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What was the short-lived SVB baking crisis all about? Has it forced the Fed’s hand? Are we done tightening? Lots of Macro questions so who better to dig into it with than the appropriately nicknamed Macro Alf. In this episode of The Derivative, we sit down with Alfonso Peccatiello, founder of The Macro Compass and owner of the wonderful Twitter handle @MacroAlf to discuss the challenges of generating alpha in a low-volatility environment.
Peccatiello shares his experience of working for ING Bank and managing the Treasury Department’s investment portfolio, how regulatory forces have pushed the large players into what looks currently like the wrong investments. They explore the difficulty of generating more return by taking the same amount of risk, especially in a market where the last basis point of carry of risk premia available was the name of the game.
Alfonso and Jeff also delve into the bond market’s predictive ability (or maybe more fair to say inability) and its role in predicting the economy’s future, the importance of risk management, and the blending of systematic and discretionary processes in making investment decisions. They emphasize the need to consider various factors when analyzing the bond market and interpreting its nuances, plus so much more!
So sit back, relax, and get ready to learn valuable insights into investment and macro trading and the challenges faced in generating alpha in a low-volatility environment — SEND IT!
From the Episode: Fed Pricing chart
Check out the complete Transcript from this week’s podcast below:
Searching for Volatile Macro Environments with Alfonso Peccatiello, The Macro Compass
Jeff Malec 00:07
Welcome to The Derivative by our RCM Alternatives, where we dive into what makes alternative investments go analyze the strategies of unique hedge fund managers and chat with interesting guests from across the investment world. Over there, it’s the final four then masters weekend and warmer weather here in Chicago. So I’m excited, but actually it’s been a rather warm winter all over sending that gas down about 70% Over the last year. So we’re going to bring on our pal Brent Belote of Caler Capital is one of the managers highlighted in our rankings white paper next week to talk through what’s happening in that gas and the rest of the energy sector. So go subscribe and sign up to get that episode as soon as it drops. On to this episode. And speaking of warmer weather, our guest today macro elf calls the south of Italy home and with that slower lifestyle, his banking background and his macro chaps. I thought he would be a great guest to help take a step back after all the dust has settled and help us unpack but now it looks like a rather short live banking crisis. Here in the US. We talked to European banks just letting them traders like him have a risk budget. Whether there is a banking crisis here in the US with the feds next move may be why and how nearly all predictions of future rates are wrong. And of course his life of pizza on the beach. Send it This episode is brought to you by RSM and their newest managed features rankings. We highlight top managers across all sorts of metrics top by return by risk by risk adjusted and more and then give you a top 15 ranking. Go to our CM all stock comm slash rankings to check it out today. And now back to show. Alright, everybody, we are here with Alfonso Beckett. TLO. How do I do? Very well, Jeff, very well. And now I got to know do you go by Alfonso or Alf? Else out of it? And I have to ask because I’m a child of the 80s. Do you ever watch the TV show out with the alien?
Alfonso Peccatiello 02:17
I’m too young for that. But I’ve been referred to, for many people to that off alien thing. Yeah,
Jeff Malec 02:23
we watched it with the kids a couple episodes during COVID. And they’re like, this is stupid. What do we watch? Like it’s a muppet trying to Yeah. So we’ll find an episode or two and send it to you. All right. But thanks for joining us. We’re recording here 8:45am On March 24, which I usually don’t get into. But we might say some stuff that is no longer relevant by the time this is released next week. So I wanted to lay that out there. It’s your afternoon you’re in the beautiful South of Italy.
Alfonso Peccatiello 02:52
That’s correct. I am in a place very close to the Amalfi Coast, which involves great weather, great food, and a lot of other things with Chiron particularly great, but overall, it’s where I was born. And that’s the place I like,
Jeff Malec 03:06
born and raised and done all your work there in South Italy,
Alfonso Peccatiello 03:10
born and raised in the south of Italy, close to the Amalfi Coast, then went to study in Germany worked between Germany and the Netherlands, running money for ING Bank for eight years. And now I basically run my own macro strategy, investment strategy firm, which means I can do it from wherever I want, which happens to be very often exactly where it was born and raised.
Jeff Malec 03:33
I saw your tweet, tweet the other day with Beach, little pizza, that look nice. We’ll come visit. So you mentioned the bank, tell us how all that came to be. And we were just talking offline a little bit of how they said run this book, which was a bit surprising to me. So give us the backstory there.
Alfonso Peccatiello 03:52
So look, Jeff, I was working for the Treasury Department of ING Bank, which is an a bank headquartered in the Netherlands, north of Europe, but actually, it’s a global bank, it’s in Australia, it’s in Poland, it’s in the US, truly a global bank. It’s been quite a nice ride, very wide range of experience, from running interest rate risk to effects to credit to any sort of risk, really, I mean, the Treasury Department of such a bank is gigantic. And it’s really involved in all the aspects of a bank, including what’s turning out to be Now the focus of everybody, which is this regulatory liquidity books, you know, that have been basically put in place after the great financial crisis, this large investment portfolio, mainly consisting of treasuries, but also mortgage backed securities and all these, you know, kind of government guaranteed liquid paper for regulatory purposes. I was in charge of a very large book that mostly comprised of that, but also I had overlay mandates effectively, which were something resembling a total return global Mark. Row look at the end of the day. The reason is look, between 2014 and 2021. People seem to have forgotten that but interest rates were negative in Europe negative in Switzerland negative in most of continental Europe and elsewhere, they were zero at best, right? So in that environment as a bank, you, especially in Europe, you can’t pass negative deposit rates to your customers, it’s very, very hard to do. So which means you’re sitting on negative net interest margin on a running basis, because you can’t charge your customers negative deposit rates, your risk free assets are negatively yielding bonds, AAA bonds, all these, you know, liquid investments that the regulation requires you to have, which means Wow, you’re bleeding carry, basically, to meet regulation, which meant, you know, a lot of these banks try to find creative ways to generate additional return. And you know, these overlay books were sometimes quite popular to try and generate some total return on top of that, interestingly, in a very low volatility environment back then, for most of the time,
Jeff Malec 06:08
though, like the answer to Who in the world would accept negative rates was really nobody there were there, but they didn’t weren’t accepting, and they were trying to obfuscate them and like and change them internally.
