The Macro Trading Floor transcript – 18 October 2024

Alf (00:01.27)

Buongiorno everyone, welcome back to The Macro Trading Floor, Alf speaking. With me, my good buddy Brent. So Brent, you had a survey for your AM/FX clients and you asked them a bit like, what do they think of elections? And what do you think the trade is if XYZ wins? Super interesting, even you have quite the audience and an institutional one. So do you wanna tell us what people said?

Brent (00:25.104)

Sure. So the results were close to what I would have expected, but there were some differences. It wasn’t exactly what I thought. So I broke it into red sweep, blue sweep, Democrat president with a split Congress, and then Republican president split Congress. Because as we’ve been discussing over the last few weeks, those are really like the four outcomes that are differentiated. And the real big clear outcome is the red sweep because you know more clearly what the policies are going to be. It’s a change from the status quo. So that’s really the big one.

So my survey was asking, and I have seen surveys that go out further, but my survey was asking, what do you think will happen in the 24 hours based on different election outcomes? Because I think that generally, if you look at historically, other than 2016 where we had the fake out, the first reaction actually has been pretty decent. in terms of bonds, people think 20 to 30 basis points higher in the 10 year yield in 24 hours.

Alf (01:35.714)

24 hours. Holy moly, wow!

Brent (01:38.104)

Yeah, so when I saw that, was like, holy shit, dude, like that seems insane. But then actually in 2016, so I’m sure people remember, unless your birth date starts with a two, unless the year of your birthday starts with a two, but most people would remember 2016. And the consensus at that time was that Trump will be bad for the economy, too much uncertainty and this and that.

So yields went down 20 basis points initially. Stocks were limit down and then yields closed up 40 basis points that day. So, or sorry, up 20 basis points. So they went down 20, then up 40 to close up 20. So actually, I don’t think the estimate is that crazy given that the election is still pretty close to a coin toss, but 20 or 30 basis points is a big move.

And then on the other outcomes, actually people had yields kind of unchanged. Even Democratic sweep or a blue sweep was surprisingly a little bit skewed to the left, but not too much. On S &Ps, kind of similar up two or 3%, consensus on red sweep and blue sweep down one or 2%. So that kind of makes sense. And then the other big ones were dollar China up a lot on a red sweep, which obviously makes sense because tariffs are the easiest thing to enact. And Trump has been talking about big tariffs, and Bitcoin higher on Trump, which again makes sense a little bit more attractive regime for regulation and more normalization and sort of sane washing of crypto that would allow institutional fund managers to add.

So I think the results are what I expected, but bigger amounts on the red sweep side and smaller moves on the blue side because it seems like the consensus is more like a blue sweep or anything with Harris on top involves mostly the status quo with some changes and then we worry about the end of 2025 but generally those were the results. So I don’t know, any surprises in there for you?

Alf (03:59.274)

No, I like the way people have answered and let’s say the wisdom of the crowd, if you wish, because if you think about risk, people always have a very binary view of risk. But I think we should look at it as probability times magnitude. And so the magnitude of certain moves, which is consistent with the magnitude of Trump’s sweep policies and how easy it is to implement such aggressive policies, well, the magnitude of those is very high when they impact the economy and then the magnitude of market moves accordingly should also be quite high.

So I am actually, I like the way they’ve answered. I would also point out that for my clients I’ve run an initial analysis and next week I’ll send the full article on how the option markets are pricing the event. It’s quite interesting. Basically, we have a model where we can derive market implied probabilities from option chains and then try to assess historically whether people are overpaying or underpaying for any specific tail and that’s in rates, equity sectors, FX.

So you would expect, Brent, that according to the results of your poll, the Trump trades would have some sort of a premium attached in option markets, because of how fast the magnitude right can be and how vicious they can unravel if Trump really goes for a sweep victory. And instead, that doesn’t really seem to be the case. Not in all assets, at least equally so.

So the way I am interpreting it, and please talk about your franchise as well, because you see trades coming through directly. When I speak to my hedge fund clients, the idea is people like to position for a Trump sweep win because they understand it’s gonna make money, but they also don’t like to, they don’t overpay, they’re not euphoric about it as if they’re maybe underestimating the magnitude. Because it doesn’t show into the skew, for example, it doesn’t show into how much people are willing to pay for this optionality in option markets.

