Playing Interest Rate Volatility
Featuring Nancy Davis and Raoul Pal
Published on: June 27th, 2019 • Duration: 15 minutesNancy Davis, founder and CIO of Quadratic Capital Management, introduces her new ETF that takes advantage of interest volatility and inflation expectations: IVOL. In this interview with Real Vision’s co-founder & CEO Raoul Pal, Davis deconstructs the structure of the ETF, highlights the cost of carry associated with the strategy, and discusses her macro outlook and where she thinks the yield curve is headed next. Filmed on May 29, 2019.
JUSTINE UNDERHILL: Welcome to Real Vision's Trade Ideas. So today, we have something a little bit different. Last month, Nancy Davis, the founder and CEO of Quadratic Capital, joined Raoul Pal for 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 Raoul's conversation with Nancy.
RAOUL PAL: Nancy, 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.
NANCY DAVIS: I know. Amazing. It's good to see you again.
RAOUL PAL: Yeah, good to see you again. So give us a little bit of background for those people who didn't see some of your earlier interviews, bit of background about yourself, what you've done in the past, and what you're doing at the moment.
NANCY DAVIS: Yeah, so I'm the founder and CEO of Quadratic Capital. I started the firm in 2013. I was at Goldman for the majority of my career, about a decade. And I originally was a trader in the derivatives group, and then moved to the proprietary group to trade cross asset class derivatives, and loved it. And I still do the same thing.
RAOUL PAL: So there's a lot of people-- I mean, a lot of our friends from those days went on 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've managed to flourish in an environment where many didn't do-- you know, they found that leaving an investment bank, they actually left a lot of the edge behind. They thought that they were the edge, and a lot of the time, it was the flow and whatever the bank got.
NANCY DAVIS: That's a really good question. And I've never been a vol trader, I would 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 sell side vol trader. And after I moved to prop, I just found it's a lot better, I think, if you can have a view on, 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 theme throughout my professional career, and something I was fortunate to find very early.
But I think it's hard to be a vol 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.
RAOUL PAL: 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 structure? Is it a macro-based view? Or how does it work?
NANCY DAVIS: So we invest with options with a directional bias on everything. So our new product that we recently launched, IVOL, is the first inflation expectations and interest rate volatility fund out there. It's a exchange traded product.
RAOUL PAL: Does anybody even know what that means?
NANCY DAVIS: So what we do is for an investor, if you're an equity investor, you want to have tail protection, for instance. It's hard to own equity volatility as an asset allocation trade because it decays so aggressively. So it's a more benign way to carry volatility as an asset class from the long side using fixed income vol. It's not as sensitive as equity vol, but it's a lot lower level. Like, the vol we're buying is 2, 2 basis points a day in normal space. So it's very, very cheap, in my opinion, and it gives you a way to have an asset allocation to the factor risk of volatility 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 wars, as well as inflation expectations. And we saw a need to really give a fixed income investor a 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 break-even is 1.59%. So that's an opportunity in an option space. And so 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 US 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, all right, we have a $3.9 trillion balance sheet. We have a fiscal budget deficit. We have unclear or radically changing monetary policy. If you look 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.
Equity, while people talk about equity vol, I think VIX today is 17. It's low, I guess, in the context. But when you look at a percentile, like one-year vol over the last decade in equities, it's about the 70th percentile. So it might be low, but it doesn't mean it's cheap.
Interest rate volatility is literally at, like, 2, 1, you know, 0.
RAOUL PAL: Same as FX--
NANCY DAVIS: Yeah, it's on its floor. So having the asymmetry to have that deflation that's priced into the market-- and whether you're a deflationist or inflationist doesn't really matter, because the big risk for all investors' portfolios is pickup in inflation, whether it's a stagflationary environment or whether we actually have good inflation, something that will hurt your fixed income holdings and your duration exposure.
RAOUL PAL: And what kind of cost is it to run that hedging strategy, therefore? So in this IVOL-- it's an ETF, is that right?
NANCY DAVIS: Yeah, it's an ETF.