Alfonso Peccatiello 06:20
Look, the it creates wrong incentive schemes, Jeff, because you are sitting on a regulatory scheme you cannot avoid where by regulation, you can’t charge negative deposit rates to your customers. In most cases, that was the situation in your on the asset side, you’re forced to own about 15 20% of your balance sheet in liquid assets that are yielding as well. Negative, even if it was walk away interest rate risk, and you buy these bonds in so called asset swaps. So you buy the bond, you pay fixed swap against it, you’re only left with the credit spread in it, that also was very compressed because of ongoing quantitative easing across the board. So you basically didn’t have a way to make money, neither from interest rate carry, nor from credit spread carry, you had a little bit left in it. Just it was basically like picking pennies in front of a steamroll literally because all this volatility event could wipe out years of carry that you had locked in such carry was that low. So you were forced to find creative solutions. And so what banks did is something that will probably come to haunt them, I think bits over the next few quarters, which is a take more carry risk. And what that meant more credit risk, which means you know, you move to commercial mortgage backed securities, mezzanine tranches, you move down the credit spectrum at the end of the day, right, you try to take more risks and try to capture more credit spreads by moving down the credit spectrum. And now it might turn to be a problem when you move into part of the cycle, which is, you know, late stage, or towards the recession, this is this exposure comes to home to you. The other was to try and be more creative with the risk you take. So, rather than taking beta risk, try to create some alpha by having overlay exposures in your portfolios.
Jeff Malec 08:16
Just popped in my head there, which came first it’s like a chicken or the egg, right? If they change these rules, you had to have all that securities was the demand by all these depositors for those securities because those rules drove rates down. But look,
Alfonso Peccatiello 08:29
it’s always difficult to say what drove walk. And the reality is that inflation was really low between 2014 and 2021. You didn’t have a lot of macro volatility, really neither in growth nor in inflation, there was no cycle, Jeff, right. So what happened is, by definition, you have no risk free rates and term premia very compressed, you have central banks trying their best to revive the credit growth, revive the economy through quantitative easing programs, you have banks that by regulation are forced into piling into this risk free asset. So you have a confluence of factors, basically, that led everybody stuck into the very same trade. And then at some point, banks were like, Yeah, but I’m not making any returns, like I need to enhance my returns on the asset side, how do I do that? Either I run more risk, beta risk, so more credit risk at the end of the day, or I’m gonna run more proactive strategies to generate some alpha.
Jeff Malec 09:27
And this ties in with the LDI themes, the same thing was going on in England there, right of like, okay, we need a little more return. Let’s either expand our duration or add something on top. So you were personally one of those pieces that got added on top saying, Hey, make us some more money.
Alfonso Peccatiello 09:44
Yes, pretty much and look, the environment was very challenging if I reflect on it going back in the past 2019 was a year for instance, where if you were a beta investor, and you just bought some bonds and some stocks took equity beta risk bond beta risk, went to sleep did absolutely nothing on it, Jeff, you made the sharp I think to Yeah, like Sorry, what? If I look back I’m like, wow, simply by allocating capital, possibly into beta risk in bonds and equities you made a killing in risk adjusted returns, which meant, well, okay, so if I’m asked to generate alpha, how do I feel about that, right? I mean, I’m supposed to generate more return by taking the same amount of risk, right. So I’m trying to make some returns which are either not like diversified against this beta, or more returns taking the same amount of risk. And back then, actually, it was very hard. I remember that trying to squeeze the last basis point of carry of risk premia available was the name of the game. So you sold volatility you sold tails, you try to generate structures that were somehow harvesting the very little risk premia left, if you reflect upon it, it was a massive selling of deals, very concentrated, everybody was having the same trade on which then in early 2020, with the pandemic, in the exogenous shock, it turned out to actually be quite a problem, right? I don’t think that’s very different from what we have seen now in the bond market, Jeff to try to make to contextualize this. narratives in global macro can be really strong. And up until three weeks ago, we had the back, I think it was the best setup ever, for almost to try and have some bond exposure on your book. And why because nobody wanted bonds anymore. Everybody hated bonds. And nobody thought they would need them any way in the near future, because the narrative was fed funds above 5% forever. You know, the economy can run with much higher interest rates, inflation is really sticky. Powell is very serious about it. And the positioning was also interesting. Many of my clients are high caliber macro hedge funds out there. And unfortunately, for some of them that have taken some hits. When you want to try and play for higher Fed Funds, over time, what you do is you do collars, you do put spreads on Sofer put spreads on Eurodollar. All of these require you to pay premium up front, but the hedge fund business is not built on Bleeding premium while you wait for an outcome, right? You are supposed to find structure that doesn’t cost you money and pays off in a convex way if you’re right. So what people thought is, I’m going to sell some coals against this. That didn’t turn out very well. I mean, there were there was such an explosion involved at the front end of the bond curve, which again, is the result of such concentrated global macro narratives. They have become quite a feature of the system, I think, rather than a bug
Jeff Malec 13:01