Brent (06:02.096)

Right. So in my business, there’s an interesting divergence because we have actually seen ravenous demand in the last three days. Dollar Mex, Dollar China, and then, of course, I think part of the move in Bitcoin and part of the move in bonds is related to the red sweep going from 30 % on polymarket to 42 % or something like that. So I think you are seeing an accumulation of Trump trades.

Now in FX, there’s kind of a weird situation because the China stimulus right before these Trump trades happened was pushing everything the other way. So the China stimulus trade was like, I better get out of dollar CNH and I better buy emerging markets. so that pushed the skew in things like dollar China the other way, like pushed the skew down. And then obviously the Trump trades push the skew back up, but net-net, it actually hasn’t moved that much.

So I think that would be consistent with what you’re saying, which is the premium in currency markets is not as high as you would think it should be simply because there was a kind of like this discount before and now the discount has been removed, which you can call a premium, but it’s not.

So yeah, the last three days has been the first time in a long time that we’ve really seen aggressive client buying of not really wingy stuff, but like call spreads in Dollar China, Dollar Mex. And I think the Mexico one’s interesting because the China one’s obvious. I mean, we don’t even need to talk about it. It’s so obvious. But the Mexico one, there’s more room for debate. So I think the initial vibe a few months ago was USMCA was one of Trump’s signature pieces of legislation. So he’s not going to touch it.

And now what he’s saying is, first of all, he wants to renegotiate it. There is a renegotiation clause in there. And second of all, he wants to limit the pass through of Chinese goods through Mexico. So in a way, it actually makes sense that Dollar Mexico higher would be something that people are interested in. I think one thing that that’s important though, is that, like you said, it’s still very probabilistic, right? Like, okay, yes, the odds have gone up, but it doesn’t mean that the thing is over and Trump has won the election already.

So there’s only so much that can get priced in because it’s still, depending on where you look and what conspiracy theories you believe about Freddie 999 buying all the polymarket contracts, there’s still two outcomes here, right? So as much as you believe that one outcome has changed, maybe it’s gone from, you know, the red sweep has gone from 30 to 40%. That doesn’t mean it’s gone to 100%, right?

So I think that puts a limit to how much people are willing to invest on, you know, even if there’s a coin toss that pays 1.7 to one, as a fund manager, you only get to make that bet once on this election. So you can’t really, you know, put your entire capital at risk. You still have to gauge the fact that Harris could still win the election.

Alf (09:21.696)

No, absolutely. And then as you said before, there are actually four outcomes. mean, the outcome we’re discussing here is one of the tail where Trump also has the House and the Senate and then pretty much can do whatever he wants. Well, of course, pending negotiations with all fronts of the Republican Party. But there are three more scenarios, right? So that’s always something to be to be kept in mind.

Brent (09:42.338)

And do you want to, I just want to give you a trivia question. Do you know what the odds of Trump winning were in the gambling markets going into 2016, like the day before the election?

Alf (09:51.65)

Extremely low, I think somewhere around 9 to 1.

Brent (09:56.76)

Yeah, 13%, so you’re pretty much smack on. So I think it’s important to remember that the gambling odds are, they’re an input, but in a football game, the 14-point underdog can still win. And this is more like the equivalent of a two-point underdog or something like that.

Alf (10:00.289)

Yeah, fair enough. But look, there is one thing that both parties, I would say pretty much any politician nowadays in the US will go for, which is deficits. And here as well, there are different tunes. There is an important part, which is that in 2025, the 2017 corporate tax and also personal income tax, apparently that Trump slashed are actually up for debate.

So of course, we’re going to keep on doing deficits, but Trump is talking about bringing the corporate corporate tax down to 15 % and Kamala is talking about bringing it up to 27. You know, it’s a matter of how many deficits and where are they directed, but it doesn’t really change much of the picture that if you ask the Congressional Budget Office, whoever is going to be the president, they’re looking at about a trillion a year. And if you look at the amount of government debt out there, Brent, I mean, a good portion of that is interest rate payments, which let me stress this out, interest rate payments are not as effective as a stimulus when it comes to deficit than primary deficit is.

