289 · Alfonso Peccatiello (MacroAlf) - Beyond Being Right - A Shift to Framework Thinking
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Risk is always a function of probability and magnitude of an event. Even if you say, look, the probability that such correlation will break is very low, you always have to remember when you size something, yes, but what is the magnitude of a loss in case that probability happens?

And when you try to look at statistical inconsistencies or arbitrages, they seem like a certain thing, right? So the problem of a certain thing is that when it goes the other way, it can cause large losses. And that's what you should consider when sizing a position. So rule number one, I think for an investor is stay in the game. Markets, speculation, and risk. This is the Chat with Traders podcast.

That's right. It's Chat with Traders, episode 289. We're so glad you're with us and hope you're doing well. I'm Tessa, your co-host, and I'm having a blast co-hosting alongside Ian and bringing to your ears fresh conversations with guests from all walks of life. Our goal?

It's simply to continually spark those aha moments and ignite your curiosity. And we hope that you are enjoying the episode so far. Today, Ian speaks with a very special guest. His name is Alfonso Peccatiello.

He goes by ALF, and I'm sure some of you, if not many of you, have heard of MacroAlf, who is quite well known in the investing and financial community on X. We get to tap into ALF's mind and experience as a big-time discretionary macro investor. ALF's approach to the financial markets is deeply rooted in macroeconomic insights, but

identifying market imbalances, and disciplined risk management. Having managed a $20 billion fixed income portfolio, ALF has seen firsthand how understanding market dynamics and timing can unlock significant value. ALF's strategies focus on spotting crowded trades, leveraging market dislocations, and carefully sizing positions to maximize returns while minimizing risk, and they're

And there's so much more to this fascinating conversation. With the launch of his hedge fund, Polyneuro Capital, he is bringing this disciplined macro-driven strategy to a broader stage. And there's so much to unpack here in this hour. So let's dive in already. Ladies and gentlemen, we are so pleased to present Alf Peccatiello, originally from Italy. Well, Alf, I'd like to welcome you to Chat with Traders.

Thank you. It's my pleasure. I listen to basically almost every episode. So as I said, it's such a pleasure to sit on the other side of the chair. So where are you now? I am in Amsterdam. I live and run my hedge fund from the Netherlands. I am very often in Italy, but let's say officially I am in Amsterdam and right now I am actually.

Okay, fantastic. Well, let's dive into your background. Tell us a little bit about, you said you grew up in Italy? My background is that I was born in a village close to the Amalfi Coast in

which sounds very fancy, but actually the Amalfi Coast is, but my village not really. It's one of these very poor places in the south of Italy, but it's also full of authentic people and you get taught a bit of a grinding mentality, I guess, right? So you have to work hard to achieve what you want and nothing is for granted, everything you got to earn.

And, you know, you also come up with this Italian accent like the one I have, which I think is a perk or negative or positive, I wouldn't say. But it's a, you know, it's a nice place to grow up in. It teaches you the hardworking mentality, really. And, you know, you have to try and achieve whatever you want.

You can and fight hard. And then I moved to the north of Italy for a bit to study at university. And then I actually won a scholarship to go to Germany. This was eye-opening when I went there because you see a very different approach to life in Northern Europe than it is in Southern Europe, right? It's a different set of values. It's much more productivity-oriented and also much more, I would say, individualistic.

as a culture than it is the south of Italy where, you know, it's an agricultural driven place. It used to be a lot more, but still today it is. So people tend to help each other like in a village and in north of Europe, it's a bit different. It's much more a business oriented culture. So I got a little bit some hard time when it comes to cultural clashes, but ultimately I'm still here right now in Amsterdam, in the Netherlands.

I moved here probably eight or 10 years ago to start working for ING, which is a Dutch bank. So I worked for them for eight years between 2014 and 2021. It was a very good career and period. And I learned a lot and I'm grateful. Ended up with me running a very large fixed income portfolio for the bank, about $20 billion. So anything that had to do with bonds,

bonds and derivatives and anything fixed income i did i made mistakes i learned try to adjust to it and then uh life went on and launched my research business the macro compass which is up and running and now uh i mean pretty much today uh launching my macro hedge fund uh which is called palinuro capital and palinuro had to be an italian name right at the end of the day

What did you study at school? You mentioned that you went to both an Italian university and a German one. So I was in Siena, this place in Tuscany, which a few listeners might be aware of because everybody likes to go to Tuscany for some reason. So yeah, I was in Siena. I studied quantitative finance, a very math-oriented program, I have to say. Also, they're useful to understand stuff like option pricing, derivatives pricing, for example.

And then I won a scholarship to go and study in Germany at the European Business School, which was again, quant finance, but a little bit more, I should say, less mathy and more computational, more applicable. But at the end of the day, I really wasn't a quant. I can understand, let's say, the dynamics and what is necessary to make a model work or what are the

let's say the statistical properties of something of variables, for example, but I'm not a quant. So at the end of the day, this was quite an experience in trying to, you know, learn a side of finance that I think a lot of people focus on because it's,

scientific. And so that's, that's something people find comfort in, but markets and also macro, which is my specialty are a lot more about connecting the dots and understanding how different things impact each other and risk management. And it's a lot more about that than it is about being a scientist really, or only a scientist.

