Vineer Bhansali on Losing Fed Independence as the Biggest Tail Risk Right Now

25:23Just like you would not go back home and say, well, what was the total return on my home insurance policy, right? It's just a positive negative 100%, right? Every single year. So would you quit buying insurance? You won't because home insurance or car insurance is not an investment. It is the cost of doing business. So that's the context in which one should think about tail risk hedging is it allows you to first protect yourself from yourself in the bad events. And then secondly, when the markets are down, the value of those hedges going up allows you to buy assets on the cheap, which results in compounded growth.

25:58Why hasn't Wall Street created an instrument where you can sell away your liquidity, to protect it from yourself automatically. I'm going to invest in this fund and I cannot sell until the year 2060. Isn't that called lockups? But do those funds actually exist? Could I buy that? And then there's two things that intuitively seem that A, you protect yourself from yourself. B, you diversify automatically by the fact that you're across time. And then C, presumably that would be more stable for securities lending and collect the little instrument. Has Wall Street created a fund that one can't get out of?

26:36I think, like Tracy just mentioned, hedge funds like to have lockups. I should just be able to buy an ETF that I can't sell. Yeah. I think if you can get over the regulators, I think that we are living in a world where mark-to-market daily NAV, et cetera, for ETFs and full transparency is required. But I do think, I mean, one very sophisticated institutional investor who was a client of ours actually said, I would pay you more if you sold me a product that actually had a longer lockup. Because this is a question I have about portfolios and diversification in general. And it goes back to the point that you made about how stocks have done very well.

27:11And the expectation is that as long as the economy grows, stocks will continue to do well for a while. 60-40 was a craze, right? And this was a good portfolio where your treasuries and your stocks balance out. But what is the case for diversification? Let's say setting aside the behavioral fact that people sell at the lows, what is the case for diversification when there is this asset class that does so well over time? Yeah, so this is great. So if you could guarantee that this asset class would keep growing always, then you would 100 % be on stock only. Now, what bonds traditionally used to do was they provided you with income that when the stock market wasn't doing well, at least you wouldn't go completely broke because you would have some yield.

27:53But I think it got taken to an extreme, right? I mean, the greatest example, and I wrote a whole book on this topic, is the European Central Bank followed the Japanese Central Bank, and then they started buying at negative yields. Yeah. And they convinced all the indexers to keep buying bonds with them, right? I mean, think about this. You were buying bonds, meaning you were lending somebody money, and you were paying them interest. And at that point, diversification is an insult. I mean, you don't want to buy a negatively yielding bond along with stocks because it does nothing for you. And we're living the consequences of it today because the bond market over the last five or seven or ten years even has had absolutely dismal zero returns.

28:29Joe, do you think people who want positive yielding bonds are entitled still? That was your position for like a whole year. I still think that. I still don't think anyone is entitled to yield. No, I don't. If you want to take the risk, go get it. But the sort of moral demands that the government must provide you yield for what? For not spending and doing anything? Give me a break. Joe spent a good year making fun of yield bugs, as you call them. That's great. Go out. Collect your yield. I'm happy for you. But don't pretend that it's some sort of moral insult that the government isn't providing you risk for yield.

29:00That is my only stance. Yeah. That's, I would argue, the U.S. government's most important role. Anyway, let's go back for a second. So it's not just the insurance idea. You touched on this, but it's also the idea that like you can get a massive windfall when there's a market crash and then you can use that money to actually go on a buying spree at a time when markets are cheap and everyone else is, you know, short on cash and they can't do the same. How do you actually deploy that into practice and how do scale, for instance, an expected windfall against the type of assets that you could potentially buy?

29:34Yeah. I think this is where the first principles thinking becomes really important. So you have to look at every portfolio is different, right? So one of the other mistakes I think people make is they think you can just pick up a finance one-on-one book and say every portfolio is identical. It's all risk neutral and everybody's exactly the same. It's just not the case. Public fund that has a 40 % or 50 % funded ratio is very different than a 90 % or a bank that's 120 % fully funded, right? So everybody has different needs. The first thing that you do is you look at the underlying portfolio's posture.

30:05How much loss can you take? Look at the systemic risk shocks that they can actually withstand. So you run a shock, you run a full distribution analysis and figure out what is the outcome under which they will be under so much distress or so much duress that they might end up having to liquidate assets. And there are actually quite a few like that right now, where if the stock market went down 20 % and privates went down about 20%, in order to raise liquidity for distribution, they would have to actually sell seed corn, right? So it's really, really bad. So that's an existential risk that you want to quantify.

