link next to the video

[00:30:01] you can click that donate link to give money if you're watching us on twitter or on LinkedIn

[00:30:05] you can go to YouTube to donate if you do get any value out of what we do today we would

[00:30:09] greatly appreciate it if you would give money it's a great cause and but before we start here

[00:30:14] Andy and get into all that stuff I talked about I just wanted to talk a little bit about your

[00:30:17] framework because you have a great framework that makes macro I think easy to understand

[00:30:22] and this is idea of islands you've always been talking about the different islands that exist

[00:30:26] and you've moved a little bit between the islands although you were in one for a really

[00:30:29] long period of time and now I think you're kind of lost at sea maybe thinking about

[00:30:32] where you're going to go next so can you talk about your island framework and how that

[00:30:37] applies to macro well I mean I'm stepping back from the islands for a second I look at

[00:30:43] changes in growth expectations changes in inflation expectations

[00:30:47] um what happens what the value of assets are by measuring term premium and risk premium

[00:30:54] and then by using um data on flow and positioning and in this particular environment

[00:31:02] the flow and positioning has really been driven by expectations of a soft landing

[00:31:10] and there are good reasons for that you know we have had we got through covid and then we

[00:31:14] had this inflationary burst as everyone came back and spent at the same time as supply

[00:31:20] chains were disrupted and then over time you know inflation is cooled it was in fact

[00:31:25] transitory at many levels and so now the question is will the uh economy go back to

[00:31:33] and land softly and what that means is that um inflation goes to target and growth uh

[00:31:42] doesn't turn down so heavily as to create a recession and that's a pretty unusual outcome

[00:31:50] particularly after the sort of meaningful stresses and significant um flows of capital

[00:32:00] that have occurred and the changes in um a you know four decade long uh secular globalization

[00:32:10] to a uh less secular less secular globalization pressure and possibly even a de-globalization

[00:32:18] at least cyclical de-globalization so all those cross-currents those winds at sea are

[00:32:25] um make it land landing a soft landing very difficult and yet for most of the last year

[00:32:33] the pricing of financial instruments has favored the idea that we will in fact soft land pretty

[00:32:43] much all of last year the fed's rate cut projections were overshot by financial markets

[00:32:51] they expected more cuts sooner and equity prices normally cuts are or happen when the

[00:33:01] economy weakens and yet equity prices priced in uh significant growth in earnings so those

[00:33:09] combinations of things you know made me think that we're in for were priced flow and positioning

[00:33:14] is priced for a soft landing and so i was on an island i called hire for longer and that

[00:33:19] was really about 18 months old um soon after the first hike rape hikes i coined that term

[00:33:27] and um used the dumb and dumber thing higher were and longer were um island to just to um

[00:33:35] to differentiate from higher for longer um and that in that place the fed raises interest rates

[00:33:42] but doesn't slow the economy and the economy doesn't land and inflation ends up being more

[00:33:48] sticky for longer and um what that means is that uh the fed has to keep pushing

[00:33:57] and so far they haven't turned the economy and so my view is that inflation has um has um

[00:34:06] still some legs to it and we'll see but really at the end of the day i left hire for

[00:34:11] longer island because and went out to sea because um market pricing now has less cuts

[00:34:20] priced in in both 2024 and 2025 only a hundred basis points of cuts are now priced in

[00:34:28] for all of the next 20ish months 13 fed meetings a hundred basis points of cuts

[00:34:35] so the market has already moved to hire for longer island and in fact positioning now

[00:34:43] expects the fed to cut less and i think that's ridiculous um so i've left

[00:34:51] do you have any any feeling where you're headed i mean i don't think you're headed to

[00:34:53] soft landing island based on what you said um and we did get after we talked to you last

[00:34:57] on excess returns we did get like some higher inflation readings so i mean are you kind of

[00:35:01] turning the wheel a little bit back to hire for longer island i am not i think that uh what

[00:35:05] matters and this is where the qra data that came out to yesterday and will come out on

[00:35:11] wednesday uh matters i think what has to happen for inflation to be killed is not the fed

[00:35:18] hiking they've hiked enough time at higher short-term interest rates cause and supply

[00:35:26] of treasuries which we've now are beginning to get and have been getting since last summer

[00:35:31] has weighed on bond prices and caused longer term yields to rise closer to

[00:35:39] current short-term yields and that to me is the pressure that puts that slows the economy