So while you were at the university or perhaps even before, did you open up a trading account? Did you make any investments? Yeah. And lost a bunch of money too, of course. So yeah, of course I tried to do that. And with no idea of how to size a position or how to watch for correlations in your portfolio or anything along the line of that, just basically punting based on my gut, um,

which is a great learning curve, if you ask me. You soon realize, unless you are completely not self-aware, but you soon realize that you're not equipped for it, and therefore you need a process. And this was also the first thing that I got taught by my mentor at

at the bank who's a guy with gray hair and i suggest everyone to look for mentors with gray hair or no hair also works as long as they've been in the business for a long time this person was a prop trader in the 90s when banks were you know still allowed before vocal rule and so on to actually do prop trading or engage in prop trading this means that he had an extreme extreme focus towards

How do you size a position? What is your plan? Not only what is your plan to stop the trade, but what is your plan to run your profits? How are you going to be able to generate this positive tail in your distribution of returns? How are you going to be able to stay in a winning trade? And also,

If the trade has negative carry, so if it's something like you're buying the Japanese yen, for instance, which is very often a currency that offers no interest rate, pretty much, and you're borrowing a currency that instead you have to pay interest rate to borrow, like you're borrowing dollars and you're paying 4% or 5%, you're buying the yen. Well, I'm sorry to break it to you, but you're going to lose money over time just by the fact that interest rate differentials work against you. So that's something that we will call in macro negative carry.

Okay, what is your plan there? For how long are you going to allow this negative carry to bite you until you basically stop the trade out? Not because of price action, but because of time, because of bleeding this negative carry. So it was all about process and framework and very little about being right, having a crystal ball. And this was quite lessened.

this guy who was giving you this advice, was he in your first job? The first job that you attended and what was, tell us about your first job and how did you get it? So the first job was in the treasury of ING. So I started as an analyst basically in the treasury department and my job was to, let's say, disentangle macroeconomic conditions and how they would affect

the various bond investments of the bank, various fixed income investments. So it's top-down macro, but it's also bottom-up on each issuers. Like if you buy a bunch of European bonds

bonds issued by different European countries. So, you know, do you prefer France or do you prefer investing in Austria or in another European country? So it's a lot of bottom up and top down macro analysis. And this was my start, right? And then after a while they said, okay, you know, this macro analysis is good, but we need your hands as well when it comes to risk taking. And this was the start, right, of effectively the evolution from a macroeconomic analyst to an investor.

to a macro investor that invests in a fixed income portfolio, being able to do a lot of stuff in fixed income from choosing different levels of credit risk. So are you going to invest in the safest countries or the most risky ones? Like, I don't know, you're going to buy some Greek bonds, for example, which when I started were something you wouldn't want to touch, or at least your risk manager got very upset if you mentioned that.

Or are you going to buy the short end of the interest rate curve, of the yield curve? Or are you going to prefer investing in the long end of the yield curve? And what is your macro reason for that? So were you given the freedom to choose the investments? I mean, because you're posing these as questions. How much flexibility did you have in making recommendations?

Yeah, quite a lot actually. Of course there is a framework. So when you join such an institution, obviously what happens is that you cannot operate freely. You have to operate within what's called the risk matrix.

So the risk matrix comes to you in the shape form of these are the issuers you can buy. This is the credit rating you're allowed to go as low at. For example, can you buy below investment grade or can you only buy investment grade? And what duration can you have in your portfolio? You know, what is the average duration? Is it going to be seven years or 10 years? What is your maximum duration? There's a various amount of limits, basically. So you should think of it like a matrix, multidimensional matrix, and you have to move within these matrix to

trying to optimize for risk-adjusted returns. So when you have this flexibility, were you able to see what they did prior to you joining the bank? Like to get an idea of how they did things before and how you did things or wanted to do things differently?

This is interesting. The answer is no. And the answer is no because of regulation. So a lot of European and US banks, basically almost all of them, are forced by regulation nowadays, and after 2013 only, that's a rule, to have large fixed income portfolios. These are called high quality liquid assets portfolio, HQLA. And what it stands for basically is

regulators that during the crisis of 2008, 2009, figured out that banks did not have enough liquid assets to face a crisis situation. So what if everybody wants to withdraw their deposits? Are banks able to serve such an outflow? And they figured out they weren't because they didn't have enough liquid assets

bonds mostly to liquidate. So guess what? Regulators figured out ex post. They hardly do this ex ante, but ex post figured out they needed to correct the problem. And they went to banks and said, how big is your balance sheet? Can you stress it out for how much deposit outflows are you going to have at any point in time? Okay. Now buy me an equal amount of liquid assets that you can liquidate on your asset side and service eventually deposit outflows.

And so bonds were a big part of it. And effectively, the bank had to create a new investment framework, like many other European and US banks, to handle this HGLA portfolio from 2013 onwards. I joined in late 2014, so there was not much history there, which was interesting because you could design, together with your risk management and your front office team, you could design an investment framework together and draw on the experience of

gray haired mentors, like my mentor who did this in the past, maybe in a slightly different format, but they had taken risk in, in, in, in the first instance in the past. So they could be very helpful there. And so, um, you mentioned bonds a lot. Were there any other type of assets that you looked at advising to buy at this and what, and if so, what were they?

So the mandate evolved over time, right? I mean, you start with what the regulator suggests you being the most preferred asset class to do that. And that's anything in fixed income, really. So bonds are very flexible because they can express plenty of views from, as I said, different level of credit risk you can take in a bond to different parts of the curve you can play with. This is much more to do with macroeconomic cycle and your view on inflation or the response of the central bank.

