Some of the best hedge funds use a global macro trading strategy to beat the markets. Alex explains how he is able to use this strategy to understand the world better and manage risk. He discusses how he reacted to March 2020 and how he is positioned for the increased volatility in the markets today.
In 2021, I was blindsided by reflexive price action in interest rate markets. What had led my prediction astray? Why was I, along with some other global macro traders, so confident that a more patient and gradual approach to tightening monetary policy was the correct bet? Were we terminally wrong, or was the whole tightening cycle that started this March just a short-term market hysteria?
The answer may lie in reflexivity. Reflexivity, when it comes to financial markets, is a term introduced by George Soros and developed in his book, The Alchemy of Finance. It describes the phenomena of price moves serving as a catalyst for further price moves in the same direction.
Another way to refer to reflexivity is the advent of price action having positive feedback. Such positive feedback can be one factor contributing to the market tendency to develop long-lasting trends.
I discussed trends in my first book, The Next Perfect Trade. Recognizing trends is integral to putting yourself in position with favorable economic expectations. Furthermore, the propensity to trend, or reflexivity of price action, contributes to the efficacy of common risk management practices.
In other words: if your losing trades tend to pyramid losses, once the price action becomes adverse, executing disciplined stops can improve your portfolio performance. Same goes for sticking with your winning trades. However, that’s not the whole story.
The Impact of Economic Gravity
I have always felt that this reflexivity of price action is a useful, but not universal, observation. In particular, my bread-and-butter—interest rate markets—exhibit a lot of negative feedback that does not play well with conventional trend-following strategies. I introduced the term “economic gravity” to describe a situation where the price becomes its own enemy.
One example is “the negative predictive power” of interest futures. The settlement price of Eurodollar futures, for example, is not dictated by market sentiment, but by the actual setting of the London Interbank Offer Rate (LIBOR), which, in turn, is dictated by US Federal Reserve policy.
The policy rate five years from now, implied by the current futures, has very little correlation with what will actually end up happening—which I can confirm through decades of observation. And if any correlation does exist, it's likely to be negative.
If the market implies higher rates today, it creates tighter borrowing conditions. When that happens, it results in an incrementally less inflationary environment and, eventually, lower policy rates.
Developing a Shield Against Uncertainty
Enter 2020. In my book, The Trades of March 2020 (now officially a Wall Street Journal bestseller), I outline how I navigated the initial COVID crisis, developing a strategy that would carry me through the rest of 2020.
The subtitle of my new book is A Shield against Uncertainty. Amidst the pandemic uncertainty, I was sure of two things:
- The pandemic would eventually pass
- Central Banks would keep adding liquidity until it became excessive—and it would stay that way for an extended period of time
This strategy successfully carried my portfolio through to the end of 2020. The Federal Reserve’s rhetoric seemed unequivocal: of course, there would be a surge in inflation, when the post-pandemic reopening occurred. But policy makers vowed to be patient and see if this inflation would prove to be transitory.
I felt strongly they would keep that vow, because no matter how robust the recovery, there would be segments of the population still suffering from the lockdowns; thus, to tighten rates immediately and impair employment growth would be uncompassionate. If anything, the Fed alluded to the fact that their policies in the past had left various swaths of population behind as an argument to be even more patient this time around.
The Rhetoric Shifted
Needless to say, by the end of 2021, this viewpoint was severely challenged. I have listened in amazement to the shift in rhetoric, which, in my opinion, has not been warranted by any shift in economic trajectory.
When questioned about higher and more persistent inflation projections, Chairman Powell pointed out that the divergent factor was unexpectedly severe supply bottlenecks. I tend to concur with this assessment.
Logically, one should assume that if there is a change in policy course, the newly discovered factors should be the cause. But how can supply bottlenecks be a reason for a tighter interest rate policy?
Let’s think it through. We still don’t know whether the underlying inflation is transitory. Those who were concerned about it in 2020 are probably still concerned. The converse is also true. It is possible, however, to argue that now, amidst some signs of economic slowdown and the lessening of the fiscal impulse, the inflation projections should be more benign than a few months ago.