I mean, think of it like who owns these T-bills? Well, in most cases, it’s either foreign entities outside the U.S. So they’re getting paid more on more T-bills they own. Nice for them. But is that inflationary? If Amundi gets paid in France for owning some T-bills and they get more coupon, is that inflationary in the US? Well, let’s talk about it. If US banks or money market funds own T-bills, is that inflationary? Not really.

So it’s more about primary deficits, but even if you look at those, they seem to be trending up anyway. So now the question is, do we think the market has changed a bit of regime when you look at stuff like gold, for example, something you wrote about, or do we think the market isn’t really paying attention because it’s like boiling a frog. It takes a lot of time until these things hit the market psychology.

Brent (12:18.274)

Yeah, it’s an interesting one because I’ve always found that gold is one of the hardest things to model. It just, you think you understand it… It’s a dollar trade. Nope. It’s not a dollar trade. It’s a risky asset. Oh, it’s a safe haven. It responds to real rates. Oh, no, it doesn’t respond to real yields at all.

And so I was looking today at before the global financial crisis. So the concept of the bond vigilantes, which we saw in 2022 in the UK, essentially says that as fiscal deficits grow and there’s more risk of some kind of not actual default, but debasement or whatever, or credit risk for the sovereign, then you should be compensated for that with a higher real yield and a higher yield. And if you chart that before the global financial crisis, that was true. As deficits got bigger in the 70s, 80s, 90s, then real yields tended to be higher. And there’s a pretty decent correlation and I’ll put up a couple of charts in the video version.

And in 2008, essentially everything changed, right? So the government essentially said, we’re gonna have a bigger role in deciding where rates are gonna be, where yields are gonna be. And you can argue that they’re not doing that now because quantitative tightening is happening, not quantitative easing. But then just look at what happened with the QRA when US yields got to 5%, Yellen essentially did a verbal intervention to cap yields.

So I think you can still argue even currently that there’s some kind of ceiling on yields. And so that ceiling means that the clearing price for bonds or for the clearing price for bonds, or the clearing price for money is distorted by financial repression by government intervention. And so what that would mean in theory is that you need a release valve.

And interestingly, so before the global financial crisis, the correlation was between deficits and real yields and deficits and gold weren’t correlated. Didn’t really, you know, it’s just a flat line with a bunch of dots all over the place. And if you look at after the global financial crisis, real yield stopped mattering and compared to deficits, and as deficits go up, gold goes up. As deficits go down, gold goes down. So I think that’s a really interesting change of regime that makes sense, like based on sort of economic textbook kind of stuff, that you need a release valve if you’re gonna be building larger and larger deficits. And it’s a pretty good explanation for why gold just keeps on going up.

Now, the hard part about it is like as a trader, for me, that’s kind of useless information. I think as an investor, if you believe that deficits will continue out into the future forever, then that raises the value of gold in a portfolio. But as a trader, it’s not like you can watch the hourly chart of the US deficit and overlay it with gold and trade off of it. But what it does mean is that you can stop looking at real yields as an indicator for gold, which has been, obviously, I’m saying that in hindsight because it was a good indicator for a long time, but now it’s not. So I think it’s an interesting change of regime that really comes out quite clearly in the data.

Alf (15:44.258)

Oh, that’s a lot to unpack there. So the first thing I would like to stress out from my perspective is that there is a couple of cases that I can point to over the last decade where bond vigilantes were truly in action. Just a couple, I can count them on one hand and I fail to remember when this was the case in the US. And why do I say that? For bond vigilantes to be in action, you need two things to happen. You need real yields to go up and you need the domestic currency to sell off. Both at the same time.

So why am I saying this? In the UK in 2022, that’s the perfect example, Brent, right? I mean, you have a politician that says, I’m gonna do fiscal deficit while domestic inflation is 10%. So you can imagine that that is not a very smart policy. So anybody who’s holding the bonds, and we’re talking about the UK and Liz Truss in 2022, anybody who’s holding UK assets actually, not only bonds, will probably say ah, I need a little bit more of a risk premium to own this stuff. And so in the pyramid of financial markets you have repo, T bills, treasuries, credit, equities, and complex stuff on top.

