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Monday, February 21, 2022

Geopolitics And Uncertainty

At the time of writing, there are considerable fears about the diplomatic situation between Russia and Ukraine. One complaint I have seen multiple times that people were annoyed that macro analysts were opining on the topic, despite a lack of qualifications in international relations. Although that might feel satisfying, the reality is that macro analysis is quite literally the analysis of everything going on in the world, and so you have little choice but to have opinions on a wide range of topics. Although one might hope that one can focus on technical issues within markets (essentially, relative value analysis), but even there, it is very difficult to avoid macro.

From a theoretical point of view, we get back to the issue of uncertainty versus randomness. Even if someone tried attaching a probability to a war, estimating the economic effects is an intractable problem. We have no hope of attaching a probability distribution to all possible future states of the world — which is a core assumption of neoclassical theory. Instead, we need to make decisions in the face of radical uncertainty.

(I am in the process of doing some SFC models work, so I only have time to put out this quick piece.)

Avoiding Macro is Hard

We can divide investor positioning/analysis into two classes: directional versus relative value. In fixed income, directional trades start off with outright exposures to duration, breakeven inflation, “aggregate” credit spreads, and volatility (e.g., being net short/long optionality). In practice, most of these risks are taken at the asset allocation level; portfolio managers mainly execute relative value trades within risk parameters set by investment mandates (other than the standard tactic of overweighting credit risk or callable mortgages).

The people in fund marketing sell the hope that relative value trades have payoffs that are not directional. Within fixed income, if we interpret “directionality” extremely literally, that would be true. However, in practice, a lot of “relative value” trades end up being directional.

The simplest example to understand are slope trades. Since these trades are normally neutral in a DV01 sense, they are immune to parallel shifts to the curve. If we define interest rate directionality as being parallel curve shifts, they are thus neutral. However, the entire premise of PCA analysis (background article) is that curve shifts are rarely perfectly parallel. If you look at the all the pontifications about curve slopes and recession risk, we see that yes, there is a macro component to slope trades. We need to move towards three-legged trades (butterflies) to get to trades that have less empirical sensitivity to the direction of interest rates.

If we move away from pure rates products, analysis is more complex. But as the Financial Crisis showed, a lot of “sophisticated” relative value trading ended up being investors taking positions against risk factors that they were unaware of.

The classic example was the craze for “two guys, a Bloomberg terminal and a spreadsheet” quantitative credit funds. They were using the amazing new Gaussian copula theory to extract value from complex CDS trades. Unfortunately, all of their trades ended being correlated to the same risk factors, and all blew up at the same time. Anyone familiar with Hyman Minsky’s analysis of “financial innovation” is not going to be surprised.

The only way to avoid being caught up in macro developments is investing in small, out-of-the-way assets. This is easy to do as a retail investor or a small fund. Fixed income is a scale business, and trade sizes are large. You might be able to find somewhat uncorrelated assets (e.g., illiquid USD high yield bonds), but the portfolio is still likely to have some directionality with respect to overall yields. What you are hoping for is that your added value is large relative to that directionality across the cycle.

In summary, investors who think they have no macro exposure quite often are just unaware of what macro risks they are running. Even though uncorrelated relative value trades are the Holy Grail of investment management, you need to understand the environment you are operating in.

Russia and Ukraine: No Idea

Despite my Ukrainian heritage, I have limited attachment to the old country, and have not followed developments. To what extent I have an analytical bias, I used to read international relations theory during the good old days of the Cold War. I am in the realpolitik camp, and view war as a continuation of politics by other means. Although we do have instances of countries just absorbing other countries because they can, the usual reason for a war breaking out is that one or both sides have made a mistake in assessing the situation. 

Canada Protests: Mopping Up

The unlawful protests in Canada have wrapped up, although people are still hopping mad. My expectation is that this will just morph into mudslinging and somewhat legal protests that only the protesters will care about. Blockades in Ontario appear unlikely, although border crossings in the West may get periodically blocked. As such, the economic impact should be close to nil.

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(c) Brian Romanchuk 2022


  1. I have yet to encounter a logical, coherent reason for a Russian invasion of Ukraine. That doesn't meant that they won't -- it just means that if they do they're stupid (as far as I can tell).

  2. 《Unfortunately, all of their trades ended being correlated to the same risk factors, and all blew up at the same time.》

    Couldn't AIG have handled it, absent the irrational, spreading panic that arbitrarily and emotionally devalued perfectly safe assets held as collateral?

    《SFC models》

    From a previous blog:

    《The algorithm assumes that the flexprice variable is strictly positive (like a sensible price).》

    Can you model bond specials?


    《A special is an issue of securities that is subject to exceptional demand in the repo and cash markets compared with very similar issues. Competition to buy or borrow a special causes potential buyers in the repo market to offer cheap cash in exchange. A special is therefore identified by a repo rate that is distinctly lower than the GC repo rate (see question 8). The demand for some specials can become so strong that the repo rate on that particular issue falls to zero or even goes negative in an otherwise positive interest rate environment. The repo market is the only financial market in which, historically, a negative rate of return has not been unusual.》


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