The Macro Trading Floor transcript – 17 January 2025

Alf (00:00.92)

Buongiorno amici, welcome back to The Macro Trading Floor. Alf speaking and my buddy Brent with me. How you doing man?

Brent (00:07.308)

I’m good Alf. How are you? So you launched and I got to say congratulations. I know it’s extremely difficult to launch a hedge fund. So, nice work.

Alf (00:14.318)

Yes, yes, yes, it has been a long in the making, about a year work just to convince investors to give me money. That’s not easy. And then the other thing is setting up operationally. I mean, somebody tells me a story like 20 years ago, you could set up a hedge fund from a garage with the fax machine and a little bit else. And now, well, garage still works as an office. That’s OK. But the problem is everything else. Regulation, compliance, and all that also happy to be alive.

Brent (00:42.534)

So I noticed in your background, it’s very sparse back there. And I have seen research that says that the less decorated the hedge fund’s office is, the better the returns. Because they’re not spending money on art and all that stuff.

Alf (00:55.34)

No, there is no art, no art over here. Just some Bloomberg terminals and people trying to look for asymmetry when we find it. Anyway, happy to be live and thanks for the nice words. But what should we talk about? I think Monday is the big day, apparently.

Brent (01:09.69)

Yeah, so this is perfect timing. Usually the timing is horrible because we record on Thursday ahead of payrolls and payrolls comes out. So this is good timing. So Monday is inauguration. It’s a holiday in the US. So stock market’s closed. So whatever you want to do in options or whatever, you better do it Friday. But and then some people are thinking that there could be an announcement that day or the 21st. But whatever you consider day one.

Now, the thing that I find really interesting about this is that I did a survey of my readers, which is mostly like institutions and a few banks and some retail. But people are just way more complacent than I would have expected on tariffs still. So you have this kind of interesting setup where the market’s long dollars for a lot of reasons, not just for tariffs, also for, you know, yields and for US exceptionalism, for a hundred different reasons. But the market isn’t that well positioned or that hardcore about the tariffs.

Like I was actually talking about Canada. So I said, what’s your base case for the following tariff outcomes for tariffs on Canada by the end of February? And more than 50 % said no tariffs on Canada at all before the end of February based on a couple of different buckets that they could have answered in.

And I find that amazing given like the trolling of Canada and we can get into that but about Canada specifically but what do you think on tariffs? Not necessarily your forecast but like are you surprised that so few people are actually ready for tariffs or no?

Alf (02:51.96)

So I find that empirically, if you look at option markets, Brent, you will find the FX market’s, I would say mildly nervous, not even too much, I would say, depending on the currency you look at, but mildly prepared. Equity markets, completely complacent, if you look at option markets. We can go into the details. And bond market, slightly worried. That’s all I see. But in general, I would agree with you that the survey reflects what’s priced in option markets, which is across the board a relative complacency.

And something I always point out, and the guy said the fund here also pointed out today, that you can also get a volatile event on the other end of it. I mean, it’s not my base case, but it could be that Trump comes out and says absolutely nothing concrete about tariffs whatsoever, and then you should get quite the rally.

If you think about the fact that you’ve had the following data over the last 10 days, you’ve had… strong retail sales control group, it’s growing at over 5 % annualized, so US consumers seem to be doing fine. You have had a decent labor market report. You have had core inflation that basically says that core PCE will be running at 2.3 % annualized, so again, friendly inflation numbers. And you have Fed officials coming to the wire saying that they’re talking about cuts and Waller today was quite dovish and he’s talking about three or four cuts this year.

If you take all of this together, Brent, and then maybe Trump is not very specific about tariffs, you could get quite a vicious rally. And I don’t think the market is even, in option markets, not even prepared for that. So it seems like the tails in general ahead of this event are somehow not fully priced, I would say.

Brent (04:37.947)

Yeah, I agree with that. And I think one of the challenges though, is that it’s not purely binary. So if you basically said like tariffs or no tariffs, then it’s binary and it’s kind of easy to trade. So you know, the thing you said about, what if he says nothing and, they talk about a negotiation period for tariffs or something like that. I mean, that’s what happened in 2017, right? And that dollar collapsed. So it definitely should be on the bingo card.