So what happened in the UK is you guess what the repo market and the Treasury market the gilts market in the UK, well, everybody said if you want me to own these bonds then you need to pay me more. So real yields went up and it was a disaster. But at the same time, the sterling went down too Brent, together with it, which is the way of foreign investors to say, if I own any UK asset, credit, equities, I don’t care what it is, it’s denominated in this currency that you guys are planning to water down massively because inflation is already 10 % and you’re gonna be doing more deficits on top. So it’s important that both components go up, real rates and then the currency goes down actually. Both of them have to happen.

The other episode I can remember is the Eurozone debt crisis, 2011, 2012. Spreads through the roof, the euro down, at the same time, this is the bond vigilantes. Now that you told me this, I’m gonna make a research piece looking for whether in the US we had a combination of real rates going up and the dollar going down. Now the episode you’re mentioning, what was it? End of 2023, right? You had real rates up and the dollar up as well. If you remember, you would have other currencies not being able to catch up with US rates and so the dollar would strengthen.

And so I think the concept by which the US is susceptible to bond vigilantes is a bit of a hard one to sell. And the reason is pretty simple, man. I mean, we have based the entire world on treasuries. Like the whole world is based on using treasuries as a collateral.

Stupid, easy, idiosyncratic example: I’m opening a hedge fund when I have to post collateral against something, people are not asking me to post Chinese renminbi or Indian bonds. They’re asking for T-bills. The prime broker doesn’t want some weird, they want T-bills. So just a simple example to say treasuries are the epicenter of the Eurodollar world we live in. So it’s very hard to see bond vigilantes in action in the US. I’m gonna shut up now.

Brent (19:15.504)

Well, another example of that actually that is a little bit ironic because the initial use case for crypto in a lot of people’s minds was to somewhat replace the dollar, but the entire crypto system is based on the dollar as well. So all the stable coins are based on the dollar, tether holds US fixed income… The entire system, every single system is based on the dollar.

So like you said, if you ever got a situation where bond vigilantes really showed up and you see US bonds selling off and dollar selling off, the thing is it’s going to be a short-term trade anyways because they’ll just intervene, right? That’s kind of the whole point of my gold thing is that they’re not going to allow the bond vigilantes to win because they have unlimited firepower. So the Fed will just buy treasuries in that case, or they’d intervene in the dollar or whatever. it’s almost like if you’re praying for that scenario, I hope you live to be 500 years old because it’s not going to happen in our lifetimes.

Alf (20:14.038)

Yeah, but you’re now making a point about gold, which is important. I mean, all I’m saying here is that I think the odds of bond vigilantes in action in the US are very low. Are they low elsewhere? Not really. We have seen it in the UK. So if you live in Canada or in Australia or somewhere else and your government tries to play that card, then I can see the bond vigilantes acting in Canadian rates and in the Canadian dollar. Yes, for sure I can see that happening. Or in Europe.

Brent (20:38.638)

Well, and that did happen actually in Canada too. So you mentioned the Eurozone and it did happen in Canada when I was a kid in the 90s. There was actually a similar thing where Canada was being downgraded. The currency was getting hit and yields were spiking and they had to institute a whole bunch of austerity programs in the government because the bond vigilantes were there.

Alf (20:59.02)

Oh wow, austerity programs, what is that?

Brent (21:08.92)

Yeah. Yeah, that’s not a word that we use anymore. You know, one thing I forgot to mention about the election stuff is I do feel it’s a little bit ironic and also interesting that going into most elections, people have raised cash. And then if you think about 2016 specifically, people viewed Trump as being bearish for equities. And people were kind of selling stocks. Obviously, the second he won the election, stocks got crushed and then eventually came back very quickly.

But I think it’s a little bit interesting and ironic that now everyone’s all in in equities, cash levels are at like multi-year lows, and it’s essentially the mirror image of 2016, if Trump wins, it’s like, okay, this is the best thing ever. And that makes me a little bit skeptical because, you know, the common knowledge just very often is wrong. And then also historically cash levels down here tend like a quarter, you know, I’m using the B of A survey to… because there’s different ways to measure cash levels. But using that survey, it’s a sell signal when cash levels get down here.

