Podcast Transcript: Nancy Davis on How to Position for True Inflation Risk

This is an edited transcript of our podcast episode with Nancy Davis, recorded on 23 November 2021 and first published on 26 November 2021. Nancy Davis is the founder and managing partner of Quadratic Capital Management. She is the portfolio manager for The Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL).  In this podcast we discuss why ETFs are attractive wrappers for active strategies, the pros and cons of investing in TIPs, risks for 2022 including stagflation, and much more. While we have tried to make the transcript as accurate as possible, if you do notice any errors, let me know by email.

Bilal Hafeez (00:01): 

Welcome to Macro Hive Conversations with Bilal Hafeez. Macro Hive brings you the best analysis to successfully invest in markets from crypto to equities, to bonds. For our latest analysis, visit Macrohive.com. 

COVID is once again sweeping across Europe and markets are reacting. The picture is fast changing and so we published a piece looking at which countries we think are most vulnerable in the coming few weeks. Crypto markets continue to be a focus for investors with Bitcoin looking to stabilise after a very large correction. To better understand whether the correction’s over, we looked at the biggest corrections in the past to see whether there are any parallels with today. And we can’t have a week without talking about inflation, but rather than joining the masses and talking about October data, we look at the past 1000 years of inflation. Yes, 1000 years. You can read all of this and more as a member of Macro Hive at Macrohive.com. And as a member, you get access to all of our research reports, our archive and webinars, our transcripts of podcasts and crucially, our member Slack room, where the Macro Hive team and members discuss markets all hours off the day. It’s refreshingly different from Twitter. 

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Now onto this episode’s guest, Nancy Davis. Nancy is the founder and managing partner of Quadratic Capital Management. She’s the portfolio manager of the Quadratic Interest Rate Volatility and Inflation Hedge ETF called IVOL. She founded Quadratic in 2013. She began her career at Goldman Sachs, where she spent in early 10 years, predominantly in prop trading, where she later became head of credit derivatives and OTC trading. Prior to starting at Quadratic, she served as a PM at Highbridge Capital Management. Now onto our conversation. 

Bilal Hafeez (02:20): 

So greetings Nancy. It’s great to have you on the podcast. I’ve been looking forward to our conversation. 

Nancy Davis (02:25): 

Thank you for having me. I’m looking forward to it as well. 

Bilal Hafeez (02:29): 

Well, the first thing I always like to do when I have any guest on the podcast is to learn a bit about their background. So it’ll be great to know where you went to university, what you studied and was it inevitable you would go into finance, and then something about the journey you’ve had until where you are now. 

Well, definitely I didn’t know even what finance was when I entered university. So it was not at all knew it was something I wanted to do from high school days. I was very fortunate to have a scholarship to attend college, an academic scholarship, and then I had a job as well to help support myself during college. And it was really through my job that I got involved in the whole finance industry and learning about the derivative markets. And so I was very fortunate to have a great opportunity there. 

Bilal Hafeez (03:17): 

Great. And then after college and university, what was your first job you had? Was it in finance your first job? 

Nancy Davis (03:23): 

Yes, my first when I was not a student job, like a full-time employee was at Goldman Sachs. See, I worked at the firm for about a decade. 

Bilal Hafeez (03:33): 

Okay, great. And which desks were you on and why did you end up in those desks? 

Nancy Davis (03:37): 

So for the majority of my career, I was on the proprietary desk. So we were managing Goldman’s own capital. It was a great environment to be. We didn’t have clients, we weren’t market makers, we were just trying to make money for the firm. And it gave us a lot of flexibility, especially across asset classes to look for. Whether it was in credit markets or commodities or equities or converts or rates, we really had a lot of flexibility. 

Bilal Hafeez (04:06): 

And then after Goldman, you struck out on your own to launch your own strategy or own your own fund? 

Nancy Davis (04:11): 

I had a couple steps in between before I launched my own fund, but I was recruited out of Goldman to a hedge fund, like a buy-side, buy-side firm. It was JP Morgan’s hedge fund. And that was actually pretty good timing to leave. Just lucky timing, it wasn’t like I had some crystal ball that I ended up accepting the job in October 2007. And then I resigned from Goldman January 6th, 2008. So it was a good time to be stepping out of a Wall Street firm and going to a hedge fund. 