And then there are much more technical things you can do in bonds. So you can do futures or you can do bonds. So the famous bond basis trade, where you basically try to look for discrepancy between how bonds are priced and how futures with the same underlying, same bonds underlying are actually priced. So there are a lot more

strategies that you can figure out only using fixed income. And we actually were very focused on that for the first three or four years. But then as time went on, there is an interesting thing in markets that works also for large institutions in general, banks, pension funds, insurances. When volatility becomes compressed and it stays compressed for a long period of time,

People get dragged on the risky side of the curve, on the risky side of the spectrum of the investment mandate. It's almost like a gravitas. So when the European Central Bank cut interest rates to zero and then started quantitative easing, so we're talking like 2015, 2016, okay?

Not everyone jumped immediately the gun and said, all right, now we've got to go and buy all the risky assets we can because look, you know, we have to. Not really, it doesn't really work that way immediately, but instead make it so that it's a couple of years that you have had zero rates and QE ongoing and no volatility spikes, nothing at all. Even the most conservative risk manager will be pressed to

by his front office people to say, hello, now we really need to do something. So it's a little bit of a herd behavior, really, which you see also in markets and you see it in institutions. And so you tend to broaden your mandate. Then you say, yeah, well, now we need to do something else, right? We need to go and do different asset classes and be more aggressive with our investment mandate. Now, when you're talking about when the volatility gets low, are you talking as reference to the VIX index or some other indicator? Indicator.

So there are a couple of indicators for vol that you can use in market or volatility. So there are two famous ones, which are, I think, decent proxy to look at. So there is the VIX, which basically looks at the market expectation for the S&P 500 implied volatility or realized volatility to be for the next 30 days. Okay.

Okay. So that's what you're looking at. You're looking at the market interpretation of how volatile the S&P is going to be. And then there is a very similar thing, which is called the move index, like move, like in moving. And the move index does, I'm going to approximate now, pretty much a similar job for bonds. So it tells you what? It

Investors are expecting the volatility to be in bond markets. And if you look at both these indices, holy moly, they were really, really low throughout the period going between 2015 and 2019. There were some occasional spikes, but for most of the time, these levels were really, really low to the point that, as I said, with the passage of time, even the most conservative risk manager said, yeah, you guys are right. We need to make money somewhere, take more risks.

In your view, how long do these cycles typically play out? And are there any red flags that pop up on when this low volatility period is, will looking to be, you know, end soon? Yeah, I think this is a million dollar question, but there are things you can look at. So what I learned running money at the bank is that you don't need to be right to make money.

This is going to sound very strange, but you don't need to be right to make money. Or let me correct the sentence or adjust it a little bit. It's not a sufficient condition to be right to make money. What is necessary as well is that you surprise consensus pricing. So when consensus is particularly strongly opinionated about something, it takes a small change of...

an event or something that changes that opinion a tiny bit to cause quite a large swing in prices. This is because the marginal buyer will be able to move the price quite aggressively as there is a herd of people which are mispositioned basically against the new set of information. So as a macro investor, your job more than being right, which I think is pretty much of an ego game or, and I think social media is even, you know,

turbocharge this game. If you go on Twitter, everybody needs to be right all the time in calling what the next macro event will be. As a macro investor instead, your job is to identify when something is getting too crowded, when consensus has an opinion which is too strong.

And there are multiple ways of doing that. But in my opinion, when it comes to low volatility, for example, right? So when is that this low volatility has become so entrenched that people are extremely relaxed about it? Well, you can take a few cues by tracking how carry trades are doing. So remember what we discussed at the beginning of the podcast, right? We said,

You sell the Japanese yen, you buy a high yielding asset. Wow, fantastic. You're getting paid while nothing happens. Low volatility means by definition, nothing happens. You're just clipping interest rate differentials by borrowing the yen, 0% interest rate and buying the Brazilian real, 10% interest rate. Beautiful. Now, when such versions of carry trades have worked

really well, so that it seems like a trivial thing, an unrisky thing to do, that's generally a good signal for you to be more careful. For the fact that too many people might be sitting in these scary trades, in these short volatility trades, and therefore it takes a tiny bit, like it's a butterfly effect. It takes a small, contrasting source of information or price action to cause a very large drawdown and a very large bout of volatility.

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What indications did you see, say, in late July or even earlier regarding the Japanese carry trade that blew up in early August? Were there any clear signs for you? Because this carry trade has been going on for a very long time, and I'm sure the bears could make this argument.

you know, many, many times, right? Yeah. So in the hedge fund, we deploy a model that basically looks at the crowdedness of such carry trades and how we do this is in like from a top level.

We create a basket of these short volatility trades and we track how they're doing. And what we track specifically is something called the Sharpe ratio. So what we do is we basically understand how investors have been generating risk-adjusted returns so that the Sharpe ratio is basically a measure of how much return have you made against how much volatility have you taken. So if the Sharpe ratio of

A diversified basket of carry trades has exceeded one to one and a half. So people have generated very competitive risk adjusted returns by merely sitting on carry trades. This has probably attracted a crowd of people towards going there because look, it's just printing money. It's amazing. And it's so simple.

And if you look at history, this index we've built is very interesting because every time that you get closer to this very high level of Sharpe ratio, like one or one and a half, it tends to tell you that

you know, it's very crowded out there. And in June, so, you know, like a month, month and a half before the problem, this sharp ratio level had reached 1.45. So quite a worrying sign that too many people were too comfortably sitting short Japanese yen. And then again, all it takes is a small butterfly effect to cause a big reverberation in markets.

I see. So what you saw in June, then, did that get your attention as because it was rare? It didn't happen too often in the years preceding leading up to the to the blow up last August was a sharp ratio considerably lower.

