SI423: Why Trend Following Might Outlast the AI Arms Race ft. Mark Rzepczynski

0:01 I have to have a strategy that can be enduring. Beyond this crowding of alpha and the changing behavior of markets, can you use machine learning to capture trends? I think the answer is yes, but at the same time this is the trend following is probably unique and different than the growing focus on machine learning as a way to create alpha.

0:32 Top traders unplugged in markets. Success doesn't come from predicting what happens next. It comes from being prepared for what you can't predict. In each episode, we go deep with some of the world's most thoughtful minds in investing, economics and beyond to understand how they think, how they prepare and how they decide and the experiences that shaped how they see the world.

0:55 No noise, no shortcuts, just real conversations to help you think better and invest with conf. Welcome or welcome back to this week's edition of the Systematic Investor series with Mark Russemcinski and I, Nils Kastrow Larsen, where each week we take the pulse of the global markets through the lens of a rules based investor.

1:15 Mark, it is great to be back with you this week. It's been a little while. How are you doing? I'm doing well. I was just, I think we were talking beforehand about fall foliage in here in New England. So we've the peak up in the mountains has occurred, but we've got a lot of color out here and so it's a, it's a great time to be in New England.

1:37 Yeah, it's actually a great time to be in Switzerland as well. We have the same beautiful colors on the mountainsides at the moment. So that's, that's great. Now we've got a very extensive lineup of topics, thanks very much to you that we're going to be talking about today. But there are a few things going around the, going on in the world right now.

1:59 So I thought we would start as we always do, just kind of going through a couple of things that may have hit our radar the last week or two. Anything stands out to you? Well, we may talk a little bit more about this later on in the podcast, but I guess I, I have been following some of the, you know, we'll sort of protests or riots in, in France and I think that that's really having a big impact on, on markets and it may not show up on a day to day but, but it does have an impact on how people view safe assets and specifically the bond markets.

2:35 Yeah, I mean I completely agree and of course we are seeing kind of record yields in France. I mean I think we're trading now the 10 year is just about 5% now in France. That's up 1.65% in yield in the last 12 months, as far as I'm aware, and a half percent alone in the last, in the last month or so.

3:00 And it is, by the way, for those who may not remember, it is a 24 year high in yields in France. So it's pretty significant. And for those of us who are old enough, it is reminiscent a little bit about some of the crisis we've had in Euroland when it comes to fixed income. Back then it was more in the, a little bit further south than France.

3:28 But it is, it is a challenge, I think when some of these large countries get to a stage where they're, where their sovereign debt is, is being tested, so to speak. And who knows where it goes from here. I mean, when you watch the videos that are being posted, assuming they're not AI generated, it looks incredibly violent and destructive and it's hard to see how this is just going to go away once you get to that stage.

4:01 So we may have to deal with this for a little while longer. Another not related to, just something that came on my radar. I don't know if you noticed that yesterday, but quite a lot of websites got taken down. I don't think they got hacked, but there were certainly some concerns about vulnerabilities that meant that people were taking them down to update.

4:28 I think it was some PHP files or whatever it was to, to make things secure. So seems a little bit shaky at the moment in, in terms of hacking and disturbances. But what I wanted to bring to you because I know you, you love, you love your acronyms like vuca. I learned a new. I learned a new one. At least new to me.

4:52 Probably not new to you, but that's fimo. You know what FIMO is? No. Tell me. Okay. Fabulous earnings momentum. Okay. And so at the moment it's like FIMO versus fomo and apparently FIMO is winning over fomo. That is not, you know, firing on all Cinela at the moment as far as understand. And for those who know much more about equities than I do, apparently FIMO is measured by actual earnings per share and that's been soaring.

5:26 And then you have fomo, which is the fear of missing out and that's reflected in the P multiples and they've been contracting a little bit, I think. But I don't know if you follow this at all. I mean, I've been traveling a lot at the moment recently and, and so conversations obviously does from time to time wander off to talk about what's going on in the equity world.

5:48 And I'm no expert, but people are saying that there are some, some interesting ways people are accounting for some of these increased valuations and suddenly it shows up in earnings. But I'm not so sure that that's something that can hold up for forever. I don't know. Any thoughts? Well, in some senses, let's go to classic dividend or a discount model.

6:13 And we know that the price of a given asset, you look at what is the earnings divided by the discount rate. And in some sense there's a limit to how much you can play with the discount rate. It is what it is your cost of capital, it can't be lower than Treasuries. So it's going to be some, we'll just sort of say Treasuries plus a credit spread.

6:38 You know, you could talk about, you know, the discount factor, looking at market risk. But we see that the discount rates are all going higher because interest rates are going higher, yet stocks are still going up. So people are scratching their head. Why does that happen? And you have to go back is because earnings have actually exceeded or the growth of earnings have exceeded the impact of the discount rate.

7:06 Once earnings stop to increase, you lose earnings momentum. Then what we're going to sort of see that the discount rate will then become more dominant and that's, that's the, it will call it for us. People who are a little bit more have a greater level of fear. That's, that's where the real fear comes in.

7:27 Yeah, no, absolutely. I mean there's definitely some, there are some prominent people out there who are kind of raising the warning flag a little bit. And also with you could say some of the tailwind that we've seen in equities the last few years, including buybacks and stuff like that, that's kind of coming to an end.

7:46 And there's obviously a lot more supply now. So the fight for capital is pretty fierce. Yeah, I mean speaking of that and kind of speaking of bonds, it's a good transition, I think into the trend following update. It has been a little bit of a soft start to Q4 after some good quarters this year so far.