and selling cars on the bond price. So basically selling puts on the yield, correct? Yeah, and to me, that’s kind of a, you’re saying the same thing as the old line of like, whatever causes the most people the most pain is what the market is going to do. Right. So from a professional standpoint, that was for sure, like a lot of the sock Jen trend index had its worst five day ever. A bunch of trend followers we track were down between five and 15%. In two days, right on the Friday and the Monday because they were Yeah, they were short. Eurodollar dollars, two years, five years, 10 years, 30 years. They’re just short across the board, which had paid out in spades over the last two years. Some of those trades have been held for 600 days by the trend
Alfonso Peccatiello 13:47
bow. Well, of course, if you’re a trend follower 2022 in rates was amazing. Right? It was one trend up very little retracement above, you know, that basically made yields break down the moving averages, you know, the trailing bands that you’re using these strategies, it was the perfect environment to run your profits for long being short rates. But the consensus was overwhelmingly I think, at some point moving towards this higher for longer thing while Jeff on the other hand, I think we had gotten already quite some strong indications that we are late stage in the macro cycle that especially certain sectors have relied on a continuous flow of credit between 2001 2014 and 2021, namely the real estate market overall, it started to see that credit flow deteriorate pretty rapidly look, I’m gonna move for a second the conversation on the real estate just to show you how important is that asset class to the overall global macro landscape? First of all, the real estate market is the biggest asset class in the world by market cap by a large margin. Jeff, you I would ask people like what’s the biggest asset class in the world? They would normally say the bond market. You have to take the bond market globally, sum up the stock market globally. And still, you are not at the market cap of the real estate market. It’s really gigantic. And it makes sense, right? I mean, it’s, it’s something that people need to live, right. So it fits the needs of people. It’s a very leveraged market mortgages back up about 80% of new house purchases in developed markets. It’s a very leveraged market by definition. And it’s systematically important as well systemically important for them.
Jeff Malec 15:36
And so what what’s that number look like? 50 trillion or something?
Alfonso Peccatiello 15:40
No, no, it’s like over $200 trillion. Okay, it’s just huge.
Jeff Malec 15:44
I was just happy I got the T, right, the trillion.
Alfonso Peccatiello 15:48
So just the Chinese real estate market before the deleveraging, we saw in 2021, and 2022, just the Chinese market was $50 trillion, one real estate market. So that’s the size we’re talking about. Now, let’s reflect on the fact that as I said before, many pension funds insurance companies, banks were looking for yields between 20 2014 and 2021. So what they ended up doing is they took more leveraged exposure to the sector, right? Mezzanine tranches, commercial market module backed securities, residential mortgage backed securities, anything that gave them leveraged exposure to the real estate market. So the flow of credit to that real estate market was actually very ample and very good for a long period of time. That has come to a sudden halt. The real estate market is frozen. I mean, housing sales are down 30 40%. year on year in the US, I mean, the level of activity in the housing market has come to a halt. New buyers are cut out of the market, Jeff, I mean, it’s unaffordable for many at this level of mortgage rates. Sellers, on the other hand, are on strike, they’re not going to sell because they locked in mortgage rates at 3% for 30 years, nobody’s going to willingly give that away. There you go, Jeff, you’re not going to sell now unless you’re really forced to right. So unless there is a deleveraging event or something, but you need to tap into that built in equity, you will notice something along a labor market cracks, I don’t know something big.
Jeff Malec 17:15
So I have a quick anecdotal thing for you in February down it i connections at the hedge fund conference and had 15 private credit meetings. My takeaway was they’re all doing mezzanine debt on commercial real estate projects, right? And the answer was, Well, what happens in a big crash and the you know, your you can’t get your money out? Oh, well, then we take possession. And usually we actually make more when that happens. So there was this kind of, yeah, rose colored, for sure. And that was just in early February. So
Alfonso Peccatiello 17:47
there you go. So this anecdotal evidence feeds into this narrative. And look, the housing market is frozen, I think is the right definition. It’s not collapsing, but it’s frozen. It’s just on stasis, waiting for something to happen. Before the banking stress, which we’re going to discuss about as well. There were some clear signs that the stasis was about to be resolved on the way down. So Blackstone and KKR, the two largest institutional investors in the housing real estate market at a gated redemptions on the largest real estate investment. So that’s never a good sign, right? Where you basically say, look, investors, I don’t want you to withdraw, because if you do, I’m going to be forced to liquidate my assets, and liquidating my assets in this market where there are no marginal buyers might actually be very problematic. So what you do is you try to limit your redemptions right. And
Jeff Malec 18:41
gated the Blackstone one last I read. Yeah. So Sergey
Alfonso Peccatiello 18:44
did not good, I would say. And the second is Blackstone defaulted on the first CMBS over $500 million. It’s not a huge deal, but it goes to show that on the commercial real estate market, especially if you cannot get these cash flows coming in, from offices from stores, because patency rates are lower. At some point, you need to sell the collateral to meet your investors demand, right? But you find no buyers, there is no marginal buyer at these prices. So we had some signs of distress was building up in the sector, Jeff, but nevertheless, people were so deaf to this and so strongly seduced by the narrative of higher for longer, that they were selling calls on bond prices. I guess this is another episode that goes to show how important is how how powerful narratives in global macro can be. And maybe the edge sometimes from a global macro manager can be the ability to detach from the narrative step back, have a data driven macro process and try to see what the market is willing to overpay or particularly depressed and underpaid for tails. I think having that assessment is really some some sort of steal some edge a bit. Both for global macro investors out there.