But I think the challenge is that there’s a few outcomes that are in the middle that are difficult. So targeted tariffs is the most confusing one because then you gotta go, okay, well, how big are the buckets? Are they targeting washing machines or are they targeting like anything that starts between A and Q in the alphabet? So the targeted tariffs thing is very difficult.

I think one of the most interesting and probable outcomes is the stair step approach, which has been advocated by quite a few people around the administration, where you say, okay, we’re putting 5 % tariff on, let’s say Canada, but it’s going to increase by 5 % every two months until it gets to 25, unless they do X, Y, and Z. And there was something on Bloomberg that kind of floated that. And the initial reaction was like, oh that’s kind of dovish and the dollar sold off.

But I think that’s probably wrong because you’re still getting tariffs. You’re still getting a lot of uncertainty and you’re potentially getting, you know, pretty quick ratcheting up that could be faster than you saw in 2018, 2019. So I think it’s interesting and confusing if they don’t do like straight up across the board tariff, which is very clearly hawkish or negotiation period, no tariff, which is very dovish. And there’s a lot of outcomes in the middle that are kind of confusing.

Alf (06:35.822)

So why don’t we take a step back maybe and try to talk about how do we think about, let’s say a big event like this one. Because the hard part is always like trading economic data. You had a monthly inflation print ahead of you. What do you do? I mean, I frankly just look through it because I don’t have any edge in predicting a monthly inflation number. What do I know? So I will just try to look through it. Some people try to make scenarios there. I think that is very hard in general, but making scenarios instead on Trump and tariffs can be done. As you said, it’s not binary, but it can still be done.

And the way I think about this is… this is the process I follow. I would map the scenarios out. Let’s say there are three of them, Brent. And then I would think of the risk in each scenario as an equation between probability of that scenario and the magnitude of the move in that scenario. So let’s say you’re looking at the S&P 500, just to make it simple. And then you have heavy tariffs. You have blurring blurbing words about nothing concrete being done. So the most dovish thing ever. Then you have the most hawkish thing ever, so heavy tires on the get-go and then you have somewhere something in the middle like the step-up approach that you just said.

Okay. So the way I would think about this is I will try to look to estimate subjectively what the drawdown or the upside could be in each of these scenarios and then I will look at what the market is pricing for each of these scenarios. And so you can use options to do that and we can go through a bit how you do that but you would then get an understanding of how the market is pricing the probability distribution of the three outcomes and how you are pricing them in terms of magnitude and then you would assign the probability of each of those and you will find basically the weighted probability outcome.

That’s the mean outcome, let’s say, but you can also play for a specific tail if you think it’s massively underpriced either as a probability or as a magnitude of the outcome, basically, compared to your subjective expectations. The hard part of all this is not the math. It’s pretty simple. The hard part is… when you put your subjective probabilities, you always have a base case, right? So you’ll put some sort of higher probability to one of the three, right? And that will mean that automatically you look for a trade there. That’s how we work as a human being.

If you have a base case, you’ve got a trade there. But sometimes the trade can be somewhere else because the probability you’re pricing at 20%, the market is pricing at 10, and on top of it, they are giving you cheap options even on top of it to play that. So you have some sort of a duty to look at that tail, even if it’s not your base case. That’s by far the hardest part, I think, of how I look at the scenarios approached. But now, how do you look at it?

Brent (09:25.136)

Well, so yeah, it’s interesting. Everything that you said, you know, makes sense to me kind of like an expected value framework. But then the other question as a more short-term trader, which I am compared to you (just in case people don’t know that) is, do I need a position ahead of it? Or is it better to just wait and react? Because a lot of times if something is really clearly binary and it’s going to follow through, it’s actually just better for me to wait and just react.

Because like, let’s say the Canada thing was just purely binary. And I think Dollar CAD is gonna move 400 points up or down. I don’t need to buy an option because when the news comes out, I’ll just buy it. Even if it’s up 100 points, I’ll buy it to make the last 300. So it’s a really complicated process. And I think it just comes down to like… the real simple aspect of it is, what are some things that I think that the market doesn’t think? Or where are my probabilities different from the market probabilities, like you said? And to me, like given the news flow, for example, on Canada, it just seems very underpriced. The tail of a move to 1.50 in dollar CAD just seems really underpriced to me.