Yes, I mean, there are very few occasions over the last 30 years where you can generate Sharpe ratios by selling vol, so being long carry or other versions of you being short volatility, where you can generate Sharpe ratios above one. Every time you were able to generate Sharpe ratios above one, even one and a half, they were always followed by a drawdown, which again, tends to be an indication that

You can only squeeze and you can only crowd a trade as much before actually it starts to be very complicated to keep generating return because you can't really attract any marginal buyer anymore. While instead, it's very easy to attract a marginal seller. You just need to spook him a little bit and then outsize negative reactions can happen.

What got the Japanese carry trade to unwind there in August? I mean, was there – do you know that there was a relatively small amount that was placed to get out of the position, which then, what, triggered – did it trigger a bunch of stop losses to unwind this? Because we're only talking about $25.

basis points and increase in interest rates, right? But that's exactly the point that we're trying to make here. It doesn't take a lot to move the needle when everybody's sitting on the same position. And so you're totally right. That 25 basis point doesn't really change even the economics of a carry trade. It's irrelevant. I mean, whether you borrow at zero or at 0.25, sorry, it's not going to change much in the big scheme of things.

But it's about the signal that the Bank of Japan was giving to investors that, you know, they hiked rates and they were looking to hike a little bit more and people weren't prepared for it.

It was not something they were expecting. They were too relaxed, basically ignoring any potential risk. And again, it's very, very easy to then, to basically unwind very crowded positions. So tracking the crowdedness in general of positions. And there are multiple ways you can do that. You should find your own way and test it and backtest it. But the main concept I want to come across with is being right, it's not a sufficient condition to make money. And I'm going to say now something else.

Victor Agani, who was one of the co-founding partners of LTCM, the huge hedge fund that then unfortunately blew up in the late 90s,

He now writes a lot about how difficult it is to make alpha and how important it is to size positions correctly and how important is risk management. And he makes you play interactive games. So this is something I would recommend the Chat with Traders community to do because it's a very strong didactic experience. So if you go on the website, I think it's called, let me check.

Elm, E-L-M, Elm. So if you go on Elm website, Elm Wealth, I think is the proper name. So if you go there, you can play a couple of games, right? And so there is the last one he published, I think yesterday, it's amazing. It's called the Crystal Ball Challenge. So again, this echoes my idea that even if you have a crystal ball, even if you are right, it's really hard to make money. So the game is structured in a beautiful way. What they did is they took...

A bunch of episodes of the last 30 years where there was a big market event, either in the stock market or in the bond market. So I don't know, some big Fed decision or labor market data or inflation data or some big stock market information. And you get to see that info one day before. So this is the dream of every trader, right? You have the market moving info one day before.

Okay, cool. Now what? So he then says you can do the S&P future or the third year bond future. So you can trade stocks and bonds. You can go long, you can go short, and you can choose how much leverage as well you want to put on each trade. So by reading the news, you will be utterly convinced this is bullish for bonds or bearish for stocks or whatever. So you can lever up or more.

Remember you have insider information one day before. How easy is this? Right? And then you can hold the position for one day. So basically you are getting an early peek into the info and then you go long or short. And at the end of the next trading day, you're automatically on one from your trade. Please go and play that game and figure out how hard it actually is even knowing information to make money. And his main point is look,

How much was it priced in? This information you don't know, right? Because you don't have a context. It's taking info from the 1987 and 1995 and 2014. And so you really don't have the context of what was going on. Did the market already know this? And when the Federal Reserve cut 50 basis point a few days ago, the first reaction of the bond market was to sell off

What? The Federal Reserve has actually cut 50 basis points. And at some point you add even the stock market didn't really know what to do at first, right? And instead you would expect, what do you mean? The Fed cuts 50. So it's 50, the stock market must rally. But what if they were cutting 50 basis points because a recession was coming? Would it be the same for the stock market? How was the market positioned ahead of the meeting?

And so go and play that game because I think it's very instructive as well for understanding how hard it is and how important it is to understand how crowded positions are and how consensus is pricing something.

So then what are the tools that you look for or indicators to show that the consensus is priced in fully or partially? Do you use indicators or websites like the Commitment of Traders report to get an idea on how crowded a trade is? I think the COT is good for certain things and is not good for others. And the reason why I say this is that the COT does not know about hedges. So

So I was a very, very large bond investor. And if you would have looked at the COT derivation, maybe of my position, you would have gotten a completely misleading set of information because the COT doesn't know whether I'm hedging something. So for example, let me make a quick example, right? So when you look at bond future positions, right? And then the COT is going to tell you, I know like people are super bearish on treasuries or super bullish on treasuries, whatever.

what they're looking at is future data. So they're looking at listed futures and then they can see the open interest and they're trying to derive something out of that. But let me break news now to people, probably people already know that, but what if I took a large, long position in the 10-year future

Then I'm shorting the bond future against it. So for me, that is not an open position in the bond itself, but it's a relative value position. So I'm going long there, but I'm going short somewhere else, which means that if treasury prices go up and down, I don't really care that much. What I care about is our treasury prices going up and down against German government bond prices, because this is the relative value trade that I made. And

They don't know about that. Even worse, they don't know about hedging in swaps or derivatives or options that I might be using to hedge my position. And so it tends to be a bit of a partial information. I would say specifically markets that are very complicated, like the bond market. So how long does it take you to look at all these different markets and synthesize all of this to get a viewpoint on how crowded a trade is? Or is that even possible?