30:40So the first thing that you do is you figure out what that risk is, a full distribution of outcomes. And then you look at the instrument set that's out there in the marketplace, starting from the most reliable and surprisingly enough, like Joe mentioned already, the cheapest one, which is equity option volatility. You can buy those put options. But people who are not willing to pay a lot of continuous premium, you can do more sophisticated tricks where you can buy indirect hedges. For instance, credit default swaps today, the CDX index, if you don't see the charts, it's actually tighter than it was pre the GFC.

31:14It's the tightest it's ever been because people are buying it for cosmetic yield reasons. So there are a lot of derivative instruments out there. What's cosmetic yield? Cosmetic yield simply means that the total yield, if you look at the yield of a corporate bond today, it is basically treasury yield plus some spread. So the treasury yields are at, call it four and a half, 4%, but the spreads are actually very tight, only 50 basis points on the CDX. So you're getting a 5%, 6 % yield, which in the context of where we were three years ago, it looks like an enormous Cosmetic. It's cosmetic. I see.

31:44It looks good. It looks good. But it's actually, you are taking too much risk. Okay, keep going. Yeah, it's a cosmetic yield. Your decorated yield. Yeah. So to me, the yield is not justified by the risks that are underlined. But there's various instruments that you can use and create a portfolio of these types of hedges.

32:15For enterprise organizations, managing all your food needs is a tall order. But with EasyCater, you get a single workplace food vendor with the tools and resources to make it easy. Giving teams across your organization an easy way to order from a huge variety of restaurants, all on one platform. All while consolidating your corporate food spend so you can control costs, streamline billing and payment, and simplify reporting. EasyCater, your business tool for food. To learn more, visit easycater.com slash podcast. You're thoughtful about where your money goes. You've got your core holdings, some recurring crypto buys, maybe even a few strategic options plays on the side.

32:57The point is, you're engaged with your investments, and Public gets that. That's why they built an investing platform for those who take it seriously. On Public, you can put together a multi-asset portfolio for the long haul. Stocks, bonds, options, crypto, it's all there. Plus an industry-leading 3.8 % APY high-yield cash account. Switch to the platform built for those who take investing seriously. Go to Public.com and earn an uncapped 1 % bonus when you transfer your portfolio. That's Public.com. Paid for by Public Investing. All investing involves the risk of loss, including loss of principal.

33:36Brokerage services for U.S.-listed registered securities, options and bonds, and a self-directed account are offered by Public Investing, Inc., member FINRA and SIPC. Crypto trading provided by Backed Crypto Solutions, LLC. Complete disclosures available at public.com slash disclosures. How can you grow your business from idea to industry leader? Bring your vision to life with smart business buying tools and technology from Amazon Business. From fast, free shipping to in-depth buying insights and automated purchase approvals, They deliver everything you need to achieve your goals. It's not easy to stand out from the crowd.

34:08Simplify how you stock up to get ahead. Go to AmazonBusiness.com for support. Is tail risk hedging like insurance from a structure of how people buy it? Is it like insurance where people sort of reload every year in a sort of, okay, start of the new year, what is the tail risk I want to put on, etc., something that renews and they have to keep paying a fee? Or is it just sort of something that can be set it and forget it, a permanent allocation that's sort of the tail risk hedge? Like talk to us about the business of selling a tail risk hedge. Yeah, definitely. So it goes up to the highest level where this becomes part of where you guys started portfolio construction.

34:48It's an asset allocation decision. It's not a trade. So the context has to be that if the agents are all lined up, meaning boards and trustees and so on, they think of this decision as protecting the portfolio or making a more robust portfolio as part of the DNA. And the tail risk becomes part of how you rebalance your portfolio over the long term. Okay. So that's how you set up the strategic portfolio. But then to your point, every year, yes, you have to renew this policy. You have to recommit premiums. Now you can pre-fund for the next five years if you wanted to. But because options decay, in order to have this reliable hedge, you sort of have to buy new options.

35:28Yes. What would be the worst kind of tail risk hedging in your view? Is it too expensive or does it not actually work when there is a big market crash? What is the ultimate sin of a tail risk strategy? Ultimate sin absolutely is the one which promises to work but doesn't work, right? So a lot of people try to reduce your costs by creating synthetic strategies, right? I already mentioned futures markets aren't very deep when you need them. But there's a lot of strategies which actually use a futures replication strategy, like the 1987 crash also purported to do. And those strategies typically don't work.

