Welcome to real visions trade ideas
so today we have something a little bit different last month Nancy Davis the founder and CEO of
Quadratic Capital joined Ralph Alpher a really interesting conversation on interest rate volatility
Inflation and the yield curve Nancy believes that she has unlocked the next big macro trade and she's designed an ETF around that idea
So just note that this is not your typical trade idea. And with that, please enjoy Rao's conversation with Nancy
That's great to have you on real vision again
I know you've been on a couple of times before but it's the first time we've actually got together and we realized that we were
Actually, probably even almost sitting next to each other in part of our career at Goldman Sachs back in the late 90s
Amazing good to see you again
Okay, so give us a little bit of background for those people who didn't see some of your earlier interviews
But the background about yourself what you've done in the past and what you're doing at the moment
Yes, so I'm the founder and CEO of quadratic capital. I started the firm in
2013 prior to that
I was like Goldman for the majority of my career about a decade and I
Originally was on the on the trader in the derivatives group and then moved to the proprietary group
to trade cross-asset class derivatives
and
And loved it and I still did the same thing. So there's a lots of people
I mean a lot of our friends from from from those days
Went in to set up kind of volatility based hedge funds for example
virtually none of them still exist
So what's given you where did you find your edge? Was it the cross asset?
What is it that gave you the edge that you know, you've managed a flourishing environment web many didn't do
You know, they found that leaving an investment bank
They actually left a lot of the edge behind they thought
They thought that they were the edge and a lot of the time it was the flow and whatever the bank got
it's a really good question and
I've never been a vault reader. I don't say I think if you have a view on
Volatility you definitely have to have a view on the underlying asset
and so when I started my career, I was a Southside vol trader and
After I moved to prop I just found it's a lot better. I think if you can have a view, you know macro view
Express it with convexity. So, you know heads you win and Tails if you lose, you know
How much?
So having that long convexity
But directional bias has been really I think a beam throughout my professional career and something I I was fortunate to find very early
but I think it's
hard to be a ball trader because it's an arbitrage strategy, right you're taking the difference between implied and realized and
Maybe you're selling one part of the curve to buy another part of the curve or you're selling one asset class
Volatility to buy another but the reality is you can lose money on both those positions
And so I think it's hard to have a lot of staying power when you're doing a RV strategy
Especially when you add volatility and options to it so in so when you started your firm
What is the core strategy? So if you're using derivatives around that to structure your views, what's the core strategy?
Is it a macro based view or how does it work? So we invest with options with the directional bias on everything. So
like our new product that we recently launched eivol is the first
inflation
expectations and
Interest rate volatility fund out there. It's a exchange-traded. I don't even know what that means. So
what we do is
new for an investor if you like if you're an equity investor you
You know want to have tail protection for instance
It's hard to own equity volatility on a you know
As an asset allocation trade because it decays so aggressively so it's a it's a more benign way to carry
Volatility as an asset class from the long side. I'm using fixed income ball. Not as
sensitive as equity ball
But it's a lot lower level like the ball we're buying is to two basis points a day in normal space
It's very very cheap in my opinion and it gives you a way to have an asset allocation to the factor is Kavala Atilla t?
without having as much decay as you would in the equity space and then for a fixed income investor the big risk there is
obviously
Central bank policy fiscal spending trade force as well as inflation expectations
and we saw a need to really give a fixed-income investor way to
capitalize on the deflation
That's been priced into the market for the next decade. I mean so current US inflation is around 2%
The five-year breakeven is one point five nine percent
So that's an opportunity in an option space. And so it's it's long options with tips
And so that gives investors exposure
It gives you inflation protected income but also options that are sensitive to inflation expectations
And we think it's pretty you know, you're never going to time these macro calls perfectly, but given the central bank in the u.s
Is so focused right now on
Increasing inflation expectations and there's been so much talk about the yield curve inverting and that's kind of crazy
If you step back and you're like, alright, we have a three point nine trillion dollar balance sheet
We have a fiscal budget deficit we have
Unclear or radically changing monetary policy
If you look you where we are now with so many cuts priced into the interest rate markets in the US versus
where we were four months ago, it's wildly different and at the same time interest rate volatility is literally at
Generational lows, um, you know equity of all people talk about equity of all I think VIX today is 17. It's
Low, I guess in the context
But when you look at a percentile like one year of all over the last decade in equities is about the 70th percentile
Yeah, so it might be low, but it doesn't mean it's cheap
interest rate volatility is literally at like
2/1, you know zero, you know so flexible. Yeah. It's it's on its floors
So having the asymmetry to have that deflation that's priced into the market and whether you're a deflation
Astoria flashiness --tz-- it doesn't really matter
Because the big risks for all investors portfolios is pickup in inflation
Whether it's a stagflation area environment or whether we actually have good inflation
It's something that will hurt your fixed income holdings in your duration exposure
and what kind of cost is it to run a
Hedging strategy therefore so in this eivol, it's an ETF. Is that right? TTFN?
So if you're running that eyeball, if you're a bar of that strategy you're looking to head some of these risks
What does it cost you to do that?