This is the key question because process is everything, especially if you're a macro trader like me. The macro is beautiful because it's unconstrained, it's diversified, it's so many markets and that's a problem. It's a problem because you're supposed to be able to screen and track new information, whether trades are crowded in which markets and the only way you can do this is

the only way you can do this is if you build processes frameworks and systems that's the only way you will do this unless you have an army of 100 people doing that for you as in like manually checking stuff and even then i wouldn't recommend it because it's prone to mistakes instead it's all about building framework processes and systems so at my hedge fund we have a ton of models and systems that are continuously screening for uh for example

asymmetries or incongruences, I should say. So for instance, let's say, let's talk about correlation. So now we're now recording this at the end of September and the news is that China is stimulating or China is announcing a stimulus package. Okay, fine. So what happens is that Chinese stocks are rallying, but also China

correlated assets are interesting because not everyone can trade Chinese stocks. So people will be looking at other things, right? That maybe they want to trade copper or the Australian dollar or anything that is historically very correlated with China. So when you have such big events, what we screen a lot for is our markets that are historically correlated with these assets behaving as they should, or are they not? And if they're not,

often there is an arbitrage. Arbitrage is a big word, sorry. There is a relative value opportunity you can try to exploit where you want basically to move towards the historical correlation or beta reaction, right? But how can you do this? How can you screen all these markets unless you have systems in place? You can't. And the same goes with tracking crowded trades. The same goes with understanding how consensus is priced. You

You can't do this manually. And so the answer to your question is it doesn't take me a lot of time simply because there are systems in place. They take a lot of time to build, yes. But once they're there, then they do the job for you continuously. The correlations are quite variable, obviously, depending on the timeframes that you're looking at. What timeframes do you look at when determining correlations and when do you adjust them? Yeah, it's a good question. So it really depends from what trader you are.

At my hedge fund, we do macro with a time horizon of three to six months on average for our trade. So we don't need to be right or to have a time horizon, which is a week or a day. We don't really care about that. We try to focus more on medium term macro themes, which we also think are a little bit less crowded in the hedge fund space. Nowadays, with the birth of the pod models in various multi-managers like Millennium or Citadel,

a lot of focus is on generating returns every week, every month. And that doesn't really optimize in our opinion for long-term macro trends that might take three or six months to unravel, which also means that our correlation, what we try to look at is stuff that is what we call macro correlated. So over a very long period of time, it has exhibited a stable correlation across regimes. And also when you look at these assets, you can explain why they are supposed to be correlated.

So Chinese stocks and iron ore or copper, why are they supposed to be correlated? Can you explain why? And maybe, maybe, yes, you can explain why. Because China is a big, big source of demand for iron ore. So when they're stimulating, they're not only popping up their local stock market, but probably they're also stimulating

projecting further demand or forward demand for these commodities. So as long as you can explain those and the relationship is robust over a long period of time, that's what we care about. What we are screening is for breakages, really, for abnormal behavior in pairs that instead should be correlated. And this is one of the many strategies that we run. And so...

How would the correlation changes over time cause your fund to increase or decrease or even eliminate position? I mean, how much would it have to move by? Yeah, so the correlation in this case is an input for the model to start screening how pairs are behaving. So if pairs are strongly correlated, we would expect that when we have a breakout in something, then the correlated assets would also behave differently.

in a certain way. When the system spots an abnormal behavior, so basically the pair supposed to be correlated isn't really behaving as such, it flags a potential signal for a trade idea. So really the calibration of correlation is more of a, let's say, a,

a check that the model has to do to tell us, okay, keep tracking these because those are really correlated. At some point, if the correlation goes down over time, so basically those two pairs used to be very correlated and for some reason they're not anymore. And it is happening in some cases. So we can discuss about this. Then the model would simply drop that as a potential correlation

pair to check, right? It will simply say, look, this used to be a strong correlation. Now it's not. So don't be surprised if asset A misbehaves against asset B because over time, the macro correlation is just basically diminishing. And this is something you've got to keep track of. And the question really becomes, what is your timeframe? Like,

new information is coming in, how valuable that new information about correlation is against your 10 or 20 year history. And there it's a very interesting discussion because

One might just be variance. It might just be noise, right? It might just be that temporarily those two things are uncorrelated and then they will convert back to their standard correlation over time. Or it might be that they're becoming uncorrelated for good reasons. So as a macro investor, it's important not only to look at models, but to always ask yourself, can I rationally explain why those two assets should be correlated or why they should now become uncorrelated all of a sudden?

I see. So you're also looking at the various news releases and placing kind of a value judgment on what kind of impact those news releases have for the correlations that you're looking at? Yes. Unfortunately, I would like to systematize everything, but you can't. Well, now with large language models, you can try and train something and make it read news for you, but I would not recommend that if you're a macro investor. So

there is always uh there's a branch of macro hedge funds which are called systematic macro i'm not i'm a discretionary macro hedge fund but systematic macro hedge funds are

basically only trying to find statistical inconsistencies in macro asset classes and not really relying on their discretionary judgment of anything. Like you were saying, reading news is a human activity. It's going to be somehow discretionary and nuanced in the way we interpret what that news means. And

Frankly, I think that there is potentially there is value in that part too. So we do that. We do screen news. We do spend time reading the news and trying to understand importantly, has consensus already incorporated this new information? Or also as one of the other mentors I have always tells me, listen to the game masters. The game masters are central bankers and policy makers.

politicians and central bankers. So why are they the game masters? Well, because they have a huge impact, the single agents, they have a huge impact with the decision-making in what they can do for the economy and for markets. So now that China has come up with a facility,

that says you can pledge collateral in this facility. So let's say cash or bonds or whatever asset you have, and we will lend against its money that you can go and use to buy Chinese stocks. Now that you know such a facility exists, okay?

