This is an edited transcript of our podcast episode with Lindsay Politi, published 17 March 2023. Lindsay is Head of Inflation Strategies at One River Asset Management. Lindsay began her career at Wellington Management in Boston where she was head of Global Inflation-linked Investments. In that role she was one of the top TIPS managers by assets, managing over $10 billion in dedicated assets, with a top quintile track record for excess in her peer group. She then joined Tudor Investment Corporation in Greenwich as a discretionary macro investor, translating her inflation strategy onto a macro hedge fund platform. She then joined One River Asset Management in 2018. In this podcast, we discuss reframing the bank crisis as a duration bubble, that the current crisis is more about liquidity than credit, how inflation distorts time, and much more. While we have tried to make the transcript as accurate as possible, if you do notice any errors, let me know by email.
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Now onto this episode’s guest, Lindsay Politi. She is the head of inflation strategies at One River Asset Management where she joined in 2018. Lindsay began her career at Wellington Management in Boston where she was global head of global inflation-linked investments. In that role, she was one of the top TIPS managers by assets managing over $10 billion in dedicated assets with a top quintile track record for excess returns and information ratios in her peer group. She then joined Tudor in Greenwich as a discretionary macro investor translating her inflation strategy onto a macro hedge fund platform. Now, onto our conversation.
So greetings and welcome, Lindsay. It’s great to have you back on the podcast show. We had you a year ago and now here we are today again.
Lindsay Politi (01:29):
Yeah, great to be back.
Reframing the Bank Crisis as a Duration Bubble
Bilal Hafeez (01:30):
Now I should add that we do need to timestamp this podcast interview because a lot is going on in the markets at the moment with lots of focuses on banks both in the US and in Europe. This is the 15th of March, Wednesday, and so what we’re talking about is all the news that has happened till this point. By the time this podcast gets released, which is two days later, I’m sure a lot more has happened. So do forgive us if we have missed some of those events. So, Lindsay, let’s perhaps start with the Silicon Valley Bank crisis and the overall banking crisis that we’re seeing at the moment. What are some of your initial thoughts around all this?
Lindsay Politi (02:08):
Yeah, so I guess my thought is a lot of things that have been happening need to be taken in the context of the decade of QE that preceded it. Where to me the ending of QE is bursting what I’m calling a duration bubble. And what’s interesting to me is that when I look at Silicon Valley Bank, and by all means, I’m not a bank analyst, so take everything with a grain of salt, it really was a duration problem. It wasn’t so much a credit problem. And in my mind it has a lot of echoes of the UK pension problem of last year where a lot of the financial industry has been pushed into longer duration assets than they might have ordinarily intended to be in really because of QE. And now that that’s starting to unwind, it’s causing little blow-ups here and there.
When the UK pension problem happened, I was saying to people, I’m not sure where else this is going to pop up, but this is a broad duration bubble that’s being unwound. So we’re going to see little blips of this. And I think that probably Silicon Valley Bank hopefully is getting resolved relatively quickly, but will probably not be the last hiccup of this nature that we see as this broad unwind happens.
Current Crisis Is More About Liquidity Than Credit
Bilal Hafeez (03:26):
And when you say duration bubble, I mean, what do you mean by that? I mean, what risk is being distorted here?
Lindsay Politi (03:34):
To talk about it a little bit more generally, the way that I think intuitively to understand duration is that it’s the time that it takes for you to get your money returned to you. And I’m talking about really in a very bond context, but it can be extrapolated out to really all financial assets. It’s a measure of time. So if you were to take a six-month bill, for example, it has a duration of 0.5, for half of the year. If you take a 30-year zero coupon bond where all of your principle’s returned in 30 years, it has a duration of 30. And when you have coupons along the way and you’re getting some of your money back incrementally, it lowers the duration. So when interest rates are higher, durations are lower, when interest rates are lower, durations are higher.
And what central banks were doing with QE and buying bonds is they were distorting duration. None of the cash flows in the economy changed. They were just shifting the present value versus the future value. And that’s what’s interesting to me about Silicon Valley Bank is unlike the GFC where you really had assets where it wasn’t at all clear what they were worth, the assets that by and large Silicon Valley had are very easy to value and their future value is not in question. The problem is their present value has shifted a lot. So it’s really a very interesting dynamic in that sense in terms of what the problem is. It’s not real losses, at least not on a cashflow or future value basis. It’s a shift in time preference that’s causing big changes in present value terms.