Alf (10:44.366)

So let’s talk about waiting versus putting the trades up front. Okay, so when you wait for something, then effectively you’re trying to say, Brent, that your edge is in digesting the news and its implications faster or better, let’s say, than what the market will be doing the first 10 to 15 minutes. You need some time to figure out what the hell is going on and then you’ll have a certain reaction to that.

So is it about reading the news faster and digesting it? Or is it about, let’s say, the market basically being too slow? So I’m going to say something about that. So I used to work for a large institution and I can guarantee there is no way that big flows are going to be moved unless it gets heavily discussed. Yes, of course, every PM can take his own bar and can deploy it and you can take trades by himself.

But if you want a huge big whale trade coming from an institution, it doesn’t happen out of the news. Impossible. It’s going to take at least a day for them to debate whether yes or no. So there is an advantage, I would say, for a fast money or a retail guy that likes to trade. But what is your edge coming from, you think, by waiting for the news?

Brent (12:05.852)

Yeah, it’s exactly what you described. So the edge can even be like I can push the buttons faster than other people. I mean, so if you create like a bunch of circles of speed versus size, you know, the smaller, faster person can react instantly to the news. So say news comes out the market makers and the retail people can just go brrr and react. Then the hedge funds will ping the banks and say, okay, buy 100, buy 100, buy 100.

And then like you said, real money you know, six hours, 12, 48 hours later, we’ll then be putting on size. So essentially if you’re fast, you can just be ahead of the big flow. Because you would think on some kind of major news that price just instantly, you know, instantaneously, like a singularity event, it just goes from 48 to 96. But what really happens is it goes 54, 61, 68.

So the issue that real money has or bigger people have is that there isn’t enough liquidity to do an infinite amount. But you can do hundreds of millions of dollar CAD on the first hundred points if it’s moving like that. So I don’t know, I think sometimes a mix is good too that you have your base case or your cheaper things on and then you try to go nuts when the news comes out and then you have both.

Alf (13:27.854)

I think I agree in general on that, as long as emotions are left home. So I would always suggest that people have some sort of a game plan and they say, if this, then that, not if this, I don’t know what, then I will make it up on the fly because that is a bit riskier, I would say, right? So if you do a scenario analysis before, you don’t have to trade it before, right? But you can look at it as the event unravels and then you have some reference point, right? Because if you try to make it up on the fly, you’ll be emotionally very involved in the prize action.

Brent (13:58.085)

Right. 100%. So I’ll always have my like grid of like, if this happens, I’ll buy dollar CAD up to X, my stop will be at Y. So I have it all kind of laid out before the thing comes out. So talking about that stuff… Some of the reactions to tariffs are kind of obvious, but some of them aren’t. And I think the most interesting one is what the bond market might do.

So tell me like, what do you, how do you look at bond market reaction to like, let’s just say to take the most extreme example to make it easier… On the 21st of January, Trump says, across the board, tariff 10% on all products to the US. What does a bond market do? The US bond market.

Alf (14:45.198)

20% global tariffs, let’s go. Let’s go, huge. I would say the bond market rallies, which is gonna sound extremely weird now, but let me try to walk through my rationale. So first of all, what is the bond market? Let’s start from 10 year bonds or 30 year bonds, okay, so what people are most interested in, okay.

So when you think of 10 year, 30 year bonds, you basically are thinking of where Fed funds will be between now and the next 10 years, plus you’re thinking about how people think about the uncertainty of growth and inflation. So you’re thinking about duration risks, term premium and this type of stuff. Now, I think the general narrative is that bonds should sell off because tariffs are big and therefore the term premium needs to go up. You know, there’s going to be more inflation, there’s going to be more volatility. So I need to get paid by that.

Well, I have a couple of rebuttals there. The first of all is I assume, and this is if my assumption is correct, that if he puts 10 or 20% global tariffs, the dollar is going to go up by quite a bit. That’s my assumption. Now, if it goes up by quite a bit, then the American consumer is going to see import prices being a little bit higher. But after the currency offset, maybe slightly higher, not a lot higher.

So yes, the US is going to experience a short-term bump in import prices, that is correct, but here is the point. Short-term bump in import prices has nothing to do with the term premium, nothing to do with the term premium. The term premium is what you want to be compensated, is what you’re asking as a compensation to own long-dated bonds because you think over the long run you’re going to face many, many, many more cycles of volatility of inflation and volatility of growth.