8:13 But actually one of the reasons why it's a little bit of a soft start is interestingly not enough, a little bit the opposite because we saw a record demand for 20 year JGBs at the latest auction. So that's actually helped yields come off in places like Japan. I think from what I remember they were almost six times oversubscribed in terms of what was offered.

8:43 So I think trend followers probably are being challenged a little bit on the fixed income part of the portfolio and that's leading to some, you know, still relatively small losses so far in October. But we're taking a little bit of a break from, from these really strong returns we've seen so far. I mean energies are still okay.

9:06 That's also something we're going to be touching on later on today. Mark. But energy trends are still good. I'm looking at the screen and even today it's up to 3% as we speak on Thursday. But, but other parts of the portfolio is a little bit more. Yeah. Challenging. Any perspective from your side in terms of the trend following world?

9:29 You can go in any direction you want so far this year or so far this quarter. Well, if you go back over time. So there was a whole school of thinking that well, trend followers only make money when bond prices are rallying and interest rates are going up down, that they couldn't make money when interest rates were going higher.

9:56 Yes. Roy Niederhofer was the author of that very famous paper that we all had to struggle with for a few years because it was very difficult to disprove that point at the time. I remember. And now that we've had a chance to, to you know, look at the history and see what's happening, part of it was because we had these such a long term secular rally in bonds and the, their Ibbotson's book came out about, you know, what, what's happening with you know, returns and it's now being issued by the cfa.

10:32 So they look at, they put a tremendous amount of, you know, graphics in there about, you know, stock prices, bond prices. And one graphic that really sort of caught my attention was that if you look at the progression of yields to 1981 and it's almost as though that yields were relatively low in the 60s and early 70s and we had inflation and then, then they peaked out with the peak of double digit inflation in the United States in 1981.

11:06 Then we had this huge secular decline in rates that went on for we'll say decades and now we're having this switch once again. So part of what was thought of that you couldn't make money trend following selling on the short side for bonds. It was part of it is because there was such this large secular trend and now that we're sort of returning to have a sense of normalcy is that we're seeing that the market is more two way and you can make money shorting bonds which that was something that 10 years ago we'd say like well that can't happen.

11:44 It's anomalous. Yeah, it's funny because I mean obviously JDBs have actually that we talked about earlier probably been one of the best markets for trend followers in the last 12 months. But just like Coco which was, you know, it was a very challenging market especially if you tried to sell it short for so many years you would be stopped out and you would take a small loss every time.

12:10 That's why it became the widow trade. But yeah, no, you just have to be patient. As Katie and I talked about last week, I think it was with the latest paper from Quantica where they talk about, you know, the importance of time in trend following and not just trying to time trend following. So. So definitely.

12:33 Yeah, well I think that we'll talk about this a little bit more. But yeah, from an institutional point of view we'll sort of say that the composition of markets of who is trading in a market will have a big impact and whether you can make money on trend following and you know, I'll call it the new institutional structural approach and sort of say that.

12:58 Well, I think I fall into that this is that you gotta go, you gotta get into the details of markets and so what we've found traditionally is that markets that have more hedgers relative to speculators, a trend follower could do better because you're taking the other side of, of of hedgers positions is that if governments are very involved in bond trading, is it that that's going to have an influence on the likelihood of trends?

13:28 Okay. If let's say that there's more profit maximizers as opposed to people who are less profit maximizing in a given market, it'll have an impact on trends. So you got to get into the. Or if you want to understand why a given market might trade in a way that's better for trend following you got to, you got to look at the institutional structures.

13:54 But okay, it's a longer discussion but yeah, I think this applies here for in JGBs. Okay. Okay, cool. No, very interesting. By the way, speaking of that, let me just plug the latest episode that we published on Wednesday. Very interesting, I have to say. Very, very interesting. It was with the Jesper Cole who is really a.

14:13 He's known as the Japan optimist and writes a lot about that. But he's got a very interesting background and has been living in Japan for like four decades or so, and really plugged in and so if, if you missed that episode, I, I really encourage you to go back and listen to it. Alan did a fantastic job in, in, you know, getting that done.

14:37 Anyways, let's continue with trend and then we'll jump to all of the topics. My trend barometer finished at 40, so at the lower end of neutral, probably in line with what we're seeing in the performance numbers. And these numbers are as of Tuesday this week. So that would be the 20th close of business beta 50 down just shy of 1% but still up 13.76 for the year.

15:01 Soc gen CTA index down one and a quarter. Still up 14 and a quarter for the year. Soc Gen Trend down just a little bit more than 1%, up 14.57 for the year. And the Short Term Traders Index that is being challenged down 1.3% in October and up 4.93% so far this year. Moving to the traditional world MSCI world as of last night up about 1% in October, up 13.3% so far this year.

15:33 The MSCI world eth so ex US and Canada down 32 basis points in October, up 10 and a half for the year. World government bonds up 62 basis points in October, but still down 2.19% for the year. And the S&P 500 total return up 1.43% so far this year and up 14.36% so far. Now, you sent over to me nine themes that we was going to cover and the first one I thought was an interesting headline you gave me because you said people matter.

16:21 A celebration and a funeral. And I thought, okay, this is going to be interesting. So what do you mean by that? Well, I think it's really important for individuals who listen to the podcast and follow markets actually sort of think a little bit about why different individuals receive the Nobel Prize in economics.

16:43 And you know, it's, and why some don't receive or some don't. So so yes, the, we'll call it the wall of shame or, or the people who think they deserve it and they haven't received it as of yet. So and the reason why is that this is, tells us a lot about a specific area of science. Some, some people might argue economics is not a science, but we'll sort of say a special area of science.

17:12 We've seen people such as who've won the Nobel Prize for working in option theory, but this one was more macro oriented. So as a dual winners, Robert hall and Michael Woodford and they received it for basically providing what we'll call the micro foundations for macroeconomics. So generally before they came along, or generally it was macroeconomics was thought of as more top down.