[00:35:46] not what the fed has done on the front end but what the market is doing on the back end

[00:35:51] and that will cause the economy to slow and i do believe that um for inflation really to be killed

[00:35:59] interest rates long-term interest rates have to be well over five percent and persist there for

[00:36:04] you know give it three four months we had that situation for two weeks in october and of course

[00:36:10] the economy slowed in the following months but wrote came roaring back in the first quarter so

[00:36:18] i think we have to have a period of time where long-term interest rates are high

[00:36:23] are high enough to slow the economy for inflation to be killed and i think that's

[00:36:28] the direction we're heading unfortunately it'll slow the economy not necessarily to a crash

[00:36:33] landing but certainly a stall and it may take um more easing than you might have expected and

[00:36:41] certainly more easing that's priced in to offset that stall so we still achieve a soft landing

[00:36:47] but i think the more likely thing is i end up at recession island

[00:36:51] given your focus on longer term rates and how much more important they are to the economy

[00:36:55] do you think the fed should have been focusing on qt more here um or should they be focusing

[00:36:59] on it more now i've been writing that for two years um and you know i think they made a huge

[00:37:05] mistake um tactically um replaying the 2019 um qt uh runoff um

[00:37:17] strategy versus what the boe does where they actually sell bonds off their balance sheet to

[00:37:22] the market in auctions i think they should have done that i think they should have done that

[00:37:27] with mortgages there are lots of um offsetting factors because a lot of the banks would be

[00:37:33] stressed if they had sold those bonds but by giving the runoff by doing runoff they gave

[00:37:39] the ball to the treasury and the treasury has had reasons why they couldn't issue coupon bonds

[00:37:45] in size and so that transmission mechanism was muted in the united states and so yeah i've been

[00:37:51] saying for years now that um the qt runoff strategy uh created problems can you talk more

[00:38:00] about this idea of handing the ball off to the treasury because this is something i learned from

[00:38:03] you you know i was really focusing on what the fed was doing and you were focusing on what janet

[00:38:06] yellen was doing the whole time can you talk about why that's more important right now well

[00:38:10] ultimately what matters too um well you can believe in supply and demand matters i do

[00:38:16] there's some people that don't um i think that supply of long-term treasuries that our new

[00:38:25] treasuries have to be assumed by someone who was perfectly happy to own risky assets before that

[00:38:33] and now has to choose to lever up to buy those risky assets or spend cash or whatever it is

[00:38:42] and by taking on more risk they want an excess return and so when the boe sells bonds to the

[00:38:52] market long-term bonds to the market that process works and the boe back of england gets

[00:39:00] pays investors an excess return over their cash to lever up to buy the bonds when you do runoff

[00:39:09] the the treasury fed did no selling all they did is let existing bonds mature

[00:39:16] and so the choice so what gets sold to the market how do they get their money back

[00:39:20] well when the fed gets its money back it is paid for by the treasury and the treasury goes

[00:39:28] into the market and borrows from the private sector and so that is the you know somebody

[00:39:34] sells bonds but it isn't the fed it's the treasury and the treasury gets to decide what

[00:39:40] to sell and to the extent they sell bills that doesn't require investors to take on much

[00:39:47] risk because they mature and you know seven days to 364 days to the extent they sell

[00:39:54] longer-term bonds particularly if they were to sell all 30-year bonds there'd be a huge impact

[00:40:01] in long-term bond prices because 30-year bonds are super risky and people don't want them

[00:40:07] so what they do is they sell a variety of bonds and what has happened in the past

[00:40:13] since october of last year not last year two years ago is the treasury has had other impacts

[00:40:20] on their issuance which prevented them from issuing bonds during the debt ceiling

[00:40:29] you know from november through of 22 through june of 2023 there was a debt ceiling and so

[00:40:37] they could were limited in terms of how much coupon debt they could issue long-term bonds

[00:40:42] they could issue they still issued some but they couldn't issue much and then what they ended up

[00:40:49] doing is using their checking account the treasury general account during this time of

[00:40:55] crisis in which they had no choice but to honor our obligations as a country while they

[00:41:01] negotiated with congress to avoid the debt ceiling and so that resulted in a stimulative

[00:41:10] effect to both assets and the economy which ended up generating a 4.9 i think percent gdp

[00:41:18] real gdp in that in q3 of 2023 so the things got pumped as the as the treasury stopped

[00:41:25] issuing muting qt and spent what they had in their checking account stimulating the economy