Bilal Hafeez (04:44): 

It’s quite funny, whenever people have moves in the year 2000, 2008, 2009, they always mention the months that they moved, just so it’s clear whether it was before Lehman’s, after Lehman’s and around that sort of time. That period is seared into everyone’s minds and souls and everything. 

Nancy Davis (05:01): 

Yeah, well, it was my first job out of college and I think it was also very traumatic when I did resign, so I remember the date. I don’t think it has much to do with ’08, as much as I just felt terrible quitting and was very nervous about it. 

Bilal Hafeez (05:15): 

Yeah. I felt the same when I left JP Morgan. So I started off at JP Morgan in the late ’90s and then moved to Deutsche Bank. And it is very hard to do the first little switch. And it’s also hard when you go to a rival sell-side firm as well. There’s some extra psychological pressure that they introduce when you do those sorts of things. So then that was Highbridge, JP. And then after that, after Highbridge? 

Nancy Davis (05:37): 

After Highbridge, I actually took … The reason that I ended up leaving Goldman was I had just had a second child and I was commuting very, very long hours from Connecticut to Lower Manhattan. My commute was about at best three hours a day, but often three and a half to four, depending on if you miss a train, you have to wait for the next one. So in the morning it was always very stable, because I would get on the train and go. Coming back, sometimes the subway would be delays, you’d miss the train at Grand Central by like two minutes and then you’re stuck waiting for the next one. So it goes from an hour and a half to closer to two. But yeah, that was the only reason I did leave was just to … Highbridge opened a Greenwich office for me, which is why I left and I also had a flexible work arrangement. 

Bilal Hafeez (06:26): 

Okay, great. Yeah. And then after Highbridge? 

Nancy Davis (06:27): 

After Highbridge, I was a stay-at-home mom and I came back to my career when my youngest started kindergarten and I decided I didn’t want it to be too much of a shock to my kids, so I decided I would go more buy-side, buy-side rather than back to the hedge fund world. But I found out that I love markets, I’m obsessed with it. I remember my boss telling me, I was watching the Bank of Japan come out on Sunday night and sending email updates and he’s like, “We can never pay you for the amount of work you’re doing.” I was like, “Don’t worry, I love it.” I love markets. 

But it was a really great confidence booster to come back and be like, I still understand this stuff, nothing’s changed, it’s just a different point of time. All the skills that I had before are still here. And it really gave me the confidence to say, I think I’m exceptional at what I do, I think I’m very uniquely skilled at what I do for a living. And it gave me the courage to really go out and say, I’m going to do this on my own, I’m going to go literally hang a shingle, start a firm. And it takes, I think a lot of guts to go from being in a job where you’re paid to work to become an entrepreneur where you’re literally paying other people to work for you and you’re getting paid nothing. So it’s actually negative income until you get to that breakeven amount, but I absolutely love doing it. I’ve been running my own business now for over eight years and I love it. And I also feel very passionate about trying to pull other people into the entrepreneurial aspect because I think if you do something that betters client outcomes, it’s a great thing to start a business around it and not just make it a job, make it really a firm and a company and a culture. 

Bilal Hafeez (08:15): 

Yes, absolutely. Yeah. And you’ve obviously been very successful over that period of time. And we’ll talk a bit more about out some of the details of the funds or the ETFs that you’re behind as well. And just a question on the career break, I mean, you did say that when you came back into markets, you slotted in very, very well. So that’s always the question I’ve always … I wondered if you take time out from markets, one does feel like that you’re going to lose all those skills, but obviously not in your case. 

Nancy Davis (08:40): 

Yeah, I do think there’s always that fear that if people take time off that you won’t be able to come back into the same role or you won’t be able to be a senior or your skillsets would erode. I think I was fortunate as a portfolio manager that I wasn’t … If I was in sales, for instance, and I had been out of the market and my relationships were what drove my business, that might be a different environment. But I think being a portfolio manager, it wasn’t like I was depending on relationships where I can see it vary depending on what you do in specifically the finance industry. If you can take time out and come back, a portfolio, you close it down, you open it up, it’s a different day, different year, it doesn’t really matter. So I think I was lucky because I’ve never been in sales or marketing or client stuff before. So I think it would be different if you were on the sell-side, sell-side. 