17:48 So you had these large theories of how you think interest rates behaved, how the economy behaved. And you'd make some assertions, you might do some empirical modeling, but you didn't really sort of go into what we call the micro foundations. And the micro foundations is saying is that what motivates individuals to make spending decisions, what is the channels of monetary policy, how does it move through the economy through lending behavior and so forth.

18:20 From Robert hall, he did a lot of work on how people make consumption decisions. So that was his focus and labor markets. Michael Woodford, his importance was on interest rate controls. And he was the one who probably influenced generations of central bankers with the ideas that there is a natural rate of interest and that central banks should either increase or decrease interest rates relative to the natural rate to sort of impact aggregate demand.

18:59 So in some senses that he also was a big proponent of look at forward expectation dependencies. So he was a big proponent for a lot of central banks that say that we should focus in on, we'll say forward guidance. So what this was really important because this has led to a lot of the models that we see currently in macroeconomics.

19:25 Now I think it's also important from as we were just discussing that we as people who are trend followers or people who are in finance, we should also focus in on, we'll call it the micro foundations of markets. And by that is that okay, who are the agents who actually trade in markets? How do exchanges set rules?

19:53 How does policy influence people's profit maximizing behavior? So instead of just sort of saying that well, let's just look at the price action, let's look at what are the structures around financial markets and how they might influence the direction of price and influence how people behave in markets.

20:19 Yeah, no, absolutely. But that's only part of what you want to cover in this. Well, the other thing is that while we are celebrating these Nobel Prize winners, Hall and Woodford is that there was someone who has had a strong influence in myself and I think for a number of people on Wall street, and it's Perry Merling and he was influential.

20:46 He spent time at Barnard College. A lot of people have taken his, his course because you could get it on Coursera on, on a, on a money view of, of of markets. And he said that money is an integrated global system. And, and as such we need to really look at how the plumbing of money works. So how does money moves through countries?

21:12 How does it move through an organization? How does it influence the wholesale payment systems and influence dealer financing? In some sense the shadow banking system is important. Now you probably did some tremendous writing as an economic historian, Al, although he wasn't trend, he wasn't trained as one.

21:37 So he did a biography of Fisher Black which obviously is everyone knows from option pricing, his name and Charles Kindleberger. And he also did a book called A New Lombard Street. But, but the important part of all of his work is, is that capital flows matter. And we should, as some people would say in crime dramas say you need to follow the money right now.

22:06 How does that really affect us? So I know we constantly talk about crisis alpha and I always view this is that we always identify crisis ex post. So say after the fact we say this is a crisis and then let's look at what the returns look like. But from a Merlin and a micro foundations point of view, our responsibility is to identify the type of environment we're in to say are we more susceptible to a crisis?

22:42 And so some work that I've been doing and I think others have worked on is looking at intermediation risk and capital. So in some sense this is that if there's a shortage of bank intermediation capital, then we're going to be more susceptible to a crisis because then if there's a shortage of capital then there's going to be a greater flight to safety.

23:11 And if that's the case, then we're going to say that there's going to be more likely some dislocation in markets. When you say shortage of capital, do you mean liquidity between banks or is it different? Well, so Merlin always talked about liquidity is more important solvency. When I talk about intermediation capital is this, is that when you think about banks and primary dealers, they serve as intermediaries between buyers and sellers in financial markets.

23:45 Okay? So because there have to as dealers they have to warehouse risk. When, when sellers want to offload some bonds, sure, it'll go to a dealer, then the dealer will hold it for a while until he could find new buyers and then, and then they will move that risk onto someone else's balance sheet. Okay, now what happens if, let's say that those dealers, intermediaries who are banks, what happens if they don't have enough capital or that they're capital constrained?

24:21 That could be because of problems in the repo market, it could just be because of balance sheet. If let's Say that they have restrictions on their balance sheet, then especially for risky assets, they're not going to be able to hold it as a warehouser. If you can't serve your warehouse function, then that means is that you're going to have to move from seller to buyer extremely quickly in a disorderly fashion.

24:50 And there's more likelihood that there's going to be dislocations in markets. Now we talked about this for bond markets. I think that the intermediation can also occur at commodities markets. We have commodity firms that act as sort of dealers in commodities markets. And so if there's greater dislocation, then I think that generally market participants are not going to then make.

25:24 They're not going to make as many strong decisions as they would normally. And generally is, is that, you know, our fundamental belief is, is that when there's more uncertainty, if there's a shortage of liquidity, then people are going to scale in and out of positions and consequently their behavior is going to lead to dislocations that might be associated with trends.

25:47 Yeah, and of course you brought up Harry Merlin because he sadly passed away unexpectedly only a few days ago. And of course he was actually a guest on the podcast. So it's very sad News. Back in 2023, he was on with, on the Ideas Lab, talking about one of his books, actually I think it was the Charles Kindleberger book that he wrote.

26:11 Right. I think he was talking about money and empires and it's amazing. He's just a prolific writer and you know, he just had had an accident and it was, it happened on a Sunday and I think this last Sunday, Sunday before, and it was reported. And it's a little bit shocking when you see people you've read, people you've listened to, and then all of a sudden is, is that there's a.

26:37 Not that you, you're going to have a goodbye, but all of a sudden is. Is that there's a sudden loss. But I think that this, this influence of, of how money operates and how this is a large international system has a strong influence in how we build portfolio within the trend world. Because we are global investors.

27:04 A trend follower is looking at, across asset classes, across time zones, across regions. And so you're, you're by nature, you're an internationalist by nature, you're going to be focusing in, on, on capital flows, even though you may not explicitly do it in your modeling, talking about, you. Know, this idea of plumbing and, and the capital being sufficient among participants and so on and so forth.