36:01And so there's many that promise and they look like they are cheaper and they don't cost any bleed, but they also do not deliver. Which again, going back to April 2nd, the only thing that worked during that April 2nd to April 8th period was reliable hedging using index options. Nothing. Duration didn't work. Trend following didn't work. A lot of other alt-risk premium strategies didn't work. So that is the cardinal sin. You just do not have the luxury to go to the constituents, your clients, whoever's bought it and said, you know, we were trying to be too smart and oops, it didn't work. As you mentioned that to even talk about buying a tail risk hedge, you have to sort of understand is what is the existential risk for the fund?

36:46And different funds have different flavors of existential risk depending on how funded they are. And so obviously, an entity that's 120 % funded is going to have very different risk scenarios than one that's 40 % funded. But you said something interesting, which is that, and I've been thinking about this a lot in a different context, which is how levered is the financial system or the real economy to an ongoing rise in the stock market? How important is that? And at what point does even a sideways stock market, let alone a decline, become risky for something that could break. And we used to think credit is the thing that breaks.

37:20But I wonder if it's in the stock area thing now where you really get the problem with the equity values don't go up. Tell us more about what you said about what happens to various types of economically important players if the stock market one day stops going up for a sustained period of time. I think you have a big problem, right? So not only is the stock, the whole system, 401ks and public pensions, they're all levered up to the stock market because that's the only way you can get to your 7.5 % or 8 % actual yield. So if the stock market doesn't keep going up and keep delivering those kind of returns, it's very hard to get to that point.

37:53Maybe if inflation rises, at least, again, cosmetically, maybe the long bond gets up to 7 % or 8%, and everybody can just lock it in and immunize, and you're there. But in real terms, you're not going to have the income that you need 30 years from now to retire. I'm fine. I have a Zerpira mortgage. So I have a mortgage that's locked in from that one sweet period of time. Yeah. Exactly. So the system is very levered. And then corporate credit, clearly, is very, very concentrated. We all read about payings and so on. But corporate credit, based on the Merton model, again, that connects equities to corporate credit spreads, is also levered to the stock market.

38:27So the stock market suddenly had a big sell-off. Corporate credits widen out, which is the real problem, right? Because if corporate credit widens out and the cost of borrowing goes up for all the corporations, maybe not the FAANG stocks, but the 493 other stocks, then how does the system produce? Because our whole system is based on borrowing. And I don't think very many companies in the US can function if your cost of operating your business was 10 % a year. Okay. Well, on that note, we would be remiss to have a tail risk person here and not ask, what's the big risk that you see on the horizon in, let's just say, the short to medium term?

39:07I think for me, the biggest risk right now is what people have been talking about is the so-called, and I call it so-called Fed independence paradigm shift, because I don't believe the Fed was ever really fully independent. But now it's coming to the fore that the fiscal and monetary authorities are actually one. So, what happens in the aftermath if the Fed actually becomes part of the central government, the fiscal authorities? I think at that point, all bets are off, because that's the one anchor that everybody, whether realistically or not, has held onto. But if interest rates can change just based on the need to finance something, that totally upside downs the financial system.

39:48So to me, that's the single biggest risk right now. So would that materialize into an inflationary risk, for instance? And then would you be focused on what you can do to offset that? Yeah, inflationary risk. And I think one of the best option trades, again, this is not a direct option. So going back to what you were asking before, you don't always just have to pay premium. The yield curve steepener, where you buy the short end of the yield curve and you sell the long end of the yield curve. Today, you can do it through using swaps and all that for essentially zero net carry. So here's an option, very similar to shorting the negatively yielding bond market in Europe a few years ago, where if you put a yield curve steepener on, either in a hyper inflationary, maybe not hyper, but a high inflationary scenario, or in an aggressive Fed cut, the yield curve steepens.

40:33So yes, so that environment is an environment in which the curve steepener could work. And yes, my zeroth order prior forecast would be that if we lose explicit independence of the Fed, the yield curve actually steepens a lot more. Something I'm interested in, so you were talking about the recent eras and the 60s and 80s, and things may have gotten a little unglued, and then the Volcker era, and then the post-COVID era, and now this question about whether what's left of Fed independence is at risk. You know, you're a physicist, and a lot of people in your space are mathematicians. Is there a limit to how much you can sort of math it out, so to speak?

