The ETF Play on Inflation and Interest Rate Volatility (w/ Nancy Davis) - YouTube

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

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