27:38 I don't know if you have a view on this, but who, who should we be looking at in terms of looking at their balance sheet at the moment? Is there anyone that you think seems a little bit dicey, so to speak, given what's going on in global fixed income markets and so on and so forth? Well, we're, we're moving into a slightly different topic.

28:02 No, no, this is just a little like a little short follow up to the, to the Merling kind of theme. No, I think that this is, we're going to talk a little bit about geoeconomics and then when you look about reserve assets and safe assets is that everyone. And part of the work on Charles Kindleberger is that you need a global hegemon who can be able to place structure in our global financial markets.

28:35 And the reason why, I think that we had tremendous globalization, the reason why we were able to get tremendous amount of trade in the post World War II period. And there were some ebbs and flows. It was a lot to do with the fact that the dollar was the dominant currency. And because we had institutions such as the World bank, the imf, where we were able to sort of provide structure and eliminate dislocations or mitigate dislocations that could have impacted trade flow, capital flow and the integration of markets around the world.

29:16 Not everyone may not agree with the, this globalization. And as trend followers or global macro followers, we're some, we should be somewhat agnostic to this, to globalization. We should say here's the environment we have and then the question comes in is how do we best exploit it? So but globalization has been a boom to most around the world.

29:44 When you look at the reduction in poverty, you look at the extent of the growing middle class in many emerging countries, this is it. A lot of that has to do it because we had a system that allowed for greater trade and capital flows around the world. But I know we're going to move on to the bonds and the global nature and all of that stuff.

30:06 But just when you mentioned that,. I, I. The way I think about it is that, yeah, I mean globalization to, to a large extent drove, say maybe was part of the, the interest rate cycle that you mentioned earlier on and four decades of falling rates. And you know, obviously at some point it became like the perfect scenario for, for central banks where, you know, everything was, seems to be under control.

30:36 We had low inflation, stable inflation, low interest rates and so on and so forth. But actually that kind of peak globalization before what we're seeing now started to happen was actually Also the, a difficult time, interestingly enough for trend followers, we enjoyed getting there. But the actual kind of, at least in my simple view, the kind of the peak three, five years of, of everything being perfect and quiet and calm was, was pretty challenging.

31:09 Not in terms of big drawdowns or anything like that, but it was just a quiet period. Let's call it a quiet period for trend. I don't know if that's exactly linear that that is what caused it, but it certainly coincided with, with peak globalization and, and a little bit of a quiet trend period. Well, part of this was it was just.

31:33 And people looked at the benign economy of the 90s. So this idea of we have a relatively stable world then, punctuated by crises is something that has been going on for decades. And we'll sort of say that because we have this benign economy, global economy for many countries, because all of them are following similar monetary policy policy is.

32:02 I don't want to say that the foundation for crisis alpha is that that is benign and then, then we have a crisis or is benign and then we have a crisis. Part of that was, you know, allowed for globalization. Globalization may not have been the, may have been the result of a benign economy, not the cause of a benign economy around the globe.

32:31 Yeah, although the period that I think of being incredibly strong for trend was kind of like 1982 through late 90s. Then we had some big. We had the tech bubble, which obviously short term was challenging, but during the bubble it was great to be a trend follower. And then shortly after you had the GFC again, same pattern.

32:58 The initial reaction because we get caught on the wrong side maybe of the crisis was challenging, but then the crisis itself turned out to be very profitable for the strategy. But I don't know, I don't remember too many crises in kind of that 80s, 90s, except for the 87 crash, of course. But other than that I don't recall.

33:22 I mean, it's a long time ago now, but I don't recall kind of the same types of. At least it's not the kind of crisis we always talk about in the trend following space because they came a little bit later. So I may, you know, so. Well, this is a whole different topic about, you know, what is our institutional memory or should economists learn from history.

33:47 And you go through the 1980s, you had the Plaza Accord, you had the SNL, you know, blow up. We had massive upheavals in markets as people started to increase exposure to junk bonds. You know, we basically decimated the savings and loan industry. In, in the United States, you know, during, during the 80s, you look at the huge overshoot in, in, in the dollar and then, and then the reversal, you know, which led to, you know, coordinated efforts from central banks.

34:22 We had the market crash. This is it. You know, there are some, you know, big dislocations. You looked at. We didn't have a euro. So you see you traded a whole different set of currencies because you had, you know, the Soros, you know, breaking of the bank of England because you had all these dislocated countries that were more moving with all separate policies.

34:46 We'll sort of say that, you know, interest rate targeting didn't really come in until, you know, the, the 1990s. So the 80s were, were a fairly volatile period. And then when you get into the 90s, we looked at, we had the Latin American crises in both 80s and then another one in the 90s with the TSE Bonos crash in Mexico, so.

35:12 And the Asian currency crisis in 98. Yeah, the Asian currency crisis in 98. Now that we talk about it, more of all these crises come to mind. So you're right. But it's funny because we never really talk about them in our industry. All the crises we point out, and especially when we talk about crisis alpha, it starts with the tech bubble, interestingly enough.

35:33 You need to go further back. And then there is crises and then there's, I'm winging it here. There are crises and there's upheavals. So crises is when you have a concentrated dislocation in markets, but there's also upheavals that occur because there's changes in the behavior of markets that lead to very long term trends.

35:57 And the idea would be commodity super cycles. We've had a number of them since the 1980s. So we, we don't consider a commodity super cycle as a crisis, but it was a major dislocation. And we may be in another super cycle again because what we'll find out is that there are periods where there's underinvestment in commodities markets.