[00:41:32] and so then they announced hey we're going to issue a ton of bills to rebuild our treasury

[00:41:40] general account and that didn't have any impact because bills the rrp was a demand

[00:41:46] of supply of demand for bills and so there wasn't really any impact on issuing a ton of bills

[00:41:55] and then finally in july they said you know what we're going to issue a bunch of coupons

[00:42:00] and that's when the market really began to sell off and that's how that transmission

[00:42:05] mechanism worked and then in october they said whoa interest rates just increased by 120

[00:42:13] basis points from the lows in july when we said we're going to issue a bunch of coupons and they

[00:42:18] said wait a second we're just going to hold on and we're not going to increase coupons this

[00:42:23] quarter well look what happened massive rally in financial assets bonds even rallied

[00:42:31] though they peaked in january on soon after christmas and the economy heated up

[00:42:39] and so it really is clear to me that the economy operates with a very short lag

[00:42:47] to changes in long-term interest rates and so that's where we are today and i think

[00:42:54] the economy will continue to act in that way so if we see for whatever reason long-term

[00:43:00] treasury but without a change in the economy but market forces pushing long-term treasury

[00:43:05] yields down below four and a half again the economy is going to heat up and if not

[00:43:11] economy should weaken yes it's been amazing to me how market moving this is and you didn't need

[00:43:16] in one of these you talked about on twitter is you don't need to necessarily predict

[00:43:19] what the treasury is going to do you sort of react to them once they do it so it's not

[00:43:23] something you have to try to front run but definitely it's been amazing to watch this and

[00:43:27] to watch the market go up you know when they're issuing less duration and the market go down

[00:43:31] when they're issuing more duration so it's been eye-opening for me to see this happen

[00:43:35] yeah i mean i think that's so normally news gets discounted and there is no advantage

[00:43:42] you have to be able to predict the outcome to make money in markets and that's super hard

[00:43:48] and so most things whether it's amazon earnings or you know the the employment cost index that

[00:43:57] we're about to get all of these things you have to predict to be able to make any money

[00:44:03] because they're fully priced in these flows and you know the qra was a sleepy report for

[00:44:10] most of my career 36 years career it only became interesting about two years ago when

[00:44:15] qt was announced and the budget deficit was so large um so those combinations have um caused

[00:44:22] it to be relevant but the flows around quantitative tightening and quantitative easing

[00:44:29] just cannot be front run they are too large for everyone to say so for instance we had qe and in

[00:44:39] after covin you know at gosh at 2800 on the s&p you know people were like ah this doesn't

[00:44:48] matter you know qe is not going to be a big deal look at covid it's going to be all the

[00:44:53] thing and in fact that was the easiest buy in history post covin because the quantitative easing

[00:45:03] was going to elevate financial assets on december 15th of 2021 the fed said we're looking at our

[00:45:12] balance sheet and then in the minutes on 20 in 2022 um they said uh in january 2022 they said

[00:45:22] yeah we're gonna do quantitative tightening and even though that took six months for them to

[00:45:28] actually engage in quantitative tightening and continued to do quantitative easing for three

[00:45:34] months the markets reacted and that was the high for 2022 and we all know what happened to

[00:45:40] bonds during that period of time and equities followed so these massive flows just cannot be

[00:45:46] front run and so you have to be patient and you know willing to take some short-term pain

[00:45:52] as you position against the news knowing that you're likely three months from now you're likely

[00:45:57] to look back and say yeah those flows matter it's amazing to me we can have these indicators

[00:46:02] that we like don't pay attention to for our whole careers and then suddenly they're really

[00:46:05] important like i remember like the cpi report for most of my career nobody cared um the same

[00:46:10] thing with this funding announcement and then suddenly it's on the radar and everybody cares

[00:46:14] um i don't know what that means but it is interesting that this type of stuff happens

[00:46:17] well we'll see i mean because these happen so infrequently and there's still you know quite

[00:46:22] a lot of people who don't believe me you know who look at these quant QRA and say what the

[00:46:27] hell's the difference and that's because they tend to be very short-term in their thinking

[00:46:31] that they think it's going to have a signaling effect and cause a market reaction instantaneously

[00:46:37] and that's just not the way this indicator works so you know i don't expect it to last

[00:46:41] forever um what i actually expect is the qra becomes less relevant because it becomes

[00:46:46] a lot more stable which is a const as qt ends which is probably going to happen within the