Why ETFs are attractive wrappers for active strategies 

Bilal Hafeez (09:35): 

Yeah. No, that’s true. And in terms of the strategies that you run and the way you’ve done it, one way would’ve been to launch a hedge fund and then you do the usual runaround to get funds into the hedge fund, but you’ve gone down a different route. So can you talk about why you did that, launching an ETF, that approach and whether it constrains you or not, or whether it was more flexible? 

Nancy Davis (09:56): 

Yeah. I didn’t really know much about ETFs initially. I thought of them as more passive index replicated retail products. But when I learned actually more about the ETFs, I was like, wow, this makes a lot of sense for what I do and it would better client outcomes because it would give the transparency of a managed account. It would give lower fees and more liquidity, which I think is one thing all portfolios need, especially with so many institutional portfolios moving to illiquids that there is no … That liquidity profile is super important, not when everything’s going out, but at some point you’re going to want it. And I just had the epiphany, I think of having public securities that are liquid inside of a private fund wrapper doesn’t make a lot of sense for clients. I think the reason that it’s so common is it’s better for managers, because they can lock up the capital, they can charge higher fees. But matching the underlying investments to the fund wrapper, I thought was a very simplistic, easy way, I invest in public securities, put it in a public fund. 

Bilal Hafeez (11:05): 

Okay. Yeah. So then it’s the wrapper you use is an ETF? How much discretion can you have with an ETF wrapper? Because my impression like yours I guess in the early days, was that it has to be very rules-based or systematic in some way. 

Nancy Davis (11:19): 

Well, you have a prospectus, right? So all ETFs have a prospectus. And I think the one G, the first generation ETFs were all index replication products, but there’s this whole new world of actively managed ETFs. So you still have to say, these are the guidelines, this is what we’re going to do, in the prospectus. But an active ETF is I think better for what we do because especially being long convexity, long optionality, you wouldn’t want to have to wait to rebalance until the end of the month or wait until an index makes a change. It’s better to be able to be nimble whenever the market moves rather than … So many events are, especially when vol markets jump, they’re not things that stick around for a long time. And so I think it makes a lot more sense to do active products for what we do at Quadratic. And I didn’t really know about active ETFs until a friend of mine started doing it, and then I was like, wow, these are amazing. It’s exactly like a commingled fund where you’re making decisions as a fiduciary for the investors, but it just gives lower fees, more transparency and more liquidity. 

Bilal Hafeez (12:33): 

And in terms of the instruments that you focus on, it’s primarily rates instruments and option-based instruments within rates. Is that the scope or do you venture further afield outside of rates? 

Nancy Davis (12:46): 

Yeah, we do. My firm is experienced in investing across all five asset classes. So our two ETFs specialise in the rate convexity markets, but we do have expertise in other markets as well. 

How best to capture true inflation risk 

Bilal Hafeez (12:59): 

Okay. Yeah. And why did you start off or why is your current focus on rates and rates convexity? Why that and not equities or credits? 

Nancy Davis (13:07): 

Well, we were really trying to solve and better client outcomes. I think whenever I talk to entrepreneurs, whatever industry they’re in, I always say, come up with a business plan, a business model that will make things better for people and that’s where you have a successful business. And the TIPS market, those are Treasuries with inflation protected security Treasuries, so those are Treasuries that reset with CPI, that market was invented in the late ’90s. It was right when I was starting my career at Goldman Sachs, and I remember thinking, this is such a bizarre thing to measure something as big as inflation with one index. You would never buy the FTSE 100 and say, aha, I have equities, or buy the Dow Jones index and say, I have equities. And inflation is even bigger and harder to measure than corporates, more than any local or global stock market. 

So I think adding another way to capture inflation and inflation expectations not measured by CPI just seemed like a very obvious thing to do. Nobody would buy one index and say, I’m done. And inflation is so much bigger than corporates, I thought it made a lot of sense. Also the CPI in the United States, it’s calculated by the Bureau of Labour Statistics and a huge chunk of it is what they call shelter, but if you dig into shelter, it’s actually owner occupied rent, and specifically a lot of it is urban rent. And so it’s just not super relevant for many investors’ inflation risk to have such a huge component be rent. 

Bilal Hafeez (14:53): 

And your approach to capture a broader sense of inflation would be to use the TIPS markets to capture the market expectation of inflation? 