It's really hard for you to say, oh, I think Chinese stocks are going to draw down 40% from here. Well, guess what? Because the policymakers are signaling to you, the game masters are telling you, hello, we can set up such facilities like the Federal Reserve did with the BTFE, the Bank Term Funding Program, where they basically said,

Give me your treasuries. I don't care what the price is. Is it 60 cents on the dollar, 70 cents on the dollar? I don't care. To me, the price, to me, Federal Reserve, the price is 100 cents on the dollar. That's it. They unilaterally have the power to decide that. They are the game masters. So listen to the game masters and importantly, try to get in the head of the game masters.

What is their incentive scheme? What do they want to achieve? And if you're able to get a bit of an edge on that, then that discretionary judgment, that human discretionary judgment can be very valuable as a macro investor. How often do you hear of a fund blowing up due to a heavy bet on long established correlations that suddenly change? Unfortunately, very often. I mean, this is, this is,

This has to do as well with risk management and drawdown control. So look, stuff happens. You have value at risk, the most used risk model in the world, I would say, in the hedge fund space. It's value at risk, also known as VAR.

So what VAR does is it just looks at history. It basically looks at history and it says, show me your portfolio. I will tell you based on history, we, they set the probability, say 95% or 99% probability. I can tell you, you're not going to lose more than X.

looking at history, which means also looking at historical correlations, right? Looking at what history has been for correlations. Okay. This is the most used risk model in finance. Okay. Obviously you can see the flaw. Future doesn't always resemble exactly the past. So it can always happen that your model didn't incorporate a breaking correlations, for example. So that can happen and you will experience it from time to time. If that

causes your fund to blow up, then your problem is another one. Then your problem is your risk management framework, your sizing. Because probably the thing that you did there is you assigned too much risk to a single position in your portfolio. Risk is always a function of probability and magnitude of an event. So

Even if you say, look, the probability that such correlation will break is very low. You always have to remember when you size something, yes, but what is the magnitude of a loss in case that probability happens? And when you try to look at

statistical inconsistencies or arbitrages, they seem like a certain thing, right? So the problem of a certain thing is that when it goes the other way, it can cause large losses. And that's what you should consider when sizing a position. The risk is magnitude times probability. So rule number one, I think for an investor is stay in the game. Stay in the game is rule number one. Have a process in place to make sure that one single position

can't ruin you effectively. That should be the rule number one. Why is it that correlations of assets can go to one in a crisis or even in a sharp market sell-off? Is there such a thing as a safe haven asset to protect us against these dramatic drop-offs? Okay, this is such an important part of risk management as well. So financial markets have become...

extremely leveraged. The reason is that we have gamified, I would say, financial markets. We have given access to implicit and explicit leverage to pretty much everyone around the world. So I think when you think of leverage, you normally think of borrowing stuff, right? And that's what people think about leverage, but it's not only necessarily that.

Leverage in this case means being able to take an outsized amount of risk in markets. And so options are one way to obtain leverage. Options are a product that has embedded leverage into them basically, because by taking a small amount of upfront risk, you can take a large impact

in markets, right? You can generate a lot of impact in markets. Think about GameStop, right? Think about people buying out of the money causing GameStop and forcing the dealers at banks to actually go and chase and have to buy stocks to cover their shorts, right? So this is a great example of that. What this has led to as well is a situation where you now have a lot of investors around the world, including institutions, using leverage to either amplify returns or

or to, in principle, try to diversify. So what is the problem there? If you think of the famous risk parity approach by Ray Dalio, what that approach says is you should,

Look at all the asset classes in the world, take exposure to all of them, be as diversified as you can. Internationally diversified stocks, bonds, commodities, the dollar, gold, you name it, buy everything you can buy and buy it in a measure so that they have the same amount of volatility contribution in your portfolio. Now, each asset is more or less volatile than the other. So you have to use leverage to balance out this volatility, right? So if you buy something like

Gold is less volatile than stocks. So if you want gold to have the same volatility contribution to your portfolio, you need to use leverage and go and buy gold with leverage to make it have the same weight in your portfolio. So all these techniques use leverage either to amplify returns or to amplify diversification. But what is the problem really? When something bad happens,

So let's say you are approaching a recession or you have a spike in inflation, or you have something that shakes the system from the foundations. What happens is that people who have used leverage and who are now experiencing losses in one asset class, for example, their losses are also amplified. And so what's going to happen is that they will have to try and

get cash somewhere to cover their margin calls, to cover their losses on leveraged positions. So what happens is really weird. It's like March, 2020, when gold goes down and bonds go down, despite the Federal Reserve cutting interest rates during a pandemic. What? Well, what is very simple. It's because if I am getting margin called on my oil contract, equity contract, whatever I'm owning,

I don't care what do I need to sell to raise cash and stay alive. I don't care what that is. I'm going to have to sell it. I'm going to have to sell my good collateral treasury called whatever it is to raise cash and cover my losses. And so what happens is that all assets, as you said, tend to move together. Correlations go to one. And this is nothing else than the side effect of

having very leveraged financial markets, both at an institutional level and now also gamifying the market so that even retail people can access explicit or implicit leverage through options, for example.

Do you know of any particular indicators that can clearly show if a market is leveraged enough to generate an asset correlation of one when the markets go down? Or does it take just very little leverage to do this, and we just have to accept the fact that this will keep repeating over and over and over again?

I'm afraid that I have to agree with your last sentence. The way we have structured markets is we have encouraged investors, institutional and retail, to take more and more implicit and explicit leverage at every occasion. And again, it's a policymaker decision because every time that you have a situation when correlations go to one and the market looks very scary, guess what? We introduce another facility to limit volatility. That's what we have been doing for the last 20 years.