41:13Because a lot of these questions are external to mathematics. And so how do you think about the limits of quantitative analysis when we're dealing with things like, will the political system allow the Federal Reserve to remain independent? Yeah, I think a lot of it is actually non-quantitative. And what I've learned, even though I come from a quantitative background, is not the math itself, but it's the sequence of logical arguments that you can make to get to a conclusion, right? So, for instance, we knew even before fancy mathematics was discovered, Lagrangians and so on, that gravity exists.

41:45Gravity's existence has been known before maybe math was invented, But gravity has been there. And so I think there's some central laws of finance which will still continue to exist regardless of the mathematical modeling of them. And Bill Gross, when I used to work with him, he used to say, some things we can take for granted, I'm paraphrasing it, but the steepness of the yield curve, the fact that the yield curve needs to be upward sloped for the financial system to function because people lend money in order to get something in return. Those are not mathematical devices. Those are really just the way the capitalist system works.

42:19So I think you can take the quantitative modeling to its own limit, but there are certain things that have happened in our system where we are at a point now where gravity, so to speak, of the financial markets are going to have to take over. But presumably also, if you can't predict the politics, because it's very difficult, especially nowadays, if you can't predict the politics, then maybe right-sizing your positions becomes more important. And so the maths actually becomes one way of dealing with the very uncertainty, non-mathematical element of what's going on. Yeah, exactly. And I think to take that point one step further, so correlation has been the greatest gift since the mid-80s to 2020, right?

43:01So you got stocks and bonds, just say it's 60-40. Stocks went up, bonds went up, and they were diversifying, which is what a beautiful place to be in, right? That sounds nice, yeah. So that was a freebie. And again, this goes back to financial gravity, just so to speak. That state of affairs, that free lunch should not exist. So I think we might be entering a phase where stocks and bonds maybe are actually not diversifying. And you have to look at other things. Gold, of course, as you mentioned, maybe Bitcoin. Who knows? But I think the fact that reliable insurance or portfolio protection is so available today using the options market, to me, would be the place where I would look.

43:36When you look at the long end of the yield curve today in the U.S., is there an element in which these concerns about the loss of Fed independence are being priced in right now? If suddenly you could snap your finger and know for a fact that the Fed will operate as it has been for the last 20 years, for the next 20 years, would there be a change? Is there some margin that's concerned there? You know what? I don't know if the Fed is going to be a committed inflation fighter as well it has been in the past. Therefore, I'm demanding extra yield today. No, not yet. I don't think so. Maybe a slight amount of premium has gone up, but one of the most striking features of the system is that if you look at the treasury yields, look at the 30-year bond today is 470, but you look at the 30-year interest rate swap, it's trading at, believe it or not, 389, right?

44:24So it's almost 85 basis points under the US treasury. Now you ask, why would somebody take the swap market at a lower yield? And I've been trading swaps since its inception back in the 1990s. Swap spreads are negative 85. And that goes back to the receiving of interest rate swaps to hedge liabilities by a lot of large institutions. So they have certainly not priced in inflationary effects into the swap market. But at some point, this has to also equilibrate. So in my view, it has not been priced in. Maybe it's too early to price in because maybe The Fed does not lose its independence and, you know, rises its phoenix from the ashes.

45:04But I'm a little bit pessimistic about it. Just going back to your storied career on Wall Street for a second, how good were you at playing Liars Poker? I was actually pretty good. I think, I mean, I learned it after I joined Salomon Brothers. It was a good group of people. And I think the first year maybe I lost a bit. But I think in the third year that I was there, I won it. And I was actually, I think, the one who took the biggest pot. And also, my boss gave me his 18-foot fishing boat. He was buying a new one as part of the settlement. Oh, in lieu of cash. He was like, here, take my own. Well, cash plus the boat.

45:40Wow. So, yeah. That's a really big pot. That was a big pot, yeah, at that point. We used to spend, after the trading day was over every day, we would print out randomized Liars poker sheets, usually about 24 or 30 of them, and we'd play about 30 rounds every day. Wait, Liars poker sheets? I thought you played with actual cash. Yeah, so actual cash, you play with dollar bills, but if you're playing 24 rounds, there are not enough dollar bills flying around. I never thought of that. Yeah, so you randomize based on how the dollar bill numbers are generated. Is there going to be a future in finance for a young physics student or a math nerd in high school today, you know, people worry about this with AI and so forth, but a young person who's quantitatively minded, do you feel confident that there will be a role for them in finance in the future?