[00:46:53] next 12 months but not soon um and the budget deficit stabilizes the impact of issuance is

[00:47:03] going to and treasury extends its duration stops using bills as a plug but

[00:47:12] extends the effect is going to be significant and put pressure on asset prices for the next

[00:47:20] couple of years but it won't be as volatile so to get to the question everybody wants us to

[00:47:26] ask uh the announcement is tomorrow um what do you expect i expect them to keep coupons the

[00:47:31] same um though the announcement yesterday regarding the total issuance was much bigger

[00:47:39] than anyone expected which indicates it's almost certain they have pressure to increase coupons

[00:47:45] but i don't expect them to do that and i expect them to announce the duration neutral

[00:47:51] uh treasury coupon buyback program which is going to be small and then we'll be on to the

[00:47:56] fed so i think most of the news broke yesterday which is that the coupons sizes are not getting

[00:48:04] smaller and the treasury general account is getting larger and both of those things are

[00:48:11] sort of anti but the what um some have been calling for regarding um political usage of the

[00:48:19] issuance um the issuant treasury issuance to ensure a democrat victory um i think that

[00:48:28] narrative is dead based on the qra we got to yesterday and thus today tomorrow's qra is

[00:48:34] actually you know really just confirmation of what i think i know now and then we'll see what

[00:48:39] the fed does and you know i expect the fed to um i expect the fed to delay uh tapering

[00:48:46] qt for another another meeting the one of their big concerns is the level of the rrp and it

[00:48:54] dropped to 325 billion on tax day but is now up to 500 billion and it doesn't really call

[00:49:02] for any concern about financial stability uh at that level and so i think they delay taper

[00:49:08] at least one more meeting um but ultimately they're gonna taper and ultimately they're gonna

[00:49:14] um stop and when they but the important thing is they're tapering runoff

[00:49:23] treasury has a bigger problem it has issued far more bills than it normally does

[00:49:31] and they're going to need to lock in term funding over time and so even though taper

[00:49:39] happens remember the mechanism has nothing to do with runoff it has to do with what gets issued

[00:49:46] and so as long as what gets issued is coupon debt assets are going to be under under pressure

[00:49:52] until they're until they're priced better it's funny you uh you would put a poll on twitter

[00:49:57] you know you just explained what's going on with the qra but you'd put a poll on twitter

[00:50:01] um about you know will janet one materially reduce coupons two spend down the tga to well

[00:50:05] below 700 billion three fund buyback of of bonds with bills um and you had one pump two pumps or

[00:50:11] three pumps and pretty much everybody picked three pumps of course and it seems like we are

[00:50:15] getting the opposite of what you know people thought we were gonna get yeah that's what i i

[00:50:19] did that because i knew what the answers were going to be i knew people were going to say

[00:50:24] they're going to pump because you know twitter is a political place my clients that are

[00:50:29] some of my clients did think that there's you know some political agenda but my large hedge fund

[00:50:35] clients um were not surprised by both the results and my view that they weren't going to pump at

[00:50:43] all um and so we'll see whether there's a again no one's front running it so it's still gonna

[00:50:49] have to take its time to play out but twitter is a place where political narratives are

[00:50:55] you know you're gonna get that result and i got it in spades and obviously they're wrong

[00:51:00] and badly wrong it's and so do you think there is no kind of election effect

[00:51:07] obviously you just sort of just say the the treasury related stuff but do you think that

[00:51:11] there's any sort of positioning or flows that change just around that election even if it's

[00:51:15] just energy or whatever it may be yeah i think i think so one thing i think matters is

[00:51:20] policies matter politics don't and i would expect changes in policy if there's a change

[00:51:28] in the administration and a certainly changes in policy if there's a in either case a um um

[00:51:39] unified um congress and um presidency i don't know if those outcomes are going to occur but

[00:51:46] you have to begin discounting them and so certain sectors are going to do better under

[00:51:51] one unified party versus the other unified party and so it's not my lane to care about

[00:51:57] well i care about but not my lane to invest on single names but single names are going to have

[00:52:02] significant issues around vests um as it relates to macro policies matter and so but

[00:52:12] what i would say about either unified outcome uh the deficit's gonna go up who pays for that

[00:52:19] increase in one case you're likely to see corporations and high net worth people

[00:52:26] see lower taxes and the spending will potentially be cut but not enough to reduce the deficit

[00:52:34] while um on the other hand you might see higher taxes but higher spending and that will continue