Bilal Hafeez (05:14):
Yeah, that makes sense. So in some ways what QE did, what lower rates did, was it distorted people’s sense of time, I suppose. People were valuing future cash flows more attractively than if you had a higher rates environment from a market-to-market perspective.
Lindsay Politi (05:32):
That’s exactly right. It sort of distorted the present value relative to the future value. So anything with a future value was valued much more highly in the present value than it would’ve been ordinarily. And this is sort of true for everything. So if you think about anything that has cash flows that are furthest away from today, those were the things that really benefited those from QE. So it’s not just long-duration bonds, it’s also venture capital or tech companies that aren’t generating profit right now, but may in the future. Anything that had the furthest outdated cash flows benefited the most and now that’s just reversing very rapidly.
How Inflation Distorts Time
Bilal Hafeez (06:12):
And then if we bring inflation into this, because obviously inflation is related to time as well, I mean how would you relate inflation to duration or this present value moving present value around?
Lindsay Politi (06:24):
Well, I think to me inflation was always very key to this for two reasons. One is that I think we like to think about central banks having unlimited balance sheets and no stops and that was never really true. For them, the stock always was inflation. That was really the point where they were not going to be able to continue with QE anymore. So there’s that element of it. But also, inflation inherently makes people want to draw consumption forward. So you’ve had this situation where peoples’ money has artificially been forced out into the future at a time when inflation makes everyone want to draw it more into the present because prices are going to be up. If you expect prices are going to be higher in the future, you want to consume today. And the problem is everyone’s assets are in the future. So that’s also why you’re having this issue where the idea of having money today is very valuable and it’s not as easy to get money into the present as many people would like.
Bilal Hafeez (07:20):
Yeah. So in some ways you get the double whammy. So if you have rates going up and inflation going up, it affects you kind of doubly, you could say.
Current Difference to 1970s Inflation – QE
Lindsay Politi (07:30):
I think that one of the questions that I get often is, is today’s inflation like some other inflationary period, most often in the 1970s? And in some ways it’s similar. What’s problematic is the decade of QE that came before it because we’re starting from a point where the financial markets were uniquely vulnerable to inflation. So to me, especially for the financial markets, it’s not just inflation and isolation. It’s inflation at a time when people had been buying negative interest rate bonds, things that were inherently going to be penalised very heavily under an inflationary environment.
Bilal Hafeez (08:07):
I mean if we play this out then, what this suggests is that unlike, say, 2008 where it was a credit event, balance sheets were… The actual assets disappeared. I mean it basically didn’t return the cash flows. This time it’s different and so it’s more of a market-to-market adjustment. We also have inflation as well. So presumably the central bank response will be different too. I mean, how are you looking, if we project this forward for the next, say, three to six months, I mean, how would you game this out with some strong assumptions that we aren’t going to see a full spiralling bank crisis like ’08?
Parallels of Current Bank Crisis to UK LDI
Lindsay Politi (08:43):
Yes. So to me, my playbook for this, and again, take this with a huge grain of salt, at least at this point, is the UK pension crisis last year, not the great financial crisis in ’08. And with that, I think the surprises in inflation that we’re seeing today were put in place by the declines in interest rates that we saw back a few months ago following the UK pension issue. So my expectation, all else equal, is that what’s going to happen is today’s low interest rates, especially flowing into things like mortgage rates. We’ve seen that housing is very mortgage rate sensitive.
Yeah, I was a little bit surprised where you can actually, if you go back and look at the data, when mortgage rates came down and after the UK pension crisis, the applications for mortgages to purchase a home went right back up. I think that that’s going to happen again. And it means, all else equal, inflation out six months is going to be a little bit higher than it would’ve been, which is especially problematic because these situations make it much harder for central banks to increase interest rates from here. Again, I think the market is questioning whether they will need to, and there’s certainly, you have to at least assume that there’s some chance that this spirals out of control. But if it doesn’t, then it probably means that their inflation problem is bigger six months out than it was before this.
Bilal Hafeez (10:16):
Obviously one difference between the UK and the US mortgage market is the UK has more floating mortgages than the US. So presumably the transmission on the US side would be less strong than what happened in the UK, I suspect.
Lindsay Politi (10:28):
Yeah, I think that in some ways what’s happening in the US mortgage market is maybe one of the ways for people to most intuitively understand the durational issue where-
Bilal Hafeez (10:40):
Okay, yeah, good point. Yeah.