46:27Absolutely. I think finance has existed from the very, very beginning because it's based on the two fundamental emotions, right? Greer and fear, right? So as long as there's greed and fear and there's smart people around, and again, going back to math and physics, it's not so much that the toolkit itself is teaching you anything special. It's just that it teaches you thinking in a discipline, logical fashion. And I think with tools like what we're seeing with AI and so on and coding becoming completely democratized, I think the ability to ask important questions rigorously becomes even more important.

46:58I think it's going to be even better than it's been. Vaneer, that was absolutely fantastic. Thank you so much for spending time with us at Huntington Beach at the Future Proof Conference. And that was great. Yeah, thank you so much. That was fantastic. Thanks for having me.

47:24Joe, that was really fun. We should have a mirror back and just do, like, stories from Wall Street in the 1990s episode. Let's just do that. I love the stories. We could do a lot more on the stories. And I'm also interested in, like, basically, you know, the philosophy of portfolio construction. I mean, obviously, there's the math of portfolio construction, but I do have a certain dissatisfaction with many conversations about portfolio construction, including this. In what sense? Well, diversified stocks have almost always gone up. I mean, I guess another question that I could have asked is, has every insurance contract on the stock market essentially so far been a waste in human history because the stock market is at all-time highs?

48:03I have questions about that. But the counterpoint to that is, and I've come to realize this as I get older in my life and in my portfolio, is there is something nice about waking up during a sell-off and going like, oh, shoot, my 401k has been absolutely decimated today. But if I look at some other position or some other tail risk hedge that I have, that's actually up a little bit and it's offset some of the pain. And if I actually had to cash out of my portfolio on that day because of whatever, I had to make a mortgage payment or whatever, then I would have some extra cash to spare. And you could get an extra return by having that extra cash available to you to then go into the market and buy stuff on the cheap.

48:43I think that we really should have an odd lots ETF that advertises its illiquidity, that you can't sell this. If you need cash now, this is not the instrument for you. If you are putting your money in this, don't expect to see it again for 30 years. But the plus side is it will keep you from making bad, irrational decisions on a day when everything is rad. I mean, there's a value in that. There's a value in that. And there's also a value in being able to sleep at night a little easier because you have different positions. But anyway, shall we leave it there? Let's leave it there. All right. This has been another episode of the All Thoughts Podcast.

49:16I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Joe Weisenthal. You can follow me at The Stalwart. Follow our guest, Veneer Bonsali. He's at Longtail Alpha. Follow our producers, Carmen Rodriguez at CarmenArmand, Dashiell Bennett at Dashbot, and Kale Brooks at Kale Brooks. For more OddLots content, go to Bloomberg.com slash OddLots. We have a daily newsletter and all of our episodes. And you can chat about these topics 24-7 in our Discord, discord.gg slash OddLots. And if you enjoy OddLots, if you like it when we talk about portfolio construction, then please leave us a positive review on your favorite podcast platform.

49:52And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening.

50:34For enterprise organizations, managing all your food needs is a tall order. But with EasyCater, you get a single workplace food vendor with the tools and resources to make it easy. Giving teams across your organization an easy way to order from a huge variety of restaurants, all on one platform. All while consolidating your corporate food spend so you can control costs, streamline billing and payment, and simplify reporting. EasyCater, your business tool for food. To learn more, visit easycater.com slash podcast. This is Tom Keen inviting you to join me for the Bloomberg Surveillance Podcast. It's about making you smarter each and every business day.

51:16We bring you a recap of what happened overnight in Europe and Asia, the day's economic data, and complete coverage of the U.S. market open. We cover stocks, bonds, commodities, currencies, even crypto, all the information you need to excel. Bloomberg Surveillance also brings you the analysis behind the headlines. We do that with lengthy conversations with our expert guests, The smartest names in economics, finance investment, and international relations. We do all this live each and every weekday that bring you the best analysis in our daily podcast. Search for Bloomberg Surveillance on YouTube, Apple, Spotify, or anywhere else you listen.

51:58On the East Coast, listen at lunch, and on the West Coast, when you wake up. That's the Bloomberg Surveillance Podcast with me, Tom Keen, along with Paul Sweeney and Lisa Mateo. Subscribe today wherever you get your podcasts.