Jeff Malec 20:02
And so you’re saying these funds for lack of a better term are saying, Hey, I’m willing to accept that tail, I’m willing to accept that rates aren’t gonna rise 120 basis points in the five years, whatever they did over two days. Right, I’m gonna accept that risk, because we’re higher for longer meant and but was that whole real estate problem driven by COVID Was that the vacancies are driven by higher rates, and there’s no one wanting to come in and do a new deal a new project at the higher rate. But
Alfonso Peccatiello 20:29
it’s a combination of both right? I mean, cash flow, deterioration comes because of luck and see rates being lower. But then from a credit flow perspective, that’s the real problem. Because such a leveraged market, Jeff, in order to keep running needs a very robust flow of credit of cheap credit being thrown at the system. And the credit wasn’t ample anymore. Tightening standards were sorry, lending standards were tightening aggressively already before the banking stress. And on top of it, it wasn’t cheap, anyway, because you know, this lending rates because of risk free rates higher, but also credit spreads wider. And basically, the resulting effect of having these credit flows being much more expensive. So you have tighter credit, more expensive credit. And that then that generally hurts any leveraged market that relies on cheap credit in the first place to keep running.
Jeff Malec 21:22
And it seemed everyone was perhaps the lag effect or whatnot, right of like, the narrative for a long time was oh, they can never raise rates, it’ll break everything. We’re saying it’ll break real estate, the biggest market in the world. And then they did raise rates and things weren’t breaking. So that’s where everyone went, Oh, this can work. We can be higher for longer.
Alfonso Peccatiello 21:40
That’s the point. You know, I mean, I think there was a point last year where people were in denial, and they said, Look, Fed Funds can never be above 3%, something’s gonna break. That narrative was also strong. So that’s why trend following on rates work extremely well, because you know, there was not a major participation fundamentals participation, which meant the path of least resistance was that rates kept pushing higher, and higher and higher, didn’t become crowded. Until, funnily enough, you were at 5% Fed Funds priced in for 18 months to go, Jeff, that’s accurate. If you reflect about that. Tightening in financial conditions hit the credit driven system, like today’s economy, under two circumstances, when there is a rapid increase in borrowing rates, then you get a shock effect, right, whether repricing or valuations, because risk free rates all of a sudden are much higher. So you have this shock effect. The second effect, which people really underestimate, I think it’s the length of tighter financial conditions like For how long are you going to keep rates at 5%. And at some point, the market was pretty convinced that the economy could basically run fine, with mortgage rates at 7%, and corporate borrowing rates at 8%. But actually, the fundamentals don’t justify that, Jeff, because after the pandemic, it’s not like the ability to generate cash flows has gone up structurally by 10, or 20%. It hasn’t, it hasn’t gone up structurally by 10 to 20%. It just means borrowing conditions are much tighter. And if you keep them tighter for longer, sooner or later, some issues are gonna come to the surface.
Jeff Malec 23:24
And I wanted to share a quick chart that you shared. Yeah. This is one of my favorites. were terrible. Us. I’m going to own the futures market here, as people in the futures market are terrible, terrible at projecting where these rates are gonna go. So for listeners that aren’t on YouTube, go check it out on our YouTube channel, but at the same time, this is that famous squiggly chart I call it of the projected Fed funds rate and the actual Fed funds rate. Look,
Alfonso Peccatiello 23:54
I mean, people are, again, there are so many well believed narratives. One of it is the bond market always knows. Right? It knows something smarter than any other market. Yeah, I’ve traded a large amount of bonds for a long period of time. But I can tell you is the bond market has a lot of informational value, Jeff, in its nuances if you’re able to recompose real rates, inflation breakevens, forward rates, implied vol credit spreads. I mean, the bond market has a wealth of information that you can try and use in your process. But its predictive ability. That’s a different story. I mean, in October 2021, the bond market looking at one year forward rates, was expecting Fed funds to be hiked by 25 basis point in 2022. The Fed hiked 475 basis point oops. Inflation breakevens one year forward one year inflation breakevens in 20 In 21, where two and a half percent, inflation ended up 2022 at something like eight. So, obviously, predictive ability as you also that chart should very clearly is debatable. So you shouldn’t rely on the bond market to know exactly what the future holds, that there is a lot of information or information on value in the nuances of the bond market that you can use in your process.
Jeff Malec 25:31
Talk a little bit about that, because most people listen to hear and to quants and systematic strategies, everything you’re doing is trying to give discretionary and correct me if I’m wrong, but kind of discretionary macro traders, the tools and the information like you said, but here, we just showed a chart of like these, this information can be incredibly not price leading, but incredibly non predictive. So how do you balance? And how do you weigh those two of how do people use this? Can they is it up to them to use it correctly?
Alfonso Peccatiello 26:01
So Jeff, look, what I do is actually a bit of a mix of both. So I have a macro process that relies on data. So from from a certain perspective, it’s quite systematic. The decision making when it comes to portfolio investment ideas that they send out to clients is obviously discretionary nature. But the risk management behind it is very systematic, the sizing of the positions, the portfolio correlations. So it’s a blend basically, of discretionary ideas coming though from a pretty systematic macro process with a pretty systematic risk management behind it a bit of blend of both said that there is quite some discretion right at the end of the day, I’m not going to lie. So look, the discretion comes from being able to piece a lot of things together, because global macro is bust. So you need to be able to get information from a lot of places and bundle them together and try to sort the puzzle out. The nuances of the bond market are very important. For instance, take implied vol in the bond market is something that is quite important to analyze. Let’s take today implied vol in the front end of the bond market, say one year, one year, two years options, okay, so basically the implied ball in price in the next year for two years operates in the US annualized while it’s running at very elevated levels, really elevated levels. So what does this tell me? Two things. A, people have D grossed pretty aggressively because once you price, a weight, that kind of wide outcomes, it means you’re not taking many risks, the amount of risk premia price there is so wide and it’s not compressing for weeks now, that it means a lot of people have been hurt, because they don’t have the capital the VAR, the balance sheet, the ability to come in and compress this risk premia. Right?