That's what we have been doing and that's what we keep doing all the time. And so this sends a very clear behavioral signal, I would say to investors, that ultimately you don't want to be the guy that

The analogy here is a very crowded party in general. So everybody's dancing and the party is great. And the sooner you join the party, the more fun you had. So if you joined the party in 2012 and you understood policymakers are going to have as objective to lower volatility in markets as much as possible, where you were an early joiner to the party. And by now you have had stellar returns investing in any asset class, any asset class worked perfectly.

Hold stocks, bonds, anything, real estate. So now what is your objective? Your objective is to enjoy the party, but not to be the guy at the front door

when it gets very crowded towards the exit, when more people understand that the music is about to stop. So it's like a game of musical chairs, pretty much, right? You always want to try and dance, but you want to be able to sit. You don't want to be the guy heading to the door together with anyone else. Is there a way to track this? That's very, very hard. But so the answer is no, I'm afraid. But it's important in your risk models to

take this into account. So when I see people having their parameters for risk on something like a correlation matrix for the last 20 years, what they're doing is they're just taking the average outcome every day or every month for the last 20 years. And that's their base. Well, guess what? If you know that the system is created in such an unbalanced way, where very often you are going to have correlation going to one,

Do stress your portfolio for what happens in that event, because it might repeat every now and then. And actually, by the way, we're structuring markets. I'm afraid you're right. It's going to repeat more often than not going forward.

For individual investors that are listening to this, some may say, you know, this all sounds fine, but it sounds very complex to me. How can I take advantage of this strategy? I mean, I've invested in some mutual funds and I hold a bunch of different stocks in the tech sector and what have you. And I feel like I'm pretty well diversified. Isn't that enough? I mean, what can the individual investor do that's not too overly complex?

Oh, that is a very good question. I would say the following. First of all, rule number one should be try to get exposure to every asset class you can. And this is going to sound very hard because there is something that I like to call the neighbor tracking error.

So that means that your neighbor has NVIDIA and you don't because you invested in a very diversified portfolio that has just a tiny bit on media, but he put 40% of his wealth in media. So he's becoming very rich and you're tracking behind.

And that's the neighbor tracking error. And it's going to try to lead you to do stuff to catch up with him. So much easier said than done to have the discipline to remain in a diversified portfolio. But that's step number one. So take exposure, not only to the US stock market, but take responsible exposure to stock markets at decent valuations around the world.

So we've had an example on Japanese equities for the last year or year and a half. They have done tremendously well. And we live in a world where we think the US has to be the best performing market, but history shows that's not always the case. So take international diversification, take emerging market exposure, take bond exposure around the world, take commodity exposure, because what if there is an inflation shock? Do you have an asset in your portfolio that does well if there is inflation? But now, even if you do this,

as well as you can, by using ETFs and accessing whatever asset class you can, you will still be facing the same problem, right? What if correlations all move to one? I mean, what happens then? The only asset that tends to do well when correlations go to one is the asset that is the denominator of all these assets. So the S&P 500 is denominated in dollars. Commodities are traded in dollars. Gold is traded in dollars. Bones also are dollar denominated.

So when you are collapsing the system, when you are deleveraging the system, very often you'll see the dollar doing well.

And that's because basically the world is based on the dollar being the global reserve currency. So we have leveraged the entire world around the dollar. So you're in a situation where foreign countries trade their goods and services in dollar and foreign countries issue dollar debt. It's all about the dollar here. That's how we have built the system. So when you compress it rapidly, then the dollar tends to do well. Problem is,

How do you get exposure to the dollar? I mean, you need to be able to trade futures. You need to be able to trade specific markets. So at that point, I would say for the standard investor,

Try to get as much diversification as possible. And then I'm afraid it's a little bit hard to avoid the correlation going to one moment if you have access to alternative investments. So, for example, specific strategies like trend following, macro, and I'm talking about now allocating to hedge funds a portion of your wealth.

In that case, if you do it well with a good manager that is equipped to actually do well in these periods, then actually that can be the true diversifier in your portfolio.

Excuse the last interruption here. This is Tessa. We hope you're enjoying this episode so far. If you love the podcast, please give Chat with Traders the best review you can on whatever platform you're listening from. This will help us to keep the episodes coming. Also, if you haven't subscribed to our email list, please hop on to chatwithtraders.com and click on subscribe so we can keep you posted of information that may be of importance. Thank you. Now back to the chat with our guest.

I frequently hear people talk about global liquidity and they love to show this chart of it increasing and increasing over the years. And however, is there a direct and timely link between liquidity, global liquidity and the price of risk assets? No. So the answer is no. The answer is no. And it can be simply shown statistically. I have done this for clients over the years. It's always very fun because

Human brains are wired for stories. Human brains are wired for narratives. Okay. So we want to have an easy and intuitive explanation. We like to think in linear terms and not in complex systems terms.

It's already fun if you think about it that you want to use, not you, I mean anyone, will want to use one variable, one single variable to explain such a complex system like the stock market globally. This sounds to me already like a very fun experiment. So it just can't work. It doesn't seem very credible. Then if you run a regression, talking about proper things, if you take liquidity in its form, which is the creation of bank reserves by the central banks, and you can take liquidity

the Fed bank reserves, and then you can some Chinese and Europe and, you know, people are becoming now global bank reserve creation. Fine. Let's do that. Let's take global bank reserves.

If you regress and you use as an explanatory variable, the changes in global bank reserves, the changes in global liquidity, and you try to take that and use it an explanatory variable for subsequent S&P 500 returns. So the exercise you're testing the hypothesis of changes in liquidity, do they explain changes in stocks that happens in the six months after?