36:23 So there's less capital expenditures than there's going to be a grind of prices moving higher across a number of different markets until, and when we have sort of a reversal of that. And that happened in 2007 or 2008 with the last super cycle. And then you have the reversal all over again. You wanted to talk a little bit more about, I think the, the current bond selloff, which obviously is on many people's radar for different reasons.

37:03 I often come across people who think, you know, oh great, bonds are now yielding, you know, 50 basis points higher than last month. This is a great time to buy bonds. And you never really, you never really hear anything bad about bonds even though they haven't made money for people for God knows how long and so on and so forth.

37:24 So what are your thoughts about the, the, the bond sell off and, and all the points you wanted to raise? Well, the key that I want to get across is the fact this is again, let's, let's look at history or our lack of, of historical context for a lot of what we do. And when you think about it, this is, is that you can have someone who started their career in 2008.

37:53 Okay, we're now in 2026. You know, we could literally have someone who spent, let's say, and let's say they started 2006. You could have someone who has spent the last two decades in an environment where interest rates were extremely low. So, and let's say someone started their career at 22, 24, now they're in their mid-40s and they never really sort of saw, you know, rates that maybe people who have a few more gray hair saw in the 80s and 90s.

38:30 And so what you think is that this current sell off in bonds is abnormal, that this is the oddity of the world, that the world is not what it was for the last two decades because of what's occurring now. And I think that the important point that I take away is that note that the current environment is a return to normalcy.

38:57 And the oddity of the bond market was the periods where we had rates that were in some cases in Europe negative and certainly close to zero. Sort of perfect example is I think they were looking at some very long term French bonds that, you know, were. Issued 100 year bonds. Yes. I can't even, I don't even know how low they must be now in price.

39:23 Some of Those have lost 80% of their value. Yeah, it's crazy. So, so when you think about it like, well, let's go back to back, back to basics is that, well, what is the, what should a nominal rate be? It should be equal to the real rate plus expected inflation plus some type of term premium or risk premium.

39:45 And so you say like, okay, what should be the real rate? Real rate is equal to the natural rate which should be, you know, growth plus productivity. So long term growth around 2% plus, you know, if you have higher productivity, real rates should actually be higher. If you look at The Atlanta Fed GDP now forecast we, they're having for third quarter is above 3%.

40:14 So if you sort of say that, well, maybe we're having a growth boom and a productivity boom, let's say that we're looking at 2.5%, two plus. Okay. And then we're going to add in expected inflation. Now you need to compare short term versus long term inflation. But if we look at just current inflation, certainly above 3% that we could look at.

40:43 So if you sort of say like, well, we're not seeing that, this talk that we're going to get back to 2%, we've been above the 2% target for now, you know, well over six years. So we're not going to probably see it in the next, in the near term even if we could see inflation abate slightly. So let's look at 3% inflation.

41:10 So now we're looking at 5, 5 and a half percent without any term premium. And term premium may be related to a number of different factors for Treasuries. One is that the term premium is negative or close to zero because the stock bond correlation was negative. The stock bond correlation is more positive.

41:32 There should be more of a term premium or a risk premium. So we have higher volatility in bonds. We've got covariance that's positive between stocks and bonds. We expect that the normal premium, as you move out the curve should be higher and that's, that's what you should expect just because of the risk of a longer duration.

41:53 And so if you sort of say that we had, you know, you know, recent auctions, you know, that were put us at, you know, five and a half percent or whatever, this is it. You know, I just, just made a case that this is close to where we are right now. Just if you look at the underlying economics. Yeah, so, so it's not that we have an oddity, it's that this is normal.

42:19 And then if you look at some crowding out because there's a tremendous demand for, for new debt in the private markets. That's, that's, that has a huge, huge impact. So, so private markets are maybe crowding out some of the public markets. And you know, the BIS Bureau, bank of International Settlements has developed sort of early warning signs based on, you know, credit to gdp.

42:48 So you look at, you know, is there a shock to credit to gdp? And what we see is, is that private markets have been controlling their balance sheets. So private markets and consumers have done a good job of cleaning up their balance sheet. They have less leverage on, in their businesses, unfortunately, Public markets.

43:11 That's not the case in public markets, meaning public debt. So their credit to GDP numbers are continuing to rise. So what we're basically saying is, is that, that consumers and businesses that they seem like they understand how they manage their balance sheets and the public has not. Right. And, and that's what we're seeing with you know, France and the United States and some of the other advanced countries.

43:40 Their, you know, overall debt to GDP ratios are increasing for the simple reason is that they haven't really sort of got their budgets under control. But this is not unusual, is it that you see these cycles where one part of the economy has a better handle on, on deficits compared to others. I mean, I seem to remember we've also had periods where the private sector had some challenges with debt and so on.

44:06 Or is that I don't know the history well enough. Yeah, there should follow a cycle and then what we should expect from the, on the public side is that the primary deficit is that we run, you know, deficits, you know, when we have a recession because we're going to have countercyclical, you know, fiscal policy and then what happens is that then once we come out of that, then we're going to use a primary surplus.

44:36 So we're not, we're not getting that. And then on top of that you add in the cost of debt. So interest is becoming a major portion of the total amount of the budget of the federal government. So it's dwarfing what we spend on many other activities. And the same is occurring in France. For example, and Japan actually from that episode that I was mentioning, I think Jesper Cole said that in Japan now they pay like a third of their budget goes to servicing debt because of the enormous rise in Japanese standards to the cost of capital.

45:14 So interesting. It kind of is a nice segue I think onto the next point you wanted to talk about which is convenience yield. So let's talk a little bit about what is convenient shield well, one more. Comment just before we move into this is that when we talked about micro foundations, I think that what we've seen is that the composition of who's trading debt has changed.