Nancy Davis (15:03): 

Yeah. So our portfolio’s mostly TIPS. So we have a core Treasury portfolio, but then we add another measure of inflation that’s not linked to the consumer price index. The problem with TIPS is they’re only CPI inflation, so they reset on a semi-annual basis based on the CPI, the consumer price index. It’s just one index and so we add interest rate options. They’re long only, fully funded, long interest rate options. And the reason we do that is that inflation is a very risky asset class. Unlike buying stock or a bond of a corporate, it can really only go to zero, even if you assume no recovery for the bond. With inflation, there’s no zero, right? It can go negative, there could be deflationary outcomes. So we like using long options to capture a asymmetric payoff when it works, but also have that defined downside in case it doesn’t work. 

Bilal Hafeez (16:05): 

And the options would be for both sides of the distribution, or is it just one side of the distribution, say you’re only looking for sharp moves up in yields? What side of distribution are you capturing with the options? 

Nancy Davis (16:18): 

Yeah, so the options are more similar I think to if you think about a bond with credit spread risk. A bond with credit risk, it has obviously rate risk and then it has credit risk. There’s only two types of bond risks, it’s rate risk, and then there’s spread risk. We don’t take corporate spread risk, we take interest rate spread risk. So it’s just something different. And so with IVOL, for instance, we want either long dated yields to go higher, which is typically more inflation expectations where investors would demand more yield to own dollar denominated debt. Or we like when the markets are pricing in lower, negative or cuts from the feds. So it also has historically had less downside than TIPS alone because inflation is a risk on asset. And so in periods like March 2020, TIPS were down 150, 175 basis points, depending on which duration you had, but our strategy actually had positive performance overall in that month because that’s when the lower front dated yields kick in, to dampen the volatility. 

Bilal Hafeez (17:32): 

Okay. So implicitly you would have a curved steepening then, is that fair? It’s a curved steepening trade embedded within there, as well as the long TIPS trade? 

Nancy Davis (17:41): 

Yes. And there’re a lot of different rates in the US market, there’s LIBOR, there’s SOFR, there’s Treasuries. We use the more, I’d say global market. We don’t want to use the Treasury market because that’s where QE purchases are dominated. So we’re using the global swap levels. So we want the widening of swaps, which can also be from credit spread risk or counterparty exposure. So it’s a neat way of capturing. It’s not just a steepner, it’s capturing real yields, it’s capturing a level of interest rate volatility and it’s capturing also the sensitivity to the spread widening. 

Bilal Hafeez (18:21): 

Swap spreads widening? 

Nancy Davis (18:23): 

Yeah. And I think the thing that many investors really need to keep in mind that I’m always surprised that they don’t know or don’t remember is that many of these passive indices are very heavily weighted to mortgages. In the United States, the Ag index, which many institutional investors consider core fixed income, the Ag has, about 30% of it is short fixed income volatility from the prepayment risk. Residential homeowners in the US can prepay their loans whenever they want, so they are long the option. If you own a financial mortgage, you’re short that option to the homeowner. So I think people might say, oh, well, why do I want to be long fixed income volatility? I’m like, well, you already short it, if you have passive indices, so why would you only want to be short? So I think it’s been a little bit of an education to explain to people that new mortgages, people call them negative convexity or prepayment risk or all these … I call them G-rated words for short volatility or short options. 

How to think about spread exposure 

Bilal Hafeez (19:30): 

And on the swap side, one thing that we have noticed is if you look at say five or 10 year swap spreads, since the global financial crisis, the spreads narrowed significantly, and it’s kind of hovered around zero and often swap spread goes negative, which is kind of odd, because you’ll think that why should a swap yield go negative because you’re exposed to, as you said earlier, bank credit risk, counter party risk and other types of risk? Why do you think that’s been the case? 

Nancy Davis (19:54): 

It’s just leverage and balance sheet constraints. The swap spreads have been negative really since the financial crisis and I think that’s just a sign of investors are generally underweight duration. There’s not enough high quality assets around the world, and so it’s just a sign of how much leverage is in the system because it doesn’t logically make sense. Why would you get paid more yield to have the US Government as your counterparty versus, I don’t know, BNP Paribas? Nothing against BNP Paribas, just the first firm that kicked out into my mind. So having negative swap spread is a bizarre situation. And I think also for what we do inside of IVOL, it’s a pretty unique environment because the Treasury curve is actually a lot steeper than the swap curve. So the swap curve is about a 15 basis point cheaper, meaning a lower number. And since we want the spread widening with that strategy, it’s actually a better buying opportunity. 