So I think it’s actually an interesting and kind of weird reverse set up here where, it doesn’t mean to be short equities right now today, but I think what it does mean is that if you are expecting like a massive bull market if Trump wins, you may be disappointed initially because there may be a lack of marginal buyers after, I mean, the first 24 hours, sure people will buy stocks. But I think there might be a lack of marginal buyers after because the sentiment to me is getting very bullish in equities.

Alf (22:44.384)

Yeah. Now, if we step back and we talk about assets like gold or equities more on a long-term horizon, the fact that you’re going to have more deficits in the U.S. merely means that the private sector is going to receive more dollars. I mean, like income tax, it’s going to be lower and corporate tax, it’s going to be lower and all that beautiful stuff. So if there are more dollars in circulation, real dollars, that is not QE dollars, like real spendable dollars, then guess what? I guess that assets denominated in dollars will go up and gold is denominated in dollars and equities are denominated in dollars.

And now when people look at gold and they say gold is going up, I always say as well, yeah, but anything else is going up, man. I mean, any asset you own basically that has any offensive property or any risk property actually is going up. Gold is not necessarily an offensive asset. It also has the tailwind that if you look at, seriously, if you look at global central banks, I mean, this is something very boring and structural, but it is important. I mean if you were Russia your FX assets were frozen man I mean like you couldn’t use them.

So of course if you now are China or any other foreign central bank, what are you gonna do? Are you gonna put a hundred percent of your money in gold? No, but are you gonna shift your allocation a bit towards gold? Yes, of course because it allows you more flexibility if some geopolitical crap is going on. So that’s like a tailwind that is behind the asset but in general for me the important part of gold is to look at gold versus risk assets.

So if you look like at equities versus gold, okay, although they have a different vol profile, but if you look at equities versus gold or other aggressive commodities like copper versus gold or oil versus gold, that’s much better to me as an indication from a macro perspective because it tells me even if there are more dollars in the systems, like where are people willing to put these dollars marginally? Are they putting them in an asset like oil or copper or equities that depend on strong economic growth to do well? Or with these new dollars are they actually preferring a defensive asset like gold?

And now if you look at the last six months, nine months, I think you see a situation where commodities against gold haven’t done really well. So gold has done better than oil or copper. Equities have done better, but vol adjusted not a lot better than gold. So it tells me that there are new dollars being created. Every asset denominated in dollars going up pretty much, and the market knows that this is going to continue as a structural situation because of deficits, but they don’t seem to be overly aggressive when you look at equities, for example, measured in gold. They’re gone up a little bit, but not a lot.

Brent (25:20.048)

Right. And I think that’s an important point sometimes because people have an aversion to deficits intellectually because, you know, there’s just this feeling that it’s, it’s not sustainable. You can’t keep spending more than you make and all that kind of stuff, which is fine. But people have been saying that since 1985.

But I think the key point that you make there is that as, as repugnant as deficits might be to you intellectually, they’re bullish.

Alf (25:47.842)

Of course they are.

Brent (25:49.518)

So in the end, when deficits are going up, you might think it’s bad for society, but it’s good for asset prices.

Alf (25:56.566)

Yeah, I mean, the question I can never get my head around is, so if you bring this to the extreme and you are the United States of America or Japan or China, what is the point at which you become scared? I mean, what needs to happen to make deficit, to scare you with deficits? Like, what?

Brent (26:19.726)

I mean, for me, I don’t know if you’re really asking or just asking rhetorically, but for me, it would be when the correlation flips and you see dollars selling off and bonds selling off because that’s then when it gets scary.

Alf (26:28.854)

Yes, yes. Correct.

Brent (26:30.715)

But the thing is, if you look at interest payments as a percentage of GDP, I mean, they’re way lower now than they were in the 1980s and 90s. So, you know, I don’t know. I just find it hard to get scared about that.

Alf (26:43.628)

But also, why are people only looking at the payment side of things? Interest payments. Who’s receiving this freaking interest, guys? I mean, if you’re paying more interest, there is somebody holding this stuff who’s very happy because you’re paying more interest. So who is this? It’s banks, it’s pension funds, it’s assets manager, it’s households. They’re receiving. So the balance sheet has two sides, right? It’s liabilities and it’s assets. So I’m not sure why people are obsessed about the liabilities, but when the government does deficits, of course, they’re blowing a hole in their balance sheet and intuitively people don’t like that.