45:47 We'll sort of say that when the government was buying up a lot of bonds because of quantitative easing, they were important player that they're not as important now because they're not using qe. What we find is unofficially at least. Unofficially so, but we are finding is that hedge funds are much more active in the debt markets through basis trading and financing.

46:12 And we'll Sort of say that my guess is that the elasticity of demand for bonds from hedge fund is much greater than what you're going to find from the government. Because if, let's say that they're not making profits, so we'll say the multi strat pods, if, if, let's say you lose 5%, you know, from your trading, even if it's a, you know, sort of arbitrage, like they're going to be, you know, reducing their positions so, so they're going to be much more sensitive.

46:45 So what our concern is is not that we're close to fair value, but we're also the fact that the composition of who's trading the debt is different now, which means that there's a greater likelihood that if they change their expectations we could have a big fallout or a big rally. It could go both ways.

47:05 So now the key about all of this is that when we think about US Bonds and other, let's say European bonds is there's that U.S. treasuries serve as a safe asset. And when there's a lot of risk in the economy, people want to move to what is the safe asset. And so consequently is that you're willing to pay a premium for the safe asset, which means their yield should be lower than other risky assets, even AAA rated bonds.

47:40 And that's the convenience yield you have. This is that I can be able to buy the safe asset I can hold as a store of value, I can protect myself from other risky assets and I could be able to do this in size because it's very liquid, it has a lot of market depth and the price isn't going to move significantly if I make these changes.

48:05 And what we find is when there's a crisis, the convenience yield goes up because there's a tremendous amount of movement. There's an increased demand for the safe asset and there may not be as much, much supply of the safe assets. So they're going to bid up the price and that creates a larger convenience yield.

48:25 Now the problem comes in is that when the government such as US treasury continues to issue more and more treasury debt, then the supply of what is perceived as the safe asset increases by more and more. And that means the convenience yield is going to be, you know, shrunk. If the convenience yield shrinks, then we'll say that our, you know, advantage and financing actually disappears.

48:57 And we could see that we're seeing that happen, especially in the long end of, of the treasury market, that what was perceived as a convenience yield may have disappeared. It's mostly on the short end now, which is in the treasury bills. Maybe one reason why the treasury is issuing more treasury bills is because that's where the convenience yield is.

49:21 Now, the same also applies with, you know, the dollar as a reserve currency now, you know, is it still the dominant currency? Yes, but on the margin, what we're seeing is that people have reduced their exposure, central bank holdings have reduced their exposure to the dollar. And what we're seeing is, is that the dollar regime is, is breaking.

49:48 And there's more of, we'll call it multipolarity from central bank reserve managers to hold a number of different alternatives. And I think this was, I think you had Ken Rogoff on the show once you talked about it, and he, he's the true expert on this. But what we're seeing is that the convenience yield of Treasuries and the convenience yield for the reserve currency of the dollar, it may not be in jeopardy, but on a relative basis, it's being diminished.

50:22 And in Europe, we'll sort of say that the large liquid bond markets have served as the safe asset. And generally this is that if we look at the history of in safe assets, know you in Europe, it's always been, you know, buns sort of German as a safe asset. You had a very liquid French market. So we'll sort of say it wasn't as safe as Germany, but it was also considered as an alternative.

50:50 But now the question comes in this is that, you know, is France a safe asset by any stretch of the imagination? And that's even relative to Italy, Spain, Portugal and sort of Greece. So it's quite possible that the southern rim that is always considered risky assets may not be as risky as what we thought before.

51:15 Yeah, that would be a change. But even gold, gold has always been thought of as a safe haven, but that certainly had its challenges in the last six months or so. Well, that's the interesting part is that we saw, you know, gold over 5,000, you know, earlier in this year. Last six months it was, you know, we probably had during summer was at 48, after it went down to about 41.

51:40 Now it's back at 4,100. So, you know, they're, you know, it. We would expect that people would be pouring more money into gold right now. And yet it's off its eyes from the summer. Yeah. Now, one of the reasons why people would even consider trying to find a safe haven is, of course, geopolitical troubles.

52:06 And we've certainly, again, had this transition in the last five years. Or so from a world that seemed relatively peaceful to a world that seems anything but peaceful. And I know you wanted to touch on this as well, so why don't we spend a few minutes on that? Well, you know, if we'll say our underlying theme for this podcast is that you got to know your history and, and part of that is developing what was the history and what isn't the history.

52:41 So we'll say that one thing I've noticed is, and we've seen this from some seminars from the cfa, from research that's coming out, that there's more of an interest in what is called geoeconomics. And we'll sort of say that if you had a global hegemony which is associated with the dollar and dollar, institutions and global institutions, what we're finding out that there's more of research is being done on geoeconomics, something that hasn't been in the, in the vocabulary.

53:17 And it's associated with the, we'll call it the, you know, call it the micro foundations of interactions between countries. And so we'll sort of say tariff wars, sanctions, associate wars, capital controls, the, that all of these, the actions of the euro, the EU relative to the US the actions of the EU relative to China.

53:46 This is that we're seeing that there's more of a focus on the interactions between geography and countries and economics and how that they might use industrial policy, tariffs, capital controls, how regions such as the Middle east might have an impact on other parts of the region. This is that there's more of a focus on how the world is becoming dislocated and how the world is becoming fragmented now say, like, well, what does that have to do with trend following?

54:24 Why is that important? And, and I think that it's important that if the world becomes more fragmented and dislocated, we should sort of see the diversification increases in markets. Markets are going to become more decoupled. Yeah. And what has been one of the major themes in trend following for the last couple of years and we could always have another podcast on how many markets you should have to be diversified.