Jeff Malec 27:56
Because in other environments, they’d look at that and be like, Oh, my God, this is so fat and juicy, we need to get in there and self correct
Alfonso Peccatiello 28:02
that now because we are reading actually the bodies are coming to the surface, right? I mean, we see the casualties in several hedge funds. And unfortunately, we’re caught into this deleveraging process. The fact that implied vol stays that wide for so long. It’s telling me people are actually de risked. So that’s the first information. Second part, institutional investors Behavior Driven by implied vol. So the bond market is at the epicenter of our system, the Treasury market is, you know, the most systemically important out there, it underpins repo markets, it underpins collateralized lending in general. So, the Treasury market needs to be strong and stable in order for other things to work sack the base of the pyramid, right? If you have daily moves of 20 basis point plus minus into your rates. Jeff, this is a byproduct of the implied war we talked about before, right. It is very hard for institutional investors to take risks down further down the curve, if the very asset which underpins the stability of the system is so unstable. So both implied and realizable in the bond market can tell you something about the ability to take risks, both from the hedge fund community and institutional investors community. And actually, even if you look at some relationship, if you look at Bond ball against multiples against credit spreads against high beta assets, you tend to see some good relationships you know what bond ball is compressing, when things are calming down, people can lever up again, take more risks, and they’ll do that when there is more risk premia available. So understanding these nuances can be very important can inform your process. Of course, it’s not the only thing that matters. Macro data also matters. Sizing also matters correlations also matters. But that’s what I try to do is put all of that together in one big box of global macro location and see what comes out of it.
Jeff Malec 30:08
And we’ll come back to that, but speak for a minute on what that box looks like there’s actually at first, when you left the bank, you were doing a just a newsletter, Twitter, then that South of Italy lifestyle, you said, Hey, we got to put out a subscription service. So tell us what that box in your words looks like?
Alfonso Peccatiello 30:26
Well, first of all, I wish I could have a southern Italian lifestyle because I actually work much longer hours now than I did at the bank run. I can’t imagine what kind of work it is to set up all of this. But it’s been fun. And it’s good. A lot of people have subscribed, which makes me happy. And also the right now, Jeff, I mean, it’s like before I was running money for the bank, nice. Now I can try to make a bit of an impact, you know, if I’m not always right, not at all. But I can try and convey my experience to a broader range of people while before its compliance. And you can’t go on an interview when you come on social media and all of that right. Now, it has a bigger social impact, which is good. I liked that part, said that. Look, when I quit my job from the bank, I thought I’m going to be a consultant only for certain counterparties. I knew already from my previous job, they actually started like that, then I realized that while there is quite a lot of appetite from people, they want to learn what I have to say, or they they find it interesting, right? Or maybe the way I say it, I don’t know. So I went on social media, and then the Twitter profile just exploded. And then I thought, well, it’s quite a lot of people interested in to that, turning into a newsletter, because I can write longer form pieces, more charts, it has, you know, tweet is very short, it’s very hard to elaborate on a macro thought in a single tweet, right? So I moved it up on a newsletter, even more response there. And at some point, I thought, you know, I’m only writing stuff, but people need more. They want to have tools, like the same stuff that I use to look at Ball adjusted returns in markets, try to connect the dots, regress find anomalies, generate trade ideas, look at what portfolios I am building. And again, everybody has its own risk appetite, but I wanted to make it more actionable. I wanted to give interactive tools research more often. So I ended up building a whole platform that does that, which is called the macro compass, where all of that is available. So not just a newsletter, you get my research pieces, but there is also much more behind including interactive tools, portfolio strategy, tactical trades, and all of that.
Jeff Malec 32:40
And that’s macro compass.com. Yeah, the macro compass.com is the website. Go check it out. I will subscribe. I’m not yet a subscriber, but we’ll check it out. Thanks, Jeff. And that comes back to my feeling of just Okay, is that is it a net? I mean, you must believe it’s a net positive for those. I’m kind of trying to separate my brain between retail type investors and hedge funds that might use that tool. We’ll start with the hedge funds of like, is it really some guy sitting in a pawn shop? Who’s going to subscribe read that stuff be like, Oh, okay. I hadn’t thought of that trade. I’m gonna do that. Do you think there’s those people out there? Yeah,
Alfonso Peccatiello 33:15
actually, I can see them. So yeah, I think which is good. Look, there are different tiers of course of service, Jeff. So there is a very high level tier for pro investors, right? That that basically covers their needs more, it tends to talk more about trades that the professional investor can put on and the retail investor instead will have a hard time trying to replicate right,
Jeff Malec 33:37
like generated default swaps or swaps, things they can ask
Alfonso Peccatiello 33:41
that is that kind of trade. Yes. Right. But not not always, but in some cases, there will be peculiar to that kind of client. So it caters for the needs of a professional investor, let’s say, then there are tears that are, you know, more of a hybrid, let’s say so you still get very high quality research, but also maybe looks at an ETF portfolio, for instance, is an expression of that because it’s tradable from anybody really in case they wanted to try and understand what am I doing from an asset allocation perspective? They can. So really, there are different tiers based on what kind of investor Are you? But the the philosophy behind this the same for everybody? It’s like, look, I have a data driven macro process. I do a lot of work. I put it all up together. Try to do this in plain English. I mean, okay, Italian accent sure that I can’t take it out. Well, I mean, with plain English is I don’t like over complications, Jeff, like, you know, there are a lot of people in our business. They try to sound very smart. Nobody understands anything what they want to say, for me, it’s different. It’s like, I have an idea data driven. I backed it up with charts, and I pass it over. And then look, I might be wrong. I am wrong. By the way. That’s the other thing. I stopped out publicly. I have no problem admitting an idea was wrong. Just do the hard work. Put it out. Apart. Only many people find that very useful. Maybe also because I’m independent.