But the question you should ask yourself, who’s the recipient of that? Who’s making money on the other side of it? And that’s you. That’s you. They’re lowering your tax rate. They’re lowering corporate tax rate. You are making money. So that’s a bit of a thing I never hear when people talk about deficits or demonize them.

Brent (27:35.236)

Well, you know what’s hilarious too is that people obviously always post the debt chart and say like, it starts with a T for trillion and all that. But imagine if you just posted a chart of Apple’s debt and you said, my God, Apple’s screwed, their debt is at all time highs. It would make no sense. You would always look at both sides of the balance sheet. And guess what? US asset valuations and US assets and household net worth and every single measure of US assets is also at the all time highs. So the balance sheet’s fine.

But anyways, I think we covered that. One kind of thing that comes out of this whole conversation is correlation between assets. And I know you’ve done some work on portfolio construction. I don’t do as much of that because my time horizon is shorter. But how do you think about, say, like portfolio construction, trade sizing, and all that stuff when you’re thinking about things that are correlated?

So like right now, equities and gold are just going up together. So gold’s not really diversifying. It’s just providing like another debasement trade in the everything bubble. But how do you think about that when you zoom out and you think about position sizing, risk management and all that stuff vis-a-vis correlation?

Alf (28:51.892)

Yeah, I think for correlations, one of the key principles I try to use is something I dubbed with an acronym, because it sounds nice. The acronym is UDES, U-D-E-S, uncorrelated during equity sell-offs. So the problem with correlations is they’re not symmetric, not at all.

So what people do is they, what they teach you at university actually, is to use something very, very cool called the variance covariance matrix. So then you look at this correlation matrices and you say, hey, let me see what assets correlates to what, and know, matrices are nice and symmetric. And what happens there is what you’re doing, Brent, is you’re taking like 10, 20 years of history, and then you’re looking at like, you know, the average rolling correlation between treasuries and bonds and commodities and gold and what have you.

There is a problem with that. The problem is that by looking at averages, you are ignoring the fact that correlations do not behave symmetrically. We all hear and we are accustomed to the fact that, hey, it’s very dangerous when correlations go to one. Yeah, yeah, yeah, it’s very dangerous. We know that. So why are you not accounting for that in your portfolio construction?

So basically the point is, like, you know, when you launch a hedge fund like mine, people want you to be uncorrelated. Of course, of course, why would they pay for beta? And I get it. But the problem is that if you ask them truly what they want from you, they don’t want you to be uncorrelated necessarily when things are fine. When things are fine, they don’t really care, to be frank. They want you to make some return, correlated, not correlated, they don’t care.

They want you to be uncorrelated when shit hits the fan, when the S &P is going down four, five, six percent in a month. And now I’m gonna stop because you have a quote from a risk officer at the hedge fund. You should absolutely go out with this now.

Brent (30:38.896)

So this was one of the most interesting things that I learned when I worked at a hedge fund. So I had the lucky benefit of sitting next to the head of risk. It was just, you know, coincidentally, that’s where my seat was. So I used to talk to him a lot and we would talk about correlation and he would say, you know, we have all these PMs and everyone is very uncorrelated until S &Ps go down 3 % in one day.

Alf (31:03.126)

Ha ha ha.

Brent (31:05.038)

And the reason is, I mean, there’s many reasons, but obviously correlations increase in times of stress. But also there’s a lot of strategies that appear to be uncorrelated, but they’re actually synthetic vol selling. So like roll down and things like that. But there’s a lot of different strategies that are essentially paying you for selling some sort of volatility, but sometimes it’s synthetic or like third derivative volatility that you’re selling. So it’s not always obvious that you’re actually doing it until the shit hits the fan and then all the correlations spike to one.

Alf (31:42.134)

Yes, that’s correct. So in general, the message I would give to people is when you’re looking to build an uncorrelated portfolio, or namely when you’re building to, when you’re trying to diversify your portfolio, whether you’re an investor with a one year, five year time horizon, or you’re a macro tactical investor with a one month or three month horizon, there are two questions you should ask yourself. That’s what I learned at least.