54:53 So, so that is a never ending question. But we'll sort of say it will ebb and flow based on the amount of geoeconomic fragmentation that we have. If we have more fragmentation, then you say you're going to get more diversification across markets. If there's less fragmentation, then what we're going to sort of say that, okay, markets become more correlated so you're going to get less diversification on the, on the market you trade so, so you need to be aware of, we'll call it the geoeconomics because that's going to have an impact on the correlation matrix that you use in the models that tell you how to diversify.

55:38 Yeah. And for those who may not be kind of in the weeds of trend following, but I do think it is important to understand and that is generally speaking, when markets are more divergent, as we see at the moment, so to speak, as you rightly say, the, the correlation between generally speaking positions and holdings in these strategies tend to come down and that actually allows us as trend followers to take a little bit more risk.

56:09 And that's also why we often perform really well during these periods when things get very correlated. As good risk managers, we should be a bit more cautious. And of course when things are highly correlated, there's also much more of a reversal risk in the portfolio. So. So yeah, we generally like these.

56:32 I remember one of Katie Kaminsky's presentations many years ago about convergent and divergent strategies and, and of course we fall all in the divergent category. So. Well, we're certainly getting around but we're not done yet. We're only halfway mark. So. And when you like in the final, to close the loop on this, dislocations and fragmentations, this is that.

57:00 I don't know how many times in trend followers often had discussion is this, is that well, there's New York cocoa and London cocoa. There's New York coffee and, and there's London coffee. There's. You could trade natural gas in, in, in Europe, you could trade natural gas in the U.S. same with, you know, with crude.

57:21 What you find out is, is that if we become more fragmented, if there's a breakdown in, in we'll say global hegemony, then what's going to mean is this, is that well, there's value at trading and if there's tariff sanctions, this is that well, maybe I have to trade both London and New York copper. I have to trade the same market in different time zones or different locations because they have different delivery points and they're going to diverge between the two.

57:55 So when we think about this from a commodities world, so I'm, you know, switching a little bit on my topics is that one of the things that I think that is becoming very evident in commodities markets is that the real problem in commodities is not what is produced, but it's what the inventories look like at any given time.

58:16 And what happens is that you're worried about what we call a stock out problem. The stock out problem is if you're running a factory or running some production process and let's say you run out of inputs, you see, if you run out of crude and you're running a refinery, well then what happens is that it's almost like you'll pay whatever price that you have to pay to make sure that you don't shut down the refinery.

58:43 Okay. If, let's say that Europe right now will say that the inventories that they have for winter is below expectations for the last five years, the inventory levels are low by any stretch. If you have a real cold Europe winter, you're going to have a stock up problem. And so when that happens, what you're going to see that markets will go parabolic.

59:10 You're going to get a big dislocation in markets. And if you think that there are markets that might have a stockout problem, then you're going to start to hoard before you think the problem is going to occur. And if everybody starts to hoard, you know what happens is that then the price is going to get, is going to have an explosive to the upside, perfect example.

59:38 Or diesel or to, to put it in sort of when we have a blizzard in our area or if you have a hurricane down south. Well, everybody goes to the grocery store before there's going to be the, the big storm hits and they clear out all the shelves. So there's a shortage of toilet paper, there's a shortage of bread.

59:58 And what happens is, is that because everybody wants to hoard because they don't want to be stocked, stocked out, then you create the very problem that you want to avoid. Yeah, yeah. I mean we saw this during COVID as well. For sure. Absolutely. And so, so I think that from a, you know, we could sort of think of crisis alpha with a, with a big C and then you kind of say crisis alpha with a small C which would be on a market by market basis.

1:00:28 And you can say like okay, there are markets. If you sort of said like I say a couple years ago with the cocoa market is this that if you thought that there was not going to be any cocoa pods available for delivery then and you're a chocolate manufacturer, you're going to pay whatever price it takes.

1:00:49 But just someone who likes chocolate. Right. And you know, especially if there's no close substitutes. So when you think about what are the markets that are more likely to have a stock out problem or what are going to have these non linearities. So you'd say look at the amount of substitutes and if, if you run a diesel truck, well, you can't just now put regular gasoline in your truck.

1:01:12 You have to have diesel. So it doesn't matter that there are other alternative fuels. If you have a diesel truck, there's only one that is necessary. Yeah, no, absolutely. Now, Mark, since we've just passed the hour, Mark, we still have a couple of points to left and I wanted to let you choose which one.

1:01:36 Let's do one more that you wanted to talk about that you felt maybe was more important at this time. Yeah. So there's some research, there's some, something about experience, there's some investor intelligence. What. Where would you like to finish off today? Well, I'm going to focus on a piece of research, but before I do this, I got to give a pitch that you're going to have to invest.

1:02:00 Ask me to come back again because I want to talk about something called the illusion of explanatory depth. So. Well, we'll take it next time you're on. So that one I'm going to put at the top of the list. Do that. So, but a piece of research because I think that more and more people are spending time looking at AI and machine learning.

1:02:22 And this is, it's not just a fad, it's the reality of the world we have. And you look at, they did some survey work to said, well, you know, of hedge fund managers, how many people are using machine learning to, to find alpha right in their strategies numbers, you know, maybe over 90%. Everybody's, everybody's using it.

1:02:47 And so, so, so someone said like, well, some researchers looked at this, they said like, well, what we want to do is look at what is the alpha half life. If you have a model, this is that, you know, a model will have a certain, you know, shelf life and if everybody starts using the model or if, you know, it may fall out of favor, the alpha has been extracted and then, or more people try to do the same thing.

1:03:17 It's the speed of adjustment of markets is going to be much faster. The nice part about trend following is, is that we may not have the same thing as a, as an alpha half life because you don't know where trends are going to go. And we accept that there are going to be periods of time where there are no trends.