Jeff Malec 35:05
I’ve been you have no agenda. Yeah, yes, I know
Alfonso Peccatiello 35:07
the kind of pressures you can get working for large institutions, you can say that you’re supposed to backup this thesis, I am supposed to do nothing. I just look at the pros have the data, I have the charts and put it out, I have no agenda behind. And it seems to be something people appreciate.
Jeff Malec 35:25
Yeah. And then to me, just if you don’t take every signal is one signal. Okay, but whatever. But let people give them the tools and let them deal with it as they would. Let’s backtrack, and just everything that’s happened since Silicon Valley Bank came on the radar, kind of what are your biggest takeaways? What’s the biggest emergence out of that?
Alfonso Peccatiello 35:53
That’s a good question. So we need to back up and try to do a level headed analysis, there is so much fear mongering out there. And oh, my God, this is systemic, and somewhere away, again. Okay, so let’s, let’s take a data driven level headed assessment. Silicon Valley Bank went down because of three things under regulation. And that can be a systemic problem, because the $200 billion bank in the US, as I will explain, doesn’t need to stick to a lot of regulation, which means regulations, pretty locks. For small banks, this can be a systemic problem, right. But also it went down because it had a very concentrated funding base. And that’s a risk in the first place. And it coupled that with horrible interest rate risk management, or in general, non prudent, let me say, to say the least, interest rate risk management. So this was the three factor that led Silicon Valley Bank to go belly up. Alright, so how many other banks in the US have such a concentrated funding base coupled with horrible risk management on the asset side? The answer is maybe a few. But if you want this to become a systemic crisis, then what we’re discussing about Jeff, is, can this be a systemic liquidity crisis? Because that’s what it is, depositors go away, your liabilities fade away, Your assets must shrink. So what do you do is you sell your assets to try and raise money to make your deposit outflows. If you want this to cascade into a broader liquidity event, it must mean two things, a fire sale of safe assets, the very safe assets that regulators forced large banks to have, yeah, which is a mismatch, correct. A fire sale of these assets, which is not met with an unwind of swaps. Because ladies and gentlemen, a prudent bank doesn’t buy, like Silicon Valley Bank did 60% of their assets into mortgage backed securities and treasuries and does not pay swaps against that that’s completely nuts, running just an oversized amount of interest rate risk that is just not prudent,
Jeff Malec 38:23
which comes back to where they were thinking higher for longer. I mean,
Alfonso Peccatiello 38:27
but it’s just ridiculously risky to do that. So two things here to say for which I for which I think that this cannot or will not turn into liquidity systemic crisis. We’ll talk about credit risk later. Let’s talk about liquidity part first. A large banks take JPMorgan, for example, Jeff, they provide you with an analysis of what is the capital hit that they take, if interest rates are going up? 100 basis point then the curve is flattening and all the adverse scenarios you can imagine an interest rate risk. And mind, Jeff, they don’t only look at bonds, which represent 15 to 15% of the balance sheet, they look at the entire balance sheet because a bank exposure to interest rate risk also comes from long duration liabilities, long duration assets, swaps that are used to mitigate the risk. So the bank looks at the entire balance sheet and they says and they say, what’s my net duration exposure? What’s my net DVO one impact of this based on my capital, JP Morgan did that and estimated that a 300 basis point move higher in rates and 100 basis point flattening of the curve, which is basically what we have seen over the last year and a half wipes out about eight to 10 billion of capital of JPMorgan sounds like a huge number. JP Morgan’s capital is $270 billion. So a four to 5% wipeout of capital not The small hit, not an existential threat, but that’s after their hedges are in place, right? Yes. After hedges, and considering as well, the entire balance sheet liabilities, assets and hedges. So that’s about eight to 10 million, it’s four to 5% of capital if I do the same exercise in Europe, where we have much tighter regulation, stress tests, mandatory stress tests on interest rate risk that the US does not have, which I find interesting. But if I do that, on Europe, where I have broader data, not only for JPMorgan, the typical European bank takes a hit of about five to 6% of capital, again, quite a significant hit, but not an existential threat. So that’s my first message to you guys. A lot of fear mongering out there. Take a step back, look at the stress test. Look at the data. It’s available. It’s a negative for the for the stock for the banking sector, but it’s not an existential threat. Second point while off. Yeah, but what if banks are really forced to sell down these treasuries because they need to meet the deposit outflows. What if it turns into a confidence crisis? Take away the deposits? Okay, so let’s
Jeff Malec 41:11
say everyone runs to JP Morgan, because they just heard you say JP, Morgan’s, fine. Yeah.