Because if it's a long vowel strategy here has some sort of implied cost right?
You know with our equity derivatives background when you buy an equity option, there's nothing you can do you're paying time decay
There's no carry is really embedded. But just like the FX markets where you can have yield differentials
Yeah in the rates market you can actually construct trades that have
Relatively benign carry if not positive carry because of the difference between the spot
Rate and the forward so with a rates position you can have positive carry
Right. Now the curve is so flat that the options don't have positive carry at the moment
but as the curve steepens options actually become positive carry, so in November
They were positive carry and it's a lot more benign than equities
So then what is the return profile because it sounds like it's a very kind of
institutional kind of hedging
Strategy, you know because you've got very kind of esoteric defined risk there big risks, but but not that most people understand them
So who's there?
Who's the who's this product for I think it's you know something that definitely is appealing to institutional investors
But I also think about like my mom, right?
My mom is a retired teacher, you know, most of her net worth is tied up in
Food no bitch situation expectations. Not at all
But like think about a regular person most of their net worth is tied up in their home
What what causes a loss of principal in real estate?
Typically, it's a pick up in mortgage rates and the back end
So the options that we're investing in they make money in a steeper yield curve environment, and they're also long fixed income volatility
So in a recession, you know
You have generally valen Crees who can do well from a hedging point of view
owning volatility is an asset cost but also if we have
Mortgage yields go up
Typically the value of a home price can go down. So I think it is appropriate
product for just regular folks to who have real estate and most
You know most real estate investors
hedge rates
They pay rates to the market to protect themselves from higher yields
This is not short bonds, which I think is what makes it so attractive
When you're paying rates or you have a payer swaption or a put on bonds your short duration
That means you're paying somebody else the coupon. Yeah, so with this product because we're treating the points between two different swap rates
It's got spread d vo one not rate t vo and show. It's not short bonds, which makes it easier to own now
there's an interesting part of this because it's you said
It tends to do well at the yield curve steepens and it tends to do well a fixed income bowl goes up
So that happens even in a bad economy. There's two ways that the yield curve can see bullish deepening or bearish deepening
So in the bullish deepening that I'm kind of expecting from sort of around these levels
I expect that volatility because having traded both the you know
The the cycles in 2000 the cycle in
2008 you get pickup in fixed income volatility is fixed income rallies like crazy
Yeah, if we go into recession, we also get a massive Stickney of the yield curve
So in that situation it works as well as the opposite situation, which is the inflationary
Steepening. Yeah
I mean that's I think what makes the products so unique is whether you
Think we're going into recession and you think the Fed is going to be cutting rates and you know, the world is exploding
It's a tractive thing because we are long fixed income ball and the yield curve can steepen from the Fed actually cutting rates
which is what you know in
historical bear markets a curve has steepened and all those periods really except for 1988 and that was coming off a very
High period of inflation in a very different level of interest rates where we are now
Yeah, but historically it's been a good I'd say tail hedge. It's not a it's not as sensitive as owning equity volatility
It's not the same as you know, having a foot position in extra days. It's not going to have that same kind of impact
So I just want to manage expectations. It's lower vol
Slower-moving but also easier to own as an asset allocation trade for those
sort of risk off events whenever they happen but also on the risk on whether we have an
Inflationary environment or even a sag Felician area environment with say trade wars escalating
You know that could be, you know, some could argue just a pickup in prices and not growth
That's kind of the stagflation area environment is sort of the the really Achilles heel of all portfolios
So I think this is a very attractive way and with all you know, two basis points a day the asymmetry that you can achieve
Using options coupled with tips, which is what we do in eivol. I think it's a pretty compelling
Macro investment so your macro. So what's your macro framework right now? What are you how do you see the world?
Because it's a quite a mixed bag of people who's looking at certain things some people they believe the yield curve and what it's doing
It's giving false signals
There's a lot of people who are looking at the inflation outlook whether they see terraces deflation or inflation area
Depending how you look at. Yeah, there's a number of things and where is your world right now?
Because you're looking across asset classes your macro person. So yeah, what do you say?
I mean, I think the the big challenge for many investors is most asset classes are very expensive
And I think since the crisis many
Acid elevators have been moving into the private space
Because those returns have been very attractive historically
but you look at whether it's private credit or private equities some of the return assumptions I think are quite high and
Whether you have a company that is a private company or a company that's public I think basic economics still hold
You know how much revenue they have how profitable are they and I see some of these
Private companies coming into the public market and IP owing and trading off dramatically
you know who I'm talking about and it makes me concerned because I think
You you have so much of the portfolio's that have moved into the private space
That the number of assets that are in public markets with liquidity is lower
and at the same time you have dealer desks that are not making markets and taking risk like people used to
coupled with you know, 10 years of
Central bank money printing has squashed volatility. So to me I guess is a value invest sir
I look at fixed-income ball as being very attractively priced. Well brilliant. Well, I wish you the best of luck with it
Let's see how it goes and see how the world develops from here as well. Thanks very much
We'll see you again soon. Thank you so much for having me on it's really been a pleasure
You