1st Year Macro HF Analyst: My Macro Framework
I did a Q&A a couple weeks ago (Q&A: First year macro hedge fund analyst | Wall Street Oasis) where I promised some people I would go more deeply into my macro view and provide some resources that I've found helpful. This is that thread.
I focus pretty heavily on how the monetary/banking/financial system functions from a high-level, what are the goals, incentives, and motivations of the major players, and how that drives capital flows across geographies and asset classes. This means understanding the activities and motivations of the largest banks (GSIBs) and Primary Dealers and how their behavior changes in response to financial/economic conditions and also how their behavior reflexively causes changes in financial conditions.
I spend a lot of time on this because leverage and credit cycles drive peaks and troughs in the real economy, especially since the financialization of the US during the 1970s and 80s.
It's also important to have a good understanding of how the financial system connects to and interacts with the real economy and where it does not. Equities, for example, are only very loosely (if at all) tethered to the real economy, whereas the rates, credit, and commodity markets are much more directly connected to real economic activity. Within each asset class you have some assets which are more idiosyncratic and some which respond more strongly to macro factors.
Copper tends to be significantly influenced by global economic growth/inflation conditions while uranium tends to be more idiosyncratic. Corporate credit can be both idiosyncratic (i.e. individual company solvency issues) or can be systemic (wave of corporate defaults due to the inability to roll financing). Rates tend to be the most closely tied to actual economic/financial conditions of any asset class because they're the foundation of the risk-free rate/opportunity cost of capital and influenced by economic growth, inflation, central bank policy, money creation/destruction, you name it.
It's Difficult Trying to Be a Jack-of-All-Trades
I tend to stay away from the nitty-gritty details of any singular asset or asset class, aside from US Treasuries for the reasons I discussed above. It's too difficult trying to be a jack-of-all trades (i.e. trying to get a handle on copper, oil, uranium, cyclical equities, that one junk bond issuance, the AUD/JPY exchange rate, etc.) and USTs sit pretty much in the middle of the global financial system. By understanding UST rates and a few related markets really well (Eurodollar futures, , FX swaps, etc.) I find tends to give you a pretty good handle on what is generally going on regarding financial flows and economic conditions. You can then make inferences based on what these markets are telling you.
For example, declining UST yields combined with a rising USD against EM currencies is a deflationary signal because it implies that global banks are stepping back from USD intermediation in the riskiest economies first (i.e. the supply of USD is falling while demand remains roughly constant). This will tend to lead poor economic conditions in developed economies by several months. Furthermore, it's often a negative signal for risk assets in financial markets because it often means that collateral terms are being re-negotiated (high-quality collateral is catching a bid and leveraged structures are being threatened). If you were pledging Italian bonds in May 2018, they're getting rejected and now you gotta scramble to find collateral that won't be rejected (i.e. German bunds or USTs). That cascades into dealers re-evaluating risk positions across the globe which leads to a reflexive tightening of financial conditions. As dealers tighten risk management, financial conditions become more inelastic, which makes financial conditions look more bleak, which triggers more risk management, so on and so forth.
What does this look like in practice?
More specifically, I pay a lot of attention to the collateral system, meaning the repo market and related activities including securities lending, collateral transformation, OTC derivatives trends, etc. This includes both domestic repo like tri-party repo/FICC cleared GCF/sponsored repo as well as the larger global uncleared bilateral repo and securities lending market. What type of and how much collateral dealers are willing to accept (and repledge) and at what haircuts basically determines the amount of leverage that can be sustained in the financial system.
I try to figure out based on the activities of large banks/dealers (as well as various market indicators) if we are in a reflationary or deflationary regime. Basically, as a result of permanent changes in financial market participant behavior (primarily banks and dealers) after the GFC as well as due to Dodd-Frank/Basel III regulations, our economy hasn't really been able to recover since 08 – meaning the trend in growth of the labor market, economic growth, you name it (even more esoteric datasets like labor force dynamism, business establishment turnover, payments through the correspondent banking system) has been broken. It's still growing, but just far more slowly than before. This is far too nuanced and complex to get into here, but its not primarily due to demographics issues, global debt levels or any of the other commonly used explanations.
In fact I think that tight financial conditions are driving poor economic performance and causing our demographics and debt issues. Demographics drive long-term economic potential, no question, but people don't realize how reflexive demographics are. People stop having as many kids (in developed markets where children are not a source of labor) during poor economic environments. Economists and policymakers were equally as concerned about the negative or flat rate of population growth in the 1930s because everybody stopped having kids because they were just focused on trying to survive. The fear about negative population growth in the 1930s seems quaint now. We also had a similarly stifling debt burden after WWII. What happened? We grew our way out of it.