Alfonso Peccatiello 41:15
But okay, let’s take a bunch of mid sized bank under pressure. This can easily, you know, scale up into some some widespread crisis. The Federal Reserve has weapons to fight a liquidity crisis, because what look what they did with the regulator’s in 2013, after the great financial crisis, they said, they are banks, you can buy treasuries, you can buy mortgage backed securities, we will basically treat them as cash for regulatory perspective, no liquidity, haircuts, basically no capital as well to attach against possible losses in these bonds. We’ll assume they’re as liquid as cash for regulatory purposes. Now, in a hiking cycle, the market value of these treasuries if you didn’t hedge them, it’s 80 cents on the dollar. So it’s not as cash and it’s sorry, doesn’t work like that, especially if you’re forced to sell them down. What the what the Fed did right now we set up a facility, the bank term funding program, that basically restores that, that sentiment, that confidence that the value of the collateral, the Treasury collateral value, is 100 cents. They don’t care if it’s trading at 70 6080. They don’t give a crap, Jeff, it’s 100. If you posted at the Fed, you’ll get funding for a year at Fed Funds plus 10 basis points, which is not cheap funding overall. I mean, it’s over four and a half percent that you pay for your funding. Yeah, it’s not like a deposit of 0%. But there was good times, they’re now gone if you’re miserable bank, but you don’t need to fire sale treasuries. This is the same backstop that the Bank of England put up when the pension fund crisis was there were these these pension funds had government bonds. But they had to meet collateral call margin calls from their derivatives. And they were fire selling these bonds, which were exacerbating the problem. And it was a widespread panic. So what the central bank did is don’t sell these bonds, please actually give them to me, I’ll lend you money. Use that money to meet the margin call if you need to make the margin call. It’s a very similar mechanism.
Jeff Malec 43:31
Yeah, just the US driven by depositor outflows in Europe driven by derivative
Alfonso Peccatiello 43:37
call rang. It’s a very similar circumstance. The Fed has weapons to backstop the liquidity side of things. That’s the first important thing, interest rate risk at the bank level. It’s a hit on banks capital, but not an existential threat if you run the numbers. Second, even if more banks are forced to meet deposits outflows, they can now post the treasuries at the Fed, they don’t need to fire Sal and start the snowball effect. Okay, level headed, these are the data. This is the stuff going on right now. Does it mean it’s all fine? Well, it’s a bit of a different story, because because some banks have mismanaged their risk Jeff and in some banks have acted a bit like cowboys, they’ve taken excessive risks, they have a very concentrated funding base. So what I think is happening is we’ll have a bit of a bifurcated system, where overall systemically the liquidity, stress will not turn into some catastrophe, but it’s going to be a bifurcated environment where people are looking for the safest forms of collateral, the safest exposures, T bills, money market funds, the boss said JP Morgan, not the boss of the community bank. They don’t know which kind of risks it has run. Why would I keep my money there because I’m not rewarded for it in the first place. So that’s a bit of the bifurcated system and long term macro impact of that is you’re drying up funds and credit for the weakest balance sheet exposures out there. Those are exactly the kind of entities that need flow of credit for the economy to run. So overall,
Jeff Malec 45:20
what you deflationary is that we’re getting to, it is
Alfonso Peccatiello 45:23
it is so medium term, any banking stress, Jeff, is this inflationary in nature, because it forces the banks to deploy their capital that resources into surviving into strengthening their balance sheet and to strengthen their liquidity position, and not into lending to the real economy. So the flow of credit dries up. And when the flow of credit dries up further on top of what it was already drying up, because of the macro cycle we’re in. It just compounds the disinflationary forces that we’re about to hit anyway.
Jeff Malec 45:59
Do you sitting there in Europe kind of have a little cheer of like, oh, the US banking system for once instead of us?
Alfonso Peccatiello 46:06
Look, I always say, we in Europe do a lot of things in a suboptimal way, undeniably. But on regulation, I think we did a bit of a better job. I mean, look, US regulation for banks below $250 billion, it’s very lacks, it’s very, very lacks Jeff, they don’t need to stick to net stable funding ratio to net stable funding ratio to liquidity coverage ratio, they have a lot of exemptions. I don’t particularly like that, because $250 billion is not a small bank. Let me give you some perspective. In Germany, if I take the top three bank in Germany, its balance sheet is less than $200 billion. Top three bank in Germany 250 billion is not a small bank, by any any any means. So this regulatory environment, which was lacks for them is actually a mistake. I think I think it’s gonna be repaired. Now, regulation is gonna get strengthened, of course, because regulators are great at admitting they were wrong after the fact they’re really good at that, but preventing not so much. And in the US, the other thing is, I mean, you guys don’t have a mandatory stress test on interest rate risk, some banks find it unbelievable. JPMorgan willingly reports, the numbers I told you before, but not because there’s a stress test. In Europe, there is a mandatory stress test called supervisory outlier test on interest rate risk, where each bank has to stress the balance sheet assets, liabilities, hedging instruments, everything, and the report every quarter, what would happen if rates go up? 200 basis points. So the regulator can you know, check?
Jeff Malec 47:54
And, of course, a bank like SBB into those hedges and whatnot. So yeah, you say you have to have hedges on or show us your stress test. And if you fail it, you have to have hedges on
Alfonso Peccatiello 48:04
that you go so yes, it’s a bit of a vengeance for Europeans. No, I’m just kidding. It’s, it’s one of that moments where you’re like, Okay, for once we did something in a more stable way than the US. That’s, that’s quite a news.
Jeff Malec 48:18
And let’s touch quickly on Swiss Credit Suisse and the Swiss bank changing the law essentially. Is that a moral hazard of like, okay, we’re going to central banks, the central government is going to start choosing winners and losers. And one, right, like what we already said, if it gets bifurcated, if I’m a small business, and I can’t get in, right, JP Morgan eventually is gonna say you have to have 100 million and XYZ, I’ve already seen that in the hedge fund space, they’ll kick out funds that are under 100 million.