1:03:35 And so it's not a half life. We're just sort of say waiting for these dislocations to occur. And the cost that you may not receive higher returns while we're waiting is just the cost of doing business. True. But for the other people that you have to think about, there's an alpha half life. So what they found that the behavior of people looking at machine learning and everyone doing the same thing has led to more crowding from adaptation of models.

1:04:11 Because a lot of the people who are now working at a lot of hedge funds have all been trained at the same schools in computer science and machine learning. So they all use the same techniques. There's establish using of transformers, maybe you know, boosted methodologies, there's, there's a set of well known methodologies that people use now within machine learning.

1:04:36 And it's almost as though that you graduate from one of these quant schools like Carnegie Mellon, you go to the University of Toronto, if it's outside the United States, this is that you were taught how to use these different approaches and they do that. What they're doing is, is that as all these people are using this, that they've been actually reducing or the half life of alpha has, has, has shortened, Alpha has reduced because everybody's crowding out the returns from strategies.

1:05:11 And then this behavior is actually that meaning is that once the alpha is crowded out from one strategy, you're going to jump to the next strategy. And because the behavior of markets will change because they're going to sort of then have a higher speed of reaction that then the markets are going to change because of this crowding behavior.

1:05:33 And so what people do is that they're going to have to say like, well now I got to find a new model. So, so now you're going to have to sort of increase the amount of computing budget to try to find new models, which is called the red queen problem that we're going to have to, you know, you know, run faster in place just to stay even.

1:05:53 So, so what they did is they looked at the 13F filings from a lot of major hedge funds and they notice is that there's an increasing similarity in the positions that a lot of major hedge funds take in major stocks. So what we're finding out is that all these strategies that have used more and more non trend following techniques, machine learning techniques that actually we'll call it, they're eating their own.

1:06:29 Now what I find is this is very interesting because like, well, how can we combat this? How do you, how do you deal with this? And obviously I'm no different than many other researchers. This is that, you know, I've had to, I don't want to say get on the machine learning bandwagon but I say like, I need to know what they're doing.

1:06:49 I need to know there's something there. And I need to sort of say, is there a way that I could do whatever I'm doing better because I'm using new techniques. And what we're finding out is this, is that, say, well, I have to have a strategy that can be enduring beyond this crowding of alpha and the changing behavior of markets.

1:07:15 And so we'll sort of say that. Can you use machine learning to capture trends? I think the answer is yes, but at the same time is that trend following is probably unique and different than the growing focus on machine learning as a way to create alpha. Yeah, I mean, it is definitely a big debate at the moment, certainly also in the investment world, in many areas of life, but certainly in the investment world, the impact of, of AI.

1:07:51 And in a sense, I'm certainly not an expert, but you would think that whoever asked AI about something that they're likely to get very similar answers if it's based on some kind of data analysis. So the question is, how useful is that if we all get the same answers? And that will be a challenge. Right.

1:08:17 And, and there's always been an attempt by all firms have been, you know, fairly secretive of what is their secret sauce, of course. So, you know, I'm sure that, you know. Well, I know for a fact is that, you know, the level of secrecy that we had, the old shop I was associated with was, you know, you know, off the, off the charts in terms of making sure that we compartmentalize knowledge and who, who knew what and where and how much details were given.

1:08:48 But there's almost a, a more fundamental issue is this, is that there's one thing to say, you know, what is our secret sauce of what we do? But now with machine learning, because it's more technique driven, is this, is that. Well, everybody is. There is no secret sauce with the techniques because the techniques are being taught and schools and those are the people that are being hired as quants in all these firms.

1:09:13 So all of them. And in some senses is that, when you think about, from an academic perspective, is this, is that. Well, if you use one technique, well, then everybody else will say that that's an accepted machine learning technique. Well, then everybody else is going to want to use it. So there's no secrecy and the techniques that are being developed.

1:09:38 Yeah. Just to round this AI talk off, I was traveling again this week and in one of the meetings someone said that, and I haven't tested this, I don't know if it's true, but he said that if you ask AI to pick a number between 1 and 10, it's going to give the same number. I don't know if that's really true, but so yeah, interesting.

1:10:03 Well, this becomes the real issue of, of, you know, if you ask AI, pick a number between 1 and 10, that's one question. If you ask the AI to say pick a number that you think everybody else will ask or will pick, you might get a different answer. And then, and then if you. So, so there have always been these experiments where you say like, well, you know, where you could run sort of say like form expectations of what, what you think everyone else will choose.

1:10:40 And then, and, and then what happens is that you get some unstable equilibrium. So, but yes, this is it now I'll be the first one to admit, and I don't think it's that that unusual is, is that I'll ask something from, from AI and then I'll use Chat GPT, I'll use Gemini, I'll use, you know, Grok, and then I'll use Claude and I'll ask the same question from the same, from each one of these and then sort of look for the differences between those and then you start saying it's like, okay, and then I'm also looking for, for what is the similarity between their answers and you find out this is that the numbers are fairly similar.

1:11:26 So now is that a good or bad thing? The fact that if you ask AI a specific question and you get the same answer, is that good or bad? If it's a fact, then it's probably a good thing. If it's something they come up with, then you never know. Yeah, but anyways, this was fun and very insightful as usual.

1:11:53 So for everyone listening and do show your appreciation for Mark and all the other wonderful co hosts that we have by going to a favorite podcast platform, leave a rating and review as it does help more people discover the podcast and join in on these conversations. Next week I'm joined by Alan. So that will be your chance to challenge him with some of your questions and as always you can email them to infooptradersonplugged.com and I'll do my very best to bring them up.

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