[00:52:43] to increase the deficit so i think either party is going to have policies that are deficit

[00:52:48] increasing because no one is willing to take the pain our elected officials get paid for

[00:52:55] providing a bigger pie for current voters at the expense of a smaller pie for future voters

[00:53:02] and i don't think anything all of that will change um and so yeah i mean i think that's

[00:53:08] you know there are small issues there are country issues tariffs etc that might be worthy

[00:53:14] of you know anticipating the outcome of the election but also anticipating the outcome of

[00:53:19] the election is a low odds bet for me um i think really the election is going to hinge on four

[00:53:25] to five states and two to three counties for each of those states and how that falls out

[00:53:30] because that's really all that matters when it comes to an electoral college decision

[00:53:38] and i just can't predict that and i had seen recently you you had mentioned

[00:53:44] the equity top is in specifically the s&p um and and i take from our conversation here that

[00:53:50] that's not just maybe a statement for this year but but possibly for for several years out in time

[00:53:55] uh please correct me on that if if i'm wrong um i would say this i would say that um i think

[00:54:03] equities are going down i think bonds are going down and at some point central bankers

[00:54:11] may or policymakers may address the decline in asset prices and in the economy particularly

[00:54:19] if we have a recession um and in that case you know you could have a rally and at any moment

[00:54:27] in any time animal spirits can cause us to blow through felicia's top um so you know this is

[00:54:35] the direction is the idea sure um do i think it'll be a long-term top i don't know honestly

[00:54:41] i hope not i like i've been a bull for most of my career and i would much prefer to be a bull

[00:54:49] and so what i'd like to do is see bonds with a term premium that makes them attractive

[00:54:54] relative to cash they don't have that and i'd like to see stocks with a equity risk premium

[00:55:01] or whatever sort of metric you want that um has i'd like to see earnings that are likely

[00:55:09] to rise instead of fall relative to expectations and multiples that are more in line with

[00:55:15] um the where treasury yields are um and if so i'm going to be a raving bull

[00:55:21] and i hope that happens soon and so can we just also think along those same lines in

[00:55:28] terms of volatility that we've been in a pretty low volatility environment generally across all

[00:55:32] assets particularly before april um is that regime likely to now shift in your view kind

[00:55:37] of cross asset ball just generally picks up from from the you know loath we've seen recently

[00:55:43] well if i'm right on supply mattering that tends to create correlate positive correlation

[00:55:48] with all assets which tends to mean diversification benefit goes away and you start

[00:55:53] to see individual asset volatilities rise so if i'm right on that yes i think individual

[00:56:00] mostly portfolio volatilities will um increase because of lower diversification benefit

[00:56:07] like we saw in 2022 but individual asset volatilities you know that's a different

[00:56:13] thing um and i wouldn't say that you know gosh you got to go out and buy um calls on

[00:56:20] um on vix um on vix futures frankly i think what that is assumes that this happens this

[00:56:29] deleveraging i'm describing which i think happens happens fast and i don't think it's a fast thing

[00:56:35] i think it's a slow thing and uh the economy weakening will be a slow thing and so i'm not

[00:56:41] pounding the table on vol here i do think portfolio vols going up though

[00:56:46] so as as we wrap up we have one closing question we want to ask everybody today in the couple

[00:56:51] minutes we have left and it's what is one interesting thing you're seeing right now do

[00:56:55] you think others should be more paying more attention to and it could be outside of vesting

[00:56:58] or inside investing however you want to take it i didn't come up with a good answer because

[00:57:03] i think i look at the thing that no one's looking at and so i would say the qra and

[00:57:08] the supply and demand of assets um but i guess what i would say is that i think it's

[00:57:14] getting a lot of attention now but i do think that china is oversold and um it is the year

[00:57:21] of the dragon and i wrote something about that before the market rallied in um early

[00:57:27] february i think that's going to be the most interesting thing whether um china assets out

[00:57:33] perform uh us assets in the next year well thank you again for joining us and for helping

[00:57:39] raise money for susan g coman if if people want to find out more about you or about damp

[00:57:42] spring where can they go well i'm at damp spring on twitter and damp spring dot com

[00:57:47] uh on the internet well thank you andy we appreciate it uh we appreciate i appreciate

[00:57:52] what you're doing for the charity my dad passed away with cancer two years ago and this

[00:57:57] charity um means a lot to me thank you so much