Alfonso Peccatiello 48:49
Credit Suisse. That was an interesting story. The timing was interesting, because it had nothing to do with all this banking crisis in the first place. It was about to die in our for 12 years, and it finally died at the most inconvenient moment. But look, this is another byproduct of lower negative interest rates is people investing in these additional tier one bonds without probably reading the fine print. Because we see regulation is one of the few in Europe, that allows for what’s called the permanent write down of additional tier one bonds, which means if the regulator deems that you ever hit the viability trigger, so basically, the banks about to go belly up. Under Swiss regulation, the regulator can choose to write down completely additional tier one bonds, which they did, but also political decision, I think to prefer certain equity owners to certain credit owners, but the regulator could do that looking at the fine print of the bonds. People have been quick in extrapolating out the additional tier one market in Europe is there because now everybody is basically subordinated to equity owners. Why would you own a bond just own the equity, right? If that is the treatment, the reality is this permanent write down clause only exists basically for the Swiss market. So the broader European market cannot operate this way regulators couldn’t trigger down and write down completely the additional tier one owner. So again, a lot of emotional feelings going around. I think in markets. This was a pretty interesting choice by the regulator, I think, but it was allowed it was nothing. How can I say completely out of the box was quite a decision anyway, which people are extrapolating, it’s valid for the overall European market, but it’s not
Jeff Malec 50:44
read my I’ve just seen the headlines haven’t dug into it of like, they changed a lot. You’re saying a pre existed,
Alfonso Peccatiello 50:51
though they didn’t change anything. So they just took a very harsh decision based on a clause visiting regulation in the fine print of these additional tier one bonds.
Jeff Malec 51:07
So I want to throw everything we just talked about a way, right, we can kind of get trapped into like, oh, this bank and rates and everything like the world throwing all that away, what’s kind of off the radar? That’s massively important that’s either bubbling up through your tools or your brain or tell us some things we’re not thinking about.
Alfonso Peccatiello 51:29
I would say, I’m gonna say China. And people are like, Yeah, of course. We’re thinking about that. Yeah. In January, you were only thinking about that, right? I mean, the only topic of discussion was China, makes me think about the Barron’s newspaper front page that said, this is the moment to invest in China, and it marked the local top. I mean, this is so what’s the thing I when I’m when a big newspaper comes out with with the front page, you know, you got to take profit, you know, but nevertheless, now, nobody talks about China anymore. It’s like nothing is happening. The reality is that China has gone through a massive deleveraging in 2021. And in 2022, si Jinping decided that the euphoria in the tech sector and the real estate market in China was overdone. And that he needed actually to rebalance the economy and take away some of this excess optimism from these sectors. He did. So I think it didn’t expect that sort of deleveraging. So he was a bit too optimistic. Again, the Chinese real estate market $50 trillion worth took a major hit in 2021, and 2022. And as people also were locked home in China, basically with a non stop, lock down for almost three years, the confidence was pretty low. But actually, in October, November, last year, things started to change pretty rapidly, we got the first verbiage that, you know, China stands behind the real estate market, it’s gonna try and stop deleveraging more friendly measures being taken, most importantly, credit being thrown at the economy already from May to 2022. It didn’t result into stronger growth already, Jeff, for a very simple reason, to the reasons a, it takes time for credit to feed into economic growth, there is a bit of a lag few quarters normally, second, people were locked home. So you can give them money, cut taxes, you know, give, do whatever you want. But if people are locked home, it’s gonna be very hard for that to feed into economic spending and economic activity that’s over. China’s now basically stopped lock downs. And it’s very clear that direction of travel is towards reopening. And there is pent up demand coming from this credit stimulus that is sitting now on the balance sheet of corporates on the balance sheet of consumers. So yes, the reopening is happening. It’s there, although people don’t talk about it anymore. But it is something that goes under the Raider. And it can be quite a force, I think for global macro. Overall. And I think people have just forgotten about it. And now the only thing any client of mine wants to talk about is the banking crisis fed cards. And this I find this interesting,
Jeff Malec 54:14
in bed that seems like that’s inflationary, versus all these deflationary forces from the banking. So you have competing factors. And then how does it work? If China can do whatever they want with rates, but if the rest of the world is not buying their cheap goods and stuff, right, there’s a issue there of it doesn’t really matter what they do internally. Yeah. How do you square that? Looky
Alfonso Peccatiello 54:37
it’s a valid point. My point is that I do not expect this to turn into a liquidity crisis snowball effect where the recession is hitting tomorrow. I think the path of least resistance is that no bank goes into receivership at the FDIC over the next three weeks, maybe some very small bank, but most of the damage is is over. Which means that if you pay massive premiums for these insurance trades, you’re going to wind them down. Because why are you bleeding carry? If nothing is happening, right? That’s what normally happens. What this means is slowly but surely markets can try to focus back on the macro rather than on this banking drama. And so the Chinese reopening is inflationary, and it plays a little bit into that theme. I think we’re moving from excesses. I mean, Jeff, it’s been pushing pool in macro in 2023. It’s gonna be like, early 2023. This inflation everywhere but Chinese reopened, so just buy Chinese assets? February 2023, to early March. Oh, it’s inflation back again, is economic activity back again, stronger dollar higher for longer sell, sell call some bonds, extremes there again. Now it’s like it’s over this is it 100 basis point of cuts being priced these year? What, like it can happen? Sure it can. But you really need to be sure about a credit crunch of recession hitting anytime soon for discards to be validated for this forwards to be validated. I think there is a chance that we were doing extremes again here. And maybe if the situation comes down a bit, plus the Chinese reopening, you might want to see another rebound up towards the macro trend of, well, we’re not in a recession yet. Well, the Fed actually needs to do a little bit more. And you can actually basically fade these extreme, I think there is a chance somebody you should consider it as well as a trading environment here.
Jeff Malec 56:46
Why are we jumping to these extremes? Is it because of more automated trading? Is it humans have become less patient? Right? Like, it seems like no one has had the kind of level headed thought you just said of like, well, we got to consider all sides of the coin. It’s just like, nope, rates cuts are back on, we’re gonna hammer