"Balance Sheet Expansion" in Order to Facilitate Economic Growth
The problem today is that we went from having a very elastic/liberalized monetary system to one which is extremely inelastic and repressed. This in and of itself isn't necessarily a bad thing, but the problem is that the financial system we've developed since the 1950s relies on continued bank "" in order to facilitate economic growth. If you take those things away without fundamentally restructuring the system, you're just left with a neutered banking system which drags on economic performance. The analogy would be something like: 1950s-2007 financial system was like a Ferrari that ran on high-octane fuel. Fast, efficient, but ultimately unstable.
Post-crisis behavioral changes and regulations have taken away the high-octane fuel and replaced it with low-grade fuel because it's safer, but now we're just trying to drive a Ferrari with shit fuel and no one is willing to try to switch out the Ferrari because it's too much work, so we're stuck trying (unsuccessfully) to switch to a low-risk financial system without fundamentally restructuring and reshaping the framework of the monetary system itself to deal with the problem of overreliance on central intermediaries (GSIBs, Primary Dealers, etc.). The Fed's trying some stuff now on the margin – standing repo facility, possibility of UST central clearing, etc. – that is attempting to regain control over the system and disintermediate primary dealers, but I'm not terribly optimistic. I think the whole system probably needs to be redesigned from the ground up.
The "Secular Stagnation" Theory
This is the cause of the "secular stagnation" theory that was popularized by Larry Summers in 2014. It's not a coincidence that Japan has had zero growth since their banking crisis in 1989, Europe has been screwed since 07-08, but especially since the European sovereign debt crisis in 2011-12, China has been falling off growth trend since 2015 (CCP is struggling to hit their 6% GDP growth target even with massive state-driven fixed asset investment) when the EM US dollar shortage hit, and the US economy has struggled in fits and starts since 07-08. A functioning money and banking system is absolutely essential for economic growth. A broken monetary system plunges economies into depressions, just like in the 1930s. The only difference is that this one is a "silent depression" because we don't have 25% unemployment – it just shows up in statistics like labor force participation instead.
Understanding the Banking System - The Hierarchy of Money
I borrow and extend a concept from Perry Mehrling and Zoltan Pozsar called "The Hierarchy of Money" to understand how all these different payment systems link up. Basically, reserve balances are liabilities of the Fed and money for banks. Bank deposits are liabilities of banks and money for individuals and businesses. Physical currency is the only final settlement mechanism that can be held by anybody (banks/businesses/individuals). If you buy something using bank deposits, reserves will be transferred via Fedwire/CHIPS to the person's bank that you bought the goods/services from. Banks facilitate the net payments of everything in the real economy and financial system. Now, there's basically no distinction between deposits and physical currency – but it is very important to understand that bank deposits are only an intermediate settlement mechanism, not a final one. This is why bank reserves matter. The Great Depression can be summarized as banks having issues in the intermediate layer of the money hierarchy (deposits were not easily convertible to physical currency).
However, financial market participants (banks, dealers, MMFs, HFs, asset managers, FX reserve managers, sovereign wealth funds, other supranational entities) have large cash portfolios which they tend to not like to hold in bank deposits, because insurance limits only cover so much (in the US the FDIC covers $250k, for other countries its similar). So, for the financial system, collateral (generally high-quality collateral i.e. highly rated sovereign bonds like USTs, UK gilts, German bunds, JGBS, etc.) takes on a role analogous to bank reserves. Agency- generally considered high-quality as they have the explicit backing of the US government, but are not as liquid or reliable as USTs. During reflationary periods when dealers are feeling bold, other types of collateral becomes acceptable (albeit a higher haircut) including IG corporates, HY corp, private-label , etc.
The Importance of Collateral
Since the GFC, basically nobody is willing to lend unsecured anymore (just look at the actual transactions that comprise or the LIBOR-OIS spread since Lehman). If you don't lend unsecured, that means you're lending secured and collateral is paramount.
Repo facilitates credit creation in the financial system and is a derivative claim on collateral analogous to how deposits are a derivative claim on the monetary base (i.e. bank reserves and physical currency). The conversion of repo collateral into further money/credit creation in the financial system (through repledging) is constantly in flux depending on the perceived quality and liquidity characteristics of the underlying collateral and general market conditions, giving rise to a "collateral multiplier" which is analogous to the deposit multiplier. Just like in the Great Depression where there were issues with conversion of the convertibility of deposits into the monetary base due to a lack of effective government backstop, today there are intermittent issues with the conversion of repo liabilities into the collateral base.
The fluctuations in the expansion/contraction of this collateral system drive reflationary/deflationary conditions in the broader financial system and global economy by facilitating or hindering the extension of credit by changing funding availability to financial intermediates throughout the globe. If funding is more expensive or less plentiful to financial intermediaries (banks, dealers), this trickles down to all other entities in the economy, because all other entities (businesses, hedge funds, individuals, etc.) depend on financial intermediaries for the extension of credit.
Just Because Credit is Cheap Doesn't Mean That It's Widely Available
In this respect, low interest rates can actually be indicative of monetary tightness in the real economy (Milton Friedman's interest rate fallacy) because everyone conflates the price of credit with the volume of credit. Just because credit is cheap doesn't mean that it's widely available – banks may only be lending to low-risk counterparties and prioritizing liquidity above everything else.