Bilal Hafeez (20:55): 

Yes. And in terms of the moves we’ve seen this year so far, it has puzzled a lot of people, especially, say the last six months. Obviously the start of the year, we still had the reflation trades unfolding, but the last few months we’ve seen incredibly high inflation prints, yet long term yields haven’t really done much, the curve’s flattened, started to flatten if anything. Have you been surprised by these sorts of moves? 

Nancy Davis (21:19): 

Well, I think the best way to explain that is you had a crystal ball right on let’s just pick March 31st, the end of the first quarter, the 10 Year Treasury was around 175 basis points and if you had a crystal ball and said, okay, what are the next five, six CPI prints? The last we had, 6.2 is the most recent and before that we had 5, over the 5 handle. I don’t think most rational people with a crystal ball on April 1, would say, all right, if you know these CPI prints, where would the 10-year be higher or lower? So I do think it’s been a bit of a surprise. And at the same time you’ve had the fed really change their tune on the hawkish commentary. So before the June FOMC meeting, the fed was, remember this line, not even thinking about thinking about raising rates. And so we did this like super … I feel like it’s like checkers where you did multiple jumps of the checker players, because we went from not even thinking about thinking about raising rates to having the dot plot show two hikes. Now the world has gotten super crazy because the rates market is pricing in, if you look at market expectations, about 160 basis points of hikes have been priced in before the end of ’23. 

So it’s an unusual time because I like to say, talk is cheap. We’ve had lots and lots of hawkish talk since the June FOMC meeting, which is interesting because it’s also been … We just found out this week that Powell is going to keep his job and is going to stay, and Brainard’s in. So I think it’ll be really interesting to see if the equity market has a stumble and I think IVOL could potentially be a pretty decent equity risk off trade because you have that 160 basis points of hikes priced in. So if we did have a sell off or credit spreads widen, I think you could actually see steepening from the expectations for hikes falling. 

Yeah. So the front end of the curve, the yields would start to fall and then the curve would steepen on that sort of basis. It almost seems like what the market’s saying is that the economy’s so fragile that if the fed does like 3, 4, 5 hikes, then inflation just can’t take off because that’s one way of rationalising why long term yields are so low and even say the 5-Year, 5-Year forward inflation expectations, while they picked up a bit, they haven’t exploded higher in the same way as say front end inflation expectations have exploded higher. And again, another link to this is why are long term real yields so low still? I mean, all of this seems to suggest that there’s a certain underlying fragility or weakness in the economy. 

I think the level of breakevens again is just CPI inflation, it’s all based on CPI. And I do think it’s definitely still low considering where the CPI prints have been, the expectations for whether it’s a two year breakeven. And the breakeven curve is actually very steeply upwards sloping because a lot of investors have been worried about if there is inflation, there’ll likely be higher rates. And I think we always try to educate investors that short duration, it’s almost like a fake name. You’re not short anything, you’re really less long. 

So I think many investors have been using IVOL as a way to actually profit, if interest rates go higher, rather than a short duration strategy, still has some duration, it might have less. And so you’re still guaranteed to lose money on the duration component inside that portfolio, but with IVOL and the options’ asymmetry, at least in the first quarter of 2021, most people were talking about inflation at this point, but TIPS on their own lost money and that’s because they do have duration risk. IVOL was able to have positive performance and we were up a little over 3% in the first quarter, even though TIPS were down and that’s because when the option, that positive convexity, kind of mirror image of a mortgage really kicks in. And so I think it’s tough because I think a lot of investors are worried about rate risk and therefore they’re buying shorter dated bonds, but I think shorter dated bonds, especially if they’re using things with credit spread risk can be quite dangerous because, if you think about the recent news like Evergrande or any kind of credit event, if you have a short dated bond, the loan needs to be amended and extended, or reissued, refinanced. And so you have less time to make the interest payment or the coupon payment. So a lot of times credit curves are quite similar to VIX curves or vol curves where they invert when the shorter dated bonds actually become more risky. And so I think part of the education process has been like, look, if you’re worried about interest rates going higher, IVOL might be a really good solution for you to actually potentially profit from that scenario rather than owning short duration where you’re going to be taking less interest rate risk, but you might have way more credit risk, because a lot of these strategies that are short duration have CMBS, ABS, MBS, CLO. 