If this is pretty much a big one-off bump, especially if it’s used as a negotiating tactic to obtain something, you shouldn’t think this should result in turn premium. This could result in a temporary bump in inflation, but long-term rates shouldn’t react to that, actually. You might make the opposite argument, where if the US does that, well, we can bet that global trade is going to slow down aggressively, we can bet that the global economy is not going to like this at all, we can bet probably as well that risk assets aren’t going to like that either, and so treasuries might serve actually as an edge. So if I need to choose in an event like that, I would say they rally, although it sounds pretty weird, I know.

Brent (17:12.816)

Well, no, so I’m with you. So the whole idea that tariffs are inflationary, think kind of like betrays what inflation is, right? It’s more like a sales tax where the prices all go up and how much they go up depends on the dollar, but it’s not like they’re going to go up every year because of the tariffs. So it’s a one-time shock, which, you know, central banks could actually look through that too. It’s not really, that’s not really what inflation is.

I did a thing in in am/FX today looking at the change in TLT just to keep it simple. So you know, the bond ETF in the US, on the main tariff days and most of mostly it’s big rallies in bonds. So either bonds did nothing or they went up a lot. And I think that’s essentially the fear factor, right? Like you said. And the thing is, the negative economic impact of tariffs and the inflationary impact, I don’t know, I feel like it more than offsets to the negative.

So then you have so to me, it’s like bonds rally, the yen rallies, cross yen sells off. And then when you look at like the currency markets, dollar rallies to compensate, and then you get a bit of a mixed bag depending on where the tariffs are. Like, obviously, when the tariffs on Mexico were threatened and then removed, you got like insane moves in dollar Mexico in 2019.

But like you said, if you’re looking at the full maturity of the instrument, 10 or 30 years, a tariff isn’t really going to change inflation over the next 10 years. It’s going to be a one-time thing that will partly be offset by the currency, partly offset by the fear factor. And in the end, to me, it’s bullish bonds for a bit, and then you kind of see what happens.

Alf (19:08.686)

Yeah, I think though the clearest assets to trade, obviously, Brent, are FX and equities. I think the reaction function there is pretty easy to pinpoint. You don’t need to talk about term premium and forward curves and stuff like that. It’s perhaps easier. And there I find super interesting a couple of observations. So first of all, I don’t know whether you noticed, but the DAX, the German equity index, is actually making new highs as we speak.

Now, of course, Trump could decide that he wants to raise as much dollars as he can and to raise as much dollars as he can, then he can pinpoint countries that have the largest trade imbalance with the US, right? That makes sense because you’re basically gonna say, well, let’s take the first five guys and they’re gonna be the ones that get the most tariff. And guess what? Germany is number four in that list.

So I mean, if you look at that, I find it very surprising that there is a lot of premium priced in the Eurodollar, for example, as an option. So if you look at the optionality in Eurodollar, you will get charged for it. We should talk about what does that mean, by the way, Brent, but for the moment, people understand that you get charged to buy Eurodollar downside optionality ahead of the event. But in the DAX, not nearly as bad, which I find quite interesting. So there is a bit of complacency going on in equity markets, particularly in equity markets of countries that could be actually directly targeted by tariffs. And I think in your am/FX, you showed that the short-term reaction to days of tariff announcements was actually, of course, not good for equities, right?

Brent (20:44.349)

That’s right. Yeah. If you look across like equities, US equities, it almost doesn’t matter what you look at. Like everything just went down on almost all of the tariff days. There was mean reversion in the days after, but the day of the tariff announcement was very bad for equities across the board. Like vol adjusted, it was the worst for but also bad for, you know, basically almost anything in the US.

And then on the FX side, like you said, dollar up, but then dollar yen actually went down on most of those days. So that obviously means cross yen went down a lot. And I mean, that’s simply a function of bonds rallying and then people buy yen as a safe haven trade in a trade war. And I mean, that’s always the question too, right? Is that the tariffs thing is gonna happen or not happen, but let’s say it happens on the 21st. It’s not just like, okay, well, they did the tariff now that’s over. Then you got to start waiting for all the retaliatory moves. So like if Canada gets tariffed, they’re going to tear up the US, right?