RAOUL PAL: So if you're running the IVOL, if you're a buyer of that strategy, you're looking to hedge some of these risks. What does it cost you to do that, because if it's a long vol strategy, it has some sort of implied cost, right?
NANCY DAVIS: 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 embedded.
But just like the FX markets where you can have yield differentials, 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, the options actually become positive carry. So in November, they were positive carry. And it's a lot more benign than equities.
RAOUL PAL: So then what is the return profile? Because it sounds like it's a very kind of institutional kind of hedging strategy, because you've got very kind of esoteric defined risks? They're big risks, but not that most people understand them. So who's this product for?
NANCY DAVIS: I think it's something that definitely is appealing to institutional investors. But I also think about my mom, right? My mom is a retired teacher. Most of her net worth is tied up in her home.
RAOUL PAL: Does she think about her forward--
NANCY DAVIS: No, but she's--
RAOUL PAL: --inflation expectations, or?
NANCY DAVIS: Not at all. But like, think about a regular person. Most of their net worth is tied up in their home. What causes a loss of principal in real estate? Typically it's a pickup in mortgage rates in 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 have generally vol increase. So you can do well from a hedging point of view, owning volatility as an asset class. But also, if we have mortgage yields go up, typically the value of a home price can go down. So I think it is a appropriate product for just regular folks too, who have real estate. And 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 pair swaption or a put on bonds, you're short duration. That means you're paying somebody else the coupon. So with this product, because we're trading the points between two different swap rates, it's got spread DV01, not rate DV01. So it's not short bonds, which makes it easier to own.
RAOUL PAL: Now there's an interesting part of this, because you said it tends to do well if the yield curve steepens, and it tends to well if fixed income vol goes up-- so that happens even in a bad economy. There's two ways that the yield curve can steepen. We have bullish steepening or bearish steepening.
So in the bullish steepening that I'm kind of expecting from sort of around these levels, I expect the volatility, because having traded both the cycles in 2000, and the cycle in 2008, you get pickup in fixed income volatility as fixed income rallies like crazy, if we go into recession. We also get massive steepening of the yield curve. So in that situation, it works as well as the opposite situation, which is the inflationary steepening?
NANCY DAVIS: Yeah, I mean that's, I think, what makes the product so unique, is whether you think we're going into recession and you think the Fed is going to be cutting rates and the world is exploding, it's an attractive thing because we are a long fixed income vol and the yield curve can steepen from the Fed actually cutting rates, which is what, in historical bear markets, the curve has steepened in all those periods, really, except for 1988. And that was coming off a very high period of inflation and a very different level of interest rates where we are now. But historically, it's been a good, I'd say, tail hedge.
It's not as sensitive as owning equity volatility. It's not the same as having a put position in equities. 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 side, whether we have an inflationary environment or even a stagflationary environment with, say, trade wars escalating, you know, that could be, some could argue, just a pickup in prices and not growth. That's kind of the stagflationary environment, is sort of the really Achilles heel of all portfolios. So I think this is a very attractive way. And with vol, you know, 2 basis points a day, the asymmetry that you can achieve using options coupled with TIPS, which is what we do in IVOL, I think it's a pretty compelling macro investment.
RAOUL PAL: Tell me about macro. So what's your macro framework right now? How do you see the world? Because there's quite a mixed bag of people who are looking at certain things. Some people don't 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 tariffs as deflationary or inflationary, depending how you look at. Yeah, there's a number of things. Where is your world right now, because you're looking across asset classes? You're macro person. So what do you see?
NANCY DAVIS: Yeah, I mean I think the big challenge for many investors is most asset classes are very expensive. And I think since the crisis, many asset allocators 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 IPOing and trading off dramatically. You know who I'm talking about. And it makes me concerned, because I think you have so much of the portfolios 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 10 years of Central Bank money printing, has squashed volatility. So to me, I guess as a value investor, I look at fixed income vol as being very attractively priced.
RAOUL PAL: 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.
NANCY DAVIS: It's my pleasure.
RAOUL PAL: And we'll see you again soon, I hope.
NANCY DAVIS: Thank you so much for having me on. It's really been a pleasure.
RAOUL PAL: Not at all. Thank you.