Bilal Hafeez (26:42): 

Yeah. So they may be shorter in duration, but you’re still long duration, just less long than longer dated bonds. So I guess the other way of playing rising yields is to just go short bond futures, just go outright short nominals. What do you think about that? Because a lot of people have been trying to just go short futures or go longer, and ETF, that’s implicitly just short futures. What’s the issue with doing that type of strategy? 

Nancy Davis (27:07): 

Well, A, it’s very negative carry, because even if rates are low, you’re still paying the coupon to somebody else and your timing has to be impeccable to do that strategy. And I think the nice thing about IVOL is the fund is long duration. We’re not short any duration. The fund has about a seven year duration. And I think globally, most investors are really underweight duration in their portfolio because there’s not enough high quality government bonds out in the world. So I don’t necessarily like the idea of just being short bonds. To me, I’d rather just be, if you want that beta risk, you might as well just be long equities, because it’s kind of the same thing. And then you’re also paying a carry and a coupon to somebody to be short bonds. 

So, I personally don’t like shorting bonds. I like owning duration, but having that positive convexity to do well when you either have lower front dated yields, which is risk off, typically, that’s credit spreads widening, the fed cutting rates or less hikes being priced in. So it’s a nice diversifier, because personally, I think the whole point of bonds is to diversify equity, it’s not add to that risk. And instead of just adding more products with credit spread risk, which, let’s take a simple example, if you own, I don’t know, Nokia bonds and Nokia stock, do you really have anything different? You’re a different part of the capital structure, but you still have the same risk to management, to the product, to the sector, to earnings per share, all those risks are still there. So instead of adding credit risk, we add rate spread risk, which I’m not saying it’s better, it’s just something different. 

Taking advantage of the shape of the forward curve to fund option premium 

Bilal Hafeez (28:48): 

Yeah. One challenge many investors have with buying options, even as a hedge is that options are expensive, implied trade above realised, and so you may not always earn back your premium. So what do you think about this issue? 

Nancy Davis (29:00): 

Yeah. I know a lot of people with an equity option background always find this concept very puzzling because if you own equity options, whether they’re calls are puts, it doesn’t matter, you pay time decay and you essentially lose money every day and there’s nothing you can do to offset that except selling options someplace else, or using spreads, or maybe buying one market versus another, putting term structure trades on. 

In the rates market, it’s not always the case, but a lot of the times, like today with IVOL, because let’s think about it, the spot Treasury curve is around 105 basis points. So swap curve is even lower, it’s about 85 basis points. But because we have 160 basis points of hikes priced in before the end of ’23, the forward curve is actually very downward sloping. So, the jargon terminology for that would be it’s in backwardation. And so the nice thing about that is we get a lot of positive roll, even if nothing happens, because our options are rolling up from the downward sloping forward. The forward right now, the two year forward, for instance, is about 12 basis points, which is significantly lower than 100 plus basis points for the spot Treasury curve. We don’t use the Treasury curve, we use the swap curve. So it’s not always the case. 

Bilal Hafeez (30:22): 

Okay. So you can use the roll to fund your premium then? 

Nancy Davis (30:25): 

Yeah. So if nothing happens and you have … It’s just like any other commodity market or any market, the forward is what the option … because options don’t expire today, they expire in the future. 

Bilal Hafeez (30:38): 

It’s priced forwards, and if spot just stays where it is, then you just get the roll. 

Nancy Davis (30:38): 

Yeah. So it’s I feel like a magic unicorn because where else can you be long volatility, long gamma, long duration, long convexity and ride the wave of roll? So a pretty nice place to be. It’s a spread product, just like if you think about credit. Let’s just take US investment grade credit, currently the spread for the CDX index for IG, it’s around 50 basis points. So a credit investor would say, okay, I need yields lower and credit spreads tighter, meaning 50 going to 30, or 40 or down. For us, our optionality, our spread is about 12 basis points. And all we say is like, nothing happens, we get roll and we want that thing to widen. So it’s kind of opposite credit where if you own a bond with credit spread risk, you want credit spreads to tighten. We own real yields in IVOL, and then we want the spread to widen between short and long dated rates. 

Are real yields too low? 

Bilal Hafeez (31:42): 

And in terms of just the level of real yields today, do you just think it’s too low? Because I mean your long at very low yields and so is that a concern or not? 