And then, so that’s what happened in, 18 and 19 in between China and the US was there was this tit for tat where like in the end equities did okay, but there was a lot of turbulence in equities because you get the first tariff, then you get the, the retaliatory tariffs. Then you get like the increase in the amount increase in what it’s targeting. So it creates a lot of uncertainty.

In the end, obviously, 2018-2019 saw a lot of volatility and 2018 was not a very good year for stocks. So to me, I think it’s a meaningful risk because if their real goal here is to completely recalibrate the global trade system, I mean, you’re not going to do that without creating some volatility and some turbulence in risky assets, in my opinion.

Alf (22:31.021)

Yes. Absolutely agree. So now should we try and figure out for people what is an expensive option or what is a cheap option? Of course everybody has his own methodology, but I think it’s good if we compare notes on that, right? So if I’d say, hey, Brent, you looked at various FX options going ahead of the event. How did you determine what options were cheap or expensive over a one month basis or a two week basis? So how do you go through that process?

Brent (23:03.804)

So the first thing I do is look at Delta one and say like, okay, can I do it without options just so I don’t have to pay time decay? And then usually if I’m doing an option, it’s like, I’m worried about getting stopped out or I want leverage. And so one of those two things comes into play. I mean, the first thing I’ll do is just look at where volatility is relative to history.

One interesting thing is that around events, a lot of times there’s this sort of anchor for volatility that’s realized, right? Like recent realized volatility just tends to anchor the, that’s the starting point for where the price of volatility is. So if realized has been super low, a lot of times then the implied will price in an event, but the event is just way too cheap because the realized recently has been so low that the market’s just anchored way too low.

So, I mean, essentially my approach is pretty simplistic. I’m just like, okay, if this happens, where do I think it’s going to go? And then I make a little spreadsheet of like, okay, how much money would I make if I do these various options? How much would I make if I do spot? And then how much benefit does the option give me relative to spot? And then also what are the odds that nothing happens? Cause that’s the worst case scenario for the option.

And if you do spot and nothing happens, you’re fine. So I kind of always assign a probability to the like, nothing’s going to happen bucket. Which in this case looks pretty small because, you know, something’s going to happen one way or the other. But yeah, that’s my approach is more like mapping out essentially the predicted paths and then comparing that to what’s priced in options and then seeing if it feels cheap.

Alf (24:49.454)

I like a lot of what you said. The first part that I want to clarify for people is leverage. And I’m going to try to be in your head now and explain what you meant with that. Of course, you can get as much leverage as you want via linear. I mean, you can do futures, you can do whatever you want, and you can get as much leverage as you want. But here in options, the interesting thing is that because you’re trading an additional dimension, at least one, maybe multiple, but at least one more compared to linear, which is time, you’re basically targeting a specific payoff that you have in mind by a specific point in time.

And that adds basically leverage because the downside that you get against that is that as Brent said, even if you’re not wrong, but just nothing happens because you are trading the dimension of time, if you’re long option, it means you have to be right by a certain expiry basically, then you’re getting leverage on the upside through the fact that you have to be right in time. It’s built into the option price. And in exchange you’re getting chopped up and basically you lose your premium if nothing happens. You don’t need to be wrong, right? You just unfortunately need to have nothing happening at the same time.

So that dimension of leverage, because people say there is leverage in options. Yeah, sure, there is leverage in futures too. I mean, that’s not necessarily the point here. It’s about having a specific view on the direction. Let’s assume you’re trading option for directionality here. You want to trade for the right direction and the right time dimension, which is very important.

And this I think links as well to the other point, which is… because there more dimensions, there are more ways you can make and you can lose money. In this case, nothing happens and you get stopped at the end of the T of your option, then also you lose money. But there is also a liquidity gap to consider. Because in an event like this, Brent, I mean, if you go along Dollar Canada and a guy goes on stage and says nothing for half an hour and then the whole speech is over, and where are the tariffs on Canada, by the way? Then you are going to get stopped really quick, basically.

And Dollar Canada is very liquid. But if you’re trading like more illiquid stuff, then there could be a good chance that you don’t get filled in your stock where you want it to be filled. So there is slippage. There is a liquidity gap. And with options, if you buy them, well, there is no liquidity gap, guys. You just spend the premium and that’s it. And you can go to sleep and you can say, look, I mark my book down to zero. I spent this premium and that’s it.