The R squared, which is basically the amount of variance in the S&P 500 returns, which is explained by the changes in global liquidity, is pretty much zero. Zero is the result. So basically they are completely irrelevant. Global liquidity is completely irrelevant as a factor to explain future returns in the stock market.

And why is that? Well, if you want to talk about the monetary side of things, it's because when you create bank reserves, when the central bank expands its balance sheet, all they're doing is they're giving money to banks. So banks now have more bank reserves. But banks cannot buy stocks with their bank reserves.

I have a question about this economic indicator that is so often used, and I haven't heard anyone being able to explain this phenomenon. And that is...

From my understanding, every time a country borrows money, they increase the debt, they borrow and spend it into the economy. Shouldn't the economic output, meaning the GDP recorded, be equal to the amount that they borrowed and spent at a minimum of a one-to-one ratio? So if they borrow a billion dollars, increase the debt by a billion, shouldn't the economic GDP also grow by a minimum of $1 billion, assuming there's no multiplier effect?

And I ask this because so many countries' economies are growing much slower than the amount of increased debt that they borrow and spend into the economy. How is this possible? This is an extremely well-phrased question because people fail to understand that fiscal deficits are not necessarily a bad thing.

So when a government has a fiscal deficit, what they're doing basically is they're blowing a hole in their balance sheet. Okay. They're saying, I am the government. Let's say the United States. I am the government that is issuing dollars. I am the government that makes the dollar legal tender. And I now say that I want to spend more dollars.

than the ones I'm getting in from taxes. That's it, what fiscal deficit really is, okay? So then we create the system where the United States needs to borrow, quote unquote, okay, fine. But they've done fiscal deficits, okay? Which is basically what you're referring to. Now, what are fiscal deficits? They are an injection of resources for the private sector. So, I mean, everybody forgets about it, but when the government does fiscal deficit, somebody's enjoying that.

So the fiscal deficits of 2020, 2021, what was that? Well, was the government sending people checks at home in their mailbox. Okay. So now do you realize that when you cash in that check, your bank account is going up, it's going up and you have no more debt on your balance sheet to offset that. That means your equity, your net wealth, your amount of richness, your wealth is going up.

To answer your question, the answer is theoretically yes to the fact that if the government has fiscal deficit, then the private sector is increasing its net wealth.

GDP though, doesn't necessarily measure the increase in net wealth in the private sector. It's a little bit of a different calculation and that's why the ratio isn't one-on-one. It can be a little bit different. It can be one and a half to one or 0.5 to one. And if you look at history, we used to be pretty good at spending the deficit, at spending the newly created money, at making it a productive endeavor, right? So basically if the government spent

$100 billion in fiscal deficits, well, guess what? The private sector was very smart at using that money for productive purposes. And so we ended up with more GDP, even than $100 billion as a result. And now we're pretty bad at it. So when the government spends $100 billion, the amount of marginal dollar of GDP that we are creating with that $100 billion spent is actually less than $100 billion. So let's say the GDP multiplier on fiscal deficits is getting lower and lower. And why is that?

Because there is more debt in the world, private sector debt, so corporates and households are more leveraged, which means that when you throw money at them, generally speaking, the first thought they have is, can I take some of this money to pay back some of my leverage? So instead of putting it at productive use, they try to reduce their own amount of leverage on their balance sheet. And the second is,

Well, we have engineered a less and less productive economy over time because, again, we are trying to kill the business cycle. I always say that policymakers are intended on not having a recession anymore in our lifetime. If they could choose, they would abolish the term recession. But what this does is it avoids the natural cleansing that a recession does. It just...

It's that process of killing zombie companies and unproductive businesses. It doesn't allow for that. So which means we're becoming less productive and less smart at using this newly created money. But you made a great point, which people fail to understand. When a government does deficits, hello, the private sector is actually enjoying that. So there is another side of the coin to making deficits and making more debt, which is while increasing the net wealth of the private sector. The question is, how productive are you in utilizing this deficit?

Mm-hmm. Well, great, Alf. Thanks for coming on the show. And to wrap things up, is there anything that you're kind of looking forward to or you're kind of excited about as you look at the markets and in your life? Well, when I look at markets, I think we are in a situation like

where the people have thrown the towel, I would say, on a recession. I think it's been called for way too long. I think the yield curve has been inverted. Now it's disinverting, but it's been inverted for two years. And so people were like, after the first year of inversion, they were like, there must be a recession now. And it never came. And so people are frustrated to the point that they're now

not even assuming a recession is a possibility anymore. And I think that might be a bit counterintuitive, like in 2007, when after the Federal Reserve hiking cycle, it seemed like everything was fine. And then ultimately, a recession effectively came in 2008. I don't think we're going to be seeing another 2008, but I just think that people...

people's attention towards a potential recession has gone down quite a lot. And then when it comes to my personal life, well, I couldn't be more excited, frankly. I just launched my macro hedge fund. It's something that I've worked on for a long time, for nine months. We've gathered large commitments from investors. We're opening the doors very soon. And I'm very, very excited about that. Well, great. Fantastic. Congratulations. So how can our listeners get in touch with you?

My messages are open on both social media platforms I use the most, Twitter or X nowadays and LinkedIn. So on Twitter, you'll find me at macroalf. Well, alf, like the first three letters of my name. And then on LinkedIn with my full name, which sounds very Italian and it's Alfonso Peccatillo. Messages are open. So hit me up. I'm always happy to chat. Fantastic. Well, Alf, it's been a pleasure. Thank you for coming on Chat with Traders.

Thank you very much, guys. I listen to every show of yours. So it's been a pleasure being on the other side.