Traders Should Stay Focused on What the Fed Will Do
So the new main concern is the current elevated levels of inflation and the adverse impact it has on the portion of the population whose wages are not catching up to the rising prices. How would higher rates help that? Higher financing costs would definitely not lower (but would, in fact, raise!) the cost of production.
The only way policy can alleviate inflation is by weakening demand, which in turn is a euphemism for making sure that people have less money with which to buy things. Thus, the government’s answer to those who complain that goods are too expensive for them is, “We will take away more of your money, so you will buy even less and then the prices will go down.”
I have learned long ago, though, that a trader should focus not on what the Federal Reserve should do, but on what they will do. Honestly, I am not sure what they should do; I am just pointing out the internal inconsistency in their approach.
What I failed to take into account was the reflexivity of political and market consensus. The outcry about inflation put pressure on the Fed to do something. Then, step by step, the conversation about tighter policy took hold. Interest futures started to price in imminent rate hikes. And then suddenly, the hikes became a reality.
The Influence of the “Market Mood”
The Central Bank never wants to surprise investors with a hike, as it might disrupt financial markets. If they intend to raise rates, but the market hasn’t priced it yet, it costs them very little to postpone the policy change for a few weeks and clarify their communications.
This time, however, the market started pricing in more and more rate hikes in advance, and the participants' mentality changed to accept the imminent lift-off as a natural and likely course of action.
Even the most intelligent investors are bound to be affected by the “market mood,” when nothing but price action changes their opinion about a long-term outcome. I am not sure whether the Federal Reserve succumbed to political pressure or genuinely changed their assessment (even if the latter doesn’t make sense to me personally). But it is very likely that this market mood influenced their thinking and led them to subconsciously accept the new policy bias.
The Potential for a New Reflexive Reality
Over the years, I have succeeded by seeing through the price action and discovering certainty in long-term economic outcomes. I saw the inevitability of rates getting to zero even when others were talking about the end of the secular bond bull market in 2018.
I capitalized on the policy pivot of 2019 and on emergency cuts of 2020. Further, instead of panicking in the middle of a crisis, I was able to buy assets in 2020 and profit from the rebound.
In 2021, however, I faced a challenge, underestimating the short-term reflexive power of the market mentality. My “stay calm and stay the course” strategy backfired because, in this case, the market proved to be reflexive.
Going forward, the mood could easily change again. More mixed economic numbers or significant correction in asset prices could cause the Fed to slow down, and then pause when more ambiguous data emerges.
But if I am to be intellectually honest, the bar for such a change in mood is high. We are yet to discover if the current inflationary pressure will be self-reinforcing or self-defeating. As a trader, I have to be prepared for this new reflexive reality.
For more advice on reflexivity in the market, you can find The Trades of March 2020 on Amazon.
Alex Gurevich is the founder and Chief Investment Officer of HonTe. After earning a PhD in mathematics from the University of Chicago, he leveraged his passion for strategic gaming into a lucrative Wall Street career. He was hailed by the Wall Street Journal in 2003 as the star trader of J.P. Morgan, where he served as Managing Director in charge of global macro trading. The author of The Next Perfect Trade, Alex Gurevich led HonTe’s macro strategy in 2020 to rank second by net return according to BarclayHedge—and in the top ten of emerging managers in all strategies by Eurekahedge.
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Today's Guest: Alex Gurevich
Bestselling author Alex Gurevich is the founder and Chief Investment Officer of HonTe. After earning a PhD in mathematics from the University of Chicago, he leveraged his passion for strategic gaming into a lucrative Wall Street career.He was hailed by the Wall Street Journal in 2003 as the star trader of J.P. Morgan, where he served as Managing Director in charge of global macro trading. The author of The Next Perfect Trade, Alex Gurevich led HonTe’s macro strategy in 2020 to rank second by net return according to BarclayHedge—and in the top ten of emerging managers in all strategies by Eurekahedge.
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