Nancy Davis (31:51): 

Well, the thing about real yields is like anything, you can look at any fixed income market and look at inflation, what actual CPI inflation has been or what other measures of inflation have been and pretty much everything is negative real yield, right? High yield bonds are negative real yield, investment grade credit is negative real yield. I think people pick a lot on the TIPS market because of the negative real yield. I’m like, no, everything’s negative real yield when you have these very, very high inflation prints. And markets can stay negative real yield for a long time, like look at the UK market, real yields are substantially lower. 

I’m not trying to take a bet about where nominal or real yields are going to go. I think the nice thing with our product is you just want it to be different, right? That’s where the alpha and the strategy comes in, whether it’s a risk off environment and, or the Fed tapers and that creates tighter financial conditions and they can’t hike as much, or whether investors see inflation, not as transitory and they start to demand more yield to own dollar denominated debt. It’s like either way, that’s good for us. We’re not taking a bet on the level of interest rates, we’re taking a bet that interest rates will change in the future. 

Risks for 2022, including stagflation 

Bilal Hafeez (33:11): 

As we go into 2022, we obviously have the taper decision that could be a bit faster taper, will the fed deliver on the rate hikes that have been priced. What types of scenarios are you most concerned about for next year? 

Nancy Davis (33:25): 

I think we’re heading into midterms in the United States, so I do think it’ll be interesting to see. We just had Powell reappointed and Brainard coming in also, and so it’ll be interesting to see composition of who makes up the FOMC. And I think the one thing that keeps me up at night a little bit is worrying about what if this is stagflation, not inflation, because I think in a stagflationary environment, I think IVOL would likely do very well in that environment because I think we’d make money with the TIPS. I think rate vol would probably be shooting through the roof. Imagine if a risk parity portfolio of stocks and bonds become positively correlated what that would do. I think it would be very good for the vol component. And I think likely if we did have a stagflationary outcome, foreign investors would demand more interest rate to own our debt, especially with the fiscal spending. 

But I do think most investors are very, very exposed to stagflation, because that would be a disastrous outcome for a 60-40 portfolio in particular. That would be stocks and bonds typically selling off together and instead of being negatively correlated, being positively correlated. So I think that’s one scenario that I feel like is … Nobody was really talking about inflation when we listed IVOL, it wasn’t a very popular thing. Now a lot of people are talking about inflation, but I don’t hear much about stagflation and I think that’s actually investors’ bigger risk. And I think the last time, at least in the United States, when we had stagflation was in the 1970s and that was a result of the oil embargo. Today, obviously not the same story, but as a result of the pandemic, we are having fiscal spending. We’re having a massive labour shortage. We have a global chip crisis around the world. It’s kind of like history repeating itself with a different underlying denominator problem. It’s not the oil embargo, it’s the chip crisis, it’s the labour shortage, it’s the supply chain disruptions. 

But all of those things could be higher prices, but not necessarily a growth higher prices. It could just be what if it hurts earnings per share? What if it hurts companies? What if consumers are not able to continue with the demand side of the equation too, especially I know for me, I’ve been putting off a lot of things just because the delays are so ridiculous, if you try to … Certain things that you want to buy or you want to change it’s just like, I don’t want to wait indefinitely for some of these items. So you’re just like, forget it. And then also, rates volatility, it’s obviously picked up recently with all the big moves you’ve had in the front end. Do you think that rates vol could go higher next year, or not, in terms of where are you from a historical perspective on rates vol? How do you see different possible paths for rates vol? 

Yeah. So with IVOL, we’re not trying to make a bet on the level of volatility. I think the thing we’re just trying to educate people on is, if you have the Ag or core fixed income, most likely you’re short fixed income volatility in the US and this is just a nice way to neutralise. Instead of only being short vol, here’s a nice way to have instead of always having negative convexity in the bond market, having something that has positive convexity. 

So to us, I know a lot of vol people get very focused on the implied volatility being higher than realised volatility, which is basically, like 99% of the time, always the case, right? Because of course the future is more unknown than now, it makes sense. But we’re not a volatility fund. We’re not trying to arb the difference between implied and realised volatility. We’re just giving access to a market, just like the mortgage market made a single CUSIP market to access that market. We are also a single CUSIP market. 