The first is, Hey man, I’m running seven trades. You look at me, I’m so diversified. Wait a second, step back. Are you really running seven trades? Are you sure? Or are you running the following book? You are long the yen, you are long bonds, and maybe you are long Swiss equities versus European equities, and then you’re long the Swiss franc. Are you sure that you’re running four trades and you’re not just running one trade, which is basically your long rates? That’s what you are across the book.

So always ask yourself, what is the principal component driver? But I mean, yes, you can do the PCA from a statistics perspective and you can sound so smart. But what I mean is ask yourself, what is the macro principal drivers of these trades? If it’s always the same answer when you go through them, I would suggest that you think twice about your book because that’s the problem number one in macro portfolios, I think.

Brent (33:00.77)

And so a simple way – cause like my quant skills aren’t that great – a simple way to think about this for me is if you take the average of the correlation, you’re going to obviously see what’s going on over time. But if you find specific regimes where there was stress and then look at the correlation and look at what your P and L would have been in those periods, I find that useful.

So like something like Aussie yen versus equities, Aussie yen can go up and equities can go down a bit. But then if you just slice all the data and look, okay, only days when S &Ps were down 3 % or more, basically every single one of those days Aussie yen will be down and it’ll be down like one and a half to three standard deviations.

So essentially if you can bucket or figure out what your kind of like danger area is, what’s the dangerous regime for your portfolio, and then look at some history, some specific history, sometimes you can figure out, okay, like I’m fine to be long Aussie yen as long as VIX is below 25, but if VIX goes above 25, I’m gonna have a problem. And you can kind of segment it out that way.

There’s a great thing in the book, How to Lie with Statistics, which is an amazing book, is written in like 1956 or something. But he says averages are useful, but also imagine you have one foot in a bucket of boiling hot water and one foot in a bucket of freezing cold water. Are you warm on average? And I think that’s a good analogy for financial market correlations is that you’re taking the average and the average is bullshit lots of the time.

Alf (34:33.442)

And the example you made is fantastic. I think we should, by the way, one day launch a fund together. Because that’s what we are doing on top of the standard stuff at my fund. We are basically stressing the book for periods when correlations went to one or the S &P drew down two standard deviations. And then we’re zooming on this. You’re like, OK, please tell me what’s the return of the book in those periods.

All of a sudden, Brent, you’ll see that it doesn’t look as good as your uncorrelated portfolio would look like in the average period, because you’re not looking at averages now, you’re looking at crap periods, when your investors don’t want you to be correlated, right? That’s exactly what you should try to avoid.

Then the second thing that I would say to people when they look at correlations is when you’re building a portfolio, the path that you should keep in mind, especially if you’re a long-term investor, is something called terminal wealth. So think like, how do I maximize my terminal wealth in 10 years from now, for example? And if you think of this, even mathematically, you will see that one of the best ways to do that is to avoid sharp drawdowns. Sharp drawdowns with a long recovery period.

So like basically 2008, okay? If you can do a bit better in that drawdown, you don’t need to make money in 2008 because then you’re amazing, but if you can do a little bit better there, because you had a truly diversified portfolio, then you’ll see that your ability to compound after a drawdown is so much faster than a guy who went down 40 % in 2008. It’s gonna take him five years to recover. For you, it’s gonna take two years, and the power of compounding will make your terminal wealth higher. So focus on the drawdown and how correlations can impact this, and please don’t look at averages only. I mean, you can, but don’t look only at averages.

Brent (36:26.234)

So hey listen, I know you have to catch a flight, so any final words or do you want to cut it off here?

Alf (36:32.258)

So yeah, before I go, I wanna say the usual thing that you should go and get covered if you trade FX or if you wanna read this research, you should ping my friend, Brent Donnelly on Bloomberg. He’s kind enough, he will reply to you. Please do, he’s a nice guy.

Brent (36:52.094)

And if you have $10 million lying around, I know somebody who’s looking for 10 bucks more in his fund.

Alf (36:59.458)

Well, that’s not me. Anyway, guys, always thanks for listening. Also ping me on Bloomberg if you want a chat. I’m also Italian, I’m nice. And we talk to you again on Friday next week. Ciao.

Brent (37:10.688)

All right, thanks, Alf. Thanks, everybody. Ciao.