That's a super quick, very high-level overview of how I generally think about markets. There's far more than I could ever fit into a post here, but I tried to hit on the main points as concisely as I could. If anyone has further questions, I can try to clarify.
Here are some resources that I have found extremely helpful in formulating my views:
If you only read one thing, this should be it. It's a powerpoint appendix to a paper he wrote for the US Treasury Office of Financial Research called "Shadow Banking: The Money View" (which is also worth reading in its own right), but this is the most comprehensive walkthrough of how the financial system works that I've seen ever seen. You might have to go through this 10 times before it finally starts to make sense, but if you can start to understand this, you're 50% of the way there. He also came out with a more updated version when he called "Money Markets after QE and Basel III" but that one is more specific to STIR (I definitely recommend going through if you're interested).
Since moving to Credit Suisse, Zoltan has done a long series called "Global Money Notes" (I think there's 31 issues in total) and a shorter series called "Global Money Dispatches." I highly recommend both, but they're a bit more advanced, so make sure you have some of the basics down first.
Manmohan Singh, Collateral Markets and Financial Plumbing 3rd edition.
This is a book that's a compilation by various papers from Manmohan Singh, who's one of the experts on global collateral markets. It's a bit dry, technical, and long, but I have yet to see another academic or market participant with such a deep understanding of the nature of collateral use in financial markets. If you're too cheap to buy the book you can get many of his individual papers online for free from the IMF:
- ft/wp/2010/wp10172.pdf">"The (sizable) Role of Rehypothecation in the Shadow Banking System" 2010
- ft/wp/2011/wp11256.pdf">"Velocity of Pledged Collateral" 2011
- "Money and Collateral" 2012
- "The (other) Deleveraging" 2012
- "The Economics of Collateral Chains" 2012
- ft/wp/2013/wp1325.pdf">"The Changing Collateral Space" 2013
- "Pledged Collateral Market's Role in Transmission to Short-Term Market Rates" 2019
This is a new book that just recently came out written by a former trader on the FRBNY's open markets desk. I don't agree with everything that he says regarding the all-pervasive strength of the Fed (central bankers gonna central bank), but he's able to distill a lot of very complicated topics into simple and understandable language in a way that I haven't seen elsewhere. Probably one of the easiest reads on this list but doesn't sacrifice any rigor or accuracy.
James Sweeney at Credit Suisse did a series on shadow banking/collateral from 2009-2013.
You can get these for free:
- "Long Shadows: Collateral Money, Asset Bubbles, and Inflation" 2009
- "Long Shadows: The Sequel"
- "When Collateral is King" 2012
- "Liquidity Required: Reshaping the Financial System" 2013
Sweeney's papers are great – Zoltan now works on this guy's team.
Most of the stuff written by Hyun Song Shin and Claudio Borio at the BIS is fantastic. Some of my favorites include:
- "FX Swaps and forwards: Missing global debt?"
- "The dollar, bank leverage, and real economic activity"
- "The dollar exchange rate as a global risk factor"
- "The failure of covered interest parity: fx hedging demand and costly balance sheets"
In terms of a high-level overview, it's a bit outdated, but you can't do better than Stigum's Money Market. It's a 1,000-page epic that covers basically all of the important players and instruments in the money markets and much more. Essential for understanding the "behavioral" element of finance since it extensively uses interviews with practitioners (kind of like the series but exclusively focused on money markets). I've read all versions because I focus very heavily on economic/financial history so I like to see how the monetary/banking system has evolved, but the most recent one was published in 2007.
If anyone is interested in economic or financial history, my personal favorite book is Financial Innovation and the Money Supply by T.M. Podolski. It was published in 1986 and is out of print now, but it perfectly captures the significance of the financial innovations happening in during the 1950s-1980s.
Another great paper on economic/financial history is "The Eurodollar Revolution in Financial Technology. Deregulation, Innovation, and Structural Change in Western Banking in the 1960s-70s" by Stefano Battilossi at the University of Madrid.
Those are all the great sources I can think of for now, and it should be a good 6 months to work through all of this.
I got a lot of requests for the twitter accounts that I like and follow so I'll list some here as well:
@fedguy12 (this is the guy who wrote Central Banking 101 – he has a great blog too)
These are all that I can think of off the top of my head, but this should give you a good start.
Edit: Formatting and added hyperlinks for materials.
Edit 2: I wasn't going to promote my own stuff, but I had a couple people ask. If anyone is interested, I post a lot of my own views on twitter (@Maroon_Macro) and I also write a newsletter where I share some longer/more nuanced views. My PM takes after Ray Dalio/ Cathie Wood's model a bit (unique openness, transparency, etc.) so he encourages me to share my non-proprietary views online to debate/find weaknesses/look at other perspectives/etc.