Instead of only being short volatility and fixed income, this is a way to also be long volatility because nobody knows whether vol’s going to go higher or lower across asset classes, it’s unknown. But in your fixed income portfolio, typically, most investors want that to diversify their other credit equities, other things in their portfolio that are potentially more risky than their government portfolio. So having something with a positive convexity, it creates a nice potential correlation. IVOL, at least historically, has not had very much correlation to equities or the Ag or high yield bonds or EM, because it’s something different. And having that long vol component kick in is a nice thing when you want diversifying assets. 

Bilal Hafeez (38:05): 

And as you said earlier, because the forward curve’s backward dated in any case that does pay for the premium, you could say. So in that way, the current level of vol is funded, you could say. But I do also like to ask a few personal questions as well. We’ve obviously talked about your strategy and markets and so on. One question is what’s the best investment advice you’ve ever received from anyone? 

Nancy Davis (38:27): 

It was probably when I was a young trader, someone told me do not spend your bonus until you’re paid your bonus. I think that was a good one. I do live and breathe that. I like using long options to express directional views inside portfolios because we fully fund them, we always know our risk. It’s a nice way of managing risk instead of most portfolio managers use stop losses, which is, I think exactly it’s basically borrow money to get more exposure than what you can actually buy now. And then when it goes against you, after you have the loss, then you start to manage risks. 

So it’s all kind of wrong way to me because you’re selling your longs after they’ve gone down, you’re covering your shorts after they’ve gone up. I think it’s a good way of thinking about having long convexity to have the potential to make more than you can lose versus leverage, which I’m not a big fan of using linear derivatives because it’s kind of like a credit card exposure, where you pay a little bit for a lot more than you can afford or that you fund. 

Bilal Hafeez (39:35): 

Yeah, that’s very sage advice there. No, I totally agree with what you’re saying there. And then the other question was obviously we’re all overwhelmed with information and data and news and so on, how do you manage that information flow? 

Nancy Davis (39:47): 

Well, I love reading and constantly, I’m just loving following what’s going on. I do think there’s so much technology now. Think about 2007, for instance, before the global financial crisis, now we all walk around with literally personal computers. I’m holding up my iPhone. It’s just the information access that we have now with technology is just exceptional. So even with text reading and keyword searches, I think we just have access to so much information. But I also think given the trend towards passive indexing and the trend to having everybody have more information faster, it likely will mean more volatile outcomes because everybody will get the information faster, move, be able to react sooner. And so it could be actually that public markets have more volatility than private markets because you have the liquidity there. 

Bilal Hafeez (40:46): 

And you mentioned you like reading, have there been any books that have really influenced you a lot, either personally or in a work context? 

Nancy Davis (40:53): 

Oh, definitely. I feel like I should write a blog or something with my favourite books because I do have a lot of books that have been … Some about finance, some about history. I’m a big history buff as well. I actually have a piece that I’m doing on favourite books from the pandemic period. 

Bilal Hafeez (41:10): 

Ah, okay. I look forward to that. Yeah. Are there any books that come to mind that you’d want to- 

Nancy Davis (41:15): 

I will save that question if you don’t mind because I’m working on that for another project. 

Bilal Hafeez (41:18): 

Okay. Okay. Great. Add some anticipation. Nice. It’s like a trailer for a movie. Okay, so we’ll include that once we get that. We’ll include it in our show notes. And now if people wanted to learn more about IVOL strategy, your thinking and Quadratic Capital Management, what’s the best way for them to do that? 

Nancy Davis (41:37): 

Probably checking out the fund website would be the best way. It’s ivoletf.com is our fund website. And the nice thing about being a ETF, it’s fully transparent public fund. There’s a tonne of materials, as well as articles and videos. So it’s rich in information, so people can make their own decisions. 

Bilal Hafeez (42:04): 

And I’ll include the link in the show notes, so people can just click straight through. And so with that, it was great speaking to you. I learned a lot and I look forward to the book recommendations in great anticipation. So good luck for what’s left of the year and good luck for 2022 and hope that you have a restful break as well with Thanksgiving coming up. 

Nancy Davis (42:22): 

Thank you. I appreciate being your guest on the podcast and I really enjoyed the conversation. 

Bilal Hafeez (42:28): 

Thanks for listening to the episode. Please subscribe to the podcast show on Apple, Spotify, or wherever you listen to podcasts and leave a five star rating, a nice comment and let other people know about the show. We’d be super grateful. And sign up to become a member of Macro Hive at Macrohive.com. We’ll be back soon, so tune in then. 

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)