So there is a lot of stuff that goes on, I guess, when considering options. And now we’re even making it very simple because we’re not talking about rolling down the vol curve. We’re not talking about trading other dimensions as well, but I guess in a nutshell, that’s a start.

Brent (27:30.234)

Yeah, for me, mostly I’m doing directional plays. So that keeps it simpler. But yeah, then it gets a lot more complicated. If you’re trying to thread the needle on something more than just direction, then that can be complicated. I mean, that’s essentially it, right? It’s that you got to pick the time and the direction and the direction has to exceed what’s priced in. And so a lot more things have to go right with options, but you can sleep better and you don’t have to stop out.

So that’s the thing too, is that if there’s some scenario where you think the path will be very choppy, then it can be impossible to ride spot because you just end up getting stopped out. So it’s a complicated decision, but I feel like every single time people should always consider those two alternatives because I think a lot of times it’s just easier to just always do options, but you spend a lot of money doing that.

I mean, most professional market makers sell options. They don’t buy them. Because there’s an embedded premium in a lot of options that makes them attractive to sell. So I feel like it’s just something that should always be considered.

Alf (28:39.608)

There is a famous picture I think of a guy that has a yacht and the yacht is like called something like theta something so short theta something like that. It’s very fun right, so basically the guy has apparently bought a yacht by selling options to people who want to go long options and just by time decay you know, the world never blows up or very hardly blows up. And then if you do that consistently and you happen to live in a period when the world hasn’t blown up for five years, then you can buy a yacht, yes, you can also call it short theta. But your yacht can blow up really fast as well, that’s also the problem.

Brent (29:16.748)

Yeah, that’s the problem is it’s a very explosive yacht. We only have a few minutes left, but I wanted to just change directions for one sec, because we didn’t really talk about monetary policy. And I think it’s interesting. So in the UK, you got some comments yesterday, where the Bank of England basically said that because gilt yields are going up, that’s a tightening of financial conditions and therefore they can preemptively cut rates. Now, okay, sure. Like that’s one way of looking at it.

But then in the U S you can argue… So this is the first time where you saw a Fed cuts rates and yields absolutely rip higher. So you can argue that yields are going up because the Fed’s too dovish, but then the solution is for, for Waller to come out and say, Hey, we better be more dovish because yields are going up. So it’s kind of an interesting and circular situation where like, at what point do you think that higher yields are a reason for the Fed to either stop cutting or cut more? You can argue both sides.

Alf (30:24.174)

It’s a great point you’re making. I think you can reduce the discussion to one key point, which is the market and the Fed right here are strongly disagreeing on where the neutral rate is. Waller comes out and says, I need to cut four times this year if data cooperates, which basically means if inflation remains well behaved. So basically he’s saying, look, I think the neutral rate is like maybe 3%. So I’m at 4.25, man. I mean, I need to cut.

And the market is saying, what did you just say? You want to cut? Don’t you see that non-farm payoffs are growing and retail sales are growing and everything is great? What do you want to cut? So you’re going to basically juice up the economy. We need to add the risk premium at the long end. And we’re going to disagree with you basically on what the neutral interest rate is. Really, that is the main problem here.

Brent (31:14.586)

And you know what’s interesting about that is, do you remember the last time the market disagreed with the Fed on its primary direction was 2021, the transitory thing. And obviously the market was right and the Fed was horribly wrong there. And I wonder if it’s the same thing here where you have inflation above target 44 months in a row. You have, you know, a lot of signs that inflation expectations are not like completely anchored. They’re kind of anchored, but not completely anchored. And you have a lot of other issues with inflation potentially now that commodities are rallying. So I wonder if it’s going to be a situation where again, the Fed is incorrect here and the market ends up being correct. But I guess we’ll find out.

Alf (32:01.304)

Yeah, we’ll find out pretty soon guys. So I think that I want to wish everyone good luck for Monday and to thank you as always for listening. I want to remind you that we don’t bite so you can always send us an email, contact us on whatever, Twitter, Bloomberg, whatever you want. And I don’t know, don’t have anything to add Brent. I would say we can call it a day, come back on Friday next week and figure out how wrong we were about tariffs.

Brent (32:30.746)

Yeah, I wish everyone good luck trading next week and hopefully we’ll see something interesting. All right, ciao.

Alf (32:36.718)

Ciao guys, talk soon.