Lindsay Politi (10:42):
Yeah, I think historically people would only stay in their homes for maybe five to seven years, but now a lot of Americans, myself included, if you look at the concentration of mortgages, and this is sort of another issue that you can extrapolate out, especially after rates came down during the pandemic, the average mortgage is very highly concentrated and most people have a mortgage under 3%. So at this point people in terms of what they’re paying to stay in their house is far below what they would need to pay if they were to move or even if they were to rent. So it just locks people into their homes for a lot longer. Maybe not necessarily locked in, in the sense that they can’t move, but that they don’t want to.
And that’s what’s happening with everything across the board is you have to pay a lot to transact in the present where if you just sit on what you have, it goes up in value over time. So that’s sort of a bit of the disconnect. And I think that’s right. I think especially for the Fed, it makes the transmission mechanism much harder. I think the transmission mechanism in the UK because of those floating rate mortgages, they’re going to hit consumers much more quickly. For the Fed, it really blunts one of their levers in terms of using interest rates to bring down inflation and growth.
Bilal Hafeez (11:58):
I have to keep coming back to this, the duration bubble idea. We saw LDI in the UK, we’ve seen regional US banks, particularly ones that are very focused on tech. What other markets do you think are vulnerable to this duration bubble bursting?
Lindsay Politi (12:15):
I think that broadly across the financial markets, this is sort of true, it’s true in insurance companies, it’s true in most pension funds. I think the issue is whether there’s a catalyst that forces people to need money today because it’s sort of a perverse issue where, again, these treasuries that Silicon Valley Bank own, they’re money good, their future value is never in question. It’s just the present value versus the future value. So it’s really, if there’s any kind of a catalyst where people need cash, it’s a liquidity issue. It’s not a credit issue, which is really kind of different in terms of its dynamics.
Bilal Hafeez (12:53):
I guess to analogize to your housing example, people are fine, but if for some reason they were forced to sell the house, suddenly they face the full force of these higher rates. And the same way people who are sitting on these underwater assets from a duration perspective, they’re okay because it’s just a market-to-market swing. The asset’s going to pay at the end, but if they’re forced to liquidate, then they have to realise the market loss and then you have a problem.
Lindsay Politi (13:18):
That’s right. I also think about it as almost a, I think people are used to trading the markets, it’s a liquidity issue and when you have a liquidity issue, you can just get big swings in the price. Because, again, to sort of bring it to the housing market, what we’re seeing is that at higher interest rates, people don’t really want to buy. And also people don’t really want to sell. You’re just getting a huge drop in inventory. This sort of ties into some of the micro topics on inflation, but you’re getting a lot of very market specific moves where in the New York area where I am, prices are going back up, but in other areas of the country, prices are going down and it’s really who’s forced to buy and who’s forced to sell and what kind of price do you need to clear that market. And with illiquidity you can just get very disparate prices.
Why Shelter Prices Are Not Falling Faster
Bilal Hafeez (14:05):
Actually, let’s go on to inflation then. Shelter is a big component of CPI. The most recent CPI numbers that were released for February showed that shelter prices are still fairly elevated. Many people have been looking for a drop in shelter prices because they look at rental prices and some kind of lagged price changes should feed through to lower shelter prices. So how are you looking at the shelter component of inflation?
Lindsay Politi (14:31):
Yeah, I guess to me, just to pull it back slightly, is going to this year, there’s a lot of assumptions that inflation was going to fall into sort of a 2% range by the end of the year, driven really by two things, housing and rents, as you pointed out, and then also goods prices. With rents it’s taken a lot longer for them to fall than a lot of people expected and I still expect them to fall. But I guess what I’m highlighting as a bit of a risk is that in these illiquid markets where you are seeing in some markets like New York where house prices are starting to go up because of that illiquidity, it may end up blunting some of the decline, especially as it takes longer for it to flow through. So definitely there’s some declines in rents in the pipeline, but depending on where mortgage rates go in this current move and depending on what that means for house prices looking out over the next three to six months, that decline may not materialise to the kind of magnitude that we were expecting a couple of months ago.
Bilal Hafeez (15:33):
And then on the goods prices, that probably has materialised, I think.
Lindsay Politi (15:38):
It has, but it looks like it’s actually already levelled off and that’s not what a lot of people expected. So it looked a little bit weak. If you look at CPI yesterday, it was a little bit weak, but a lot of that was driven by used cars. If you took used cars out of it, that goods piece was up 3.9% month over per month annualised. So a bit higher than people would’ve expected. If you looked at the Manheim, this is wholesale used car prices, they’ve turned around pretty surprisingly. So they’ve been up meaningfully and it looks almost like a V bottom if you were to look at the charts. So that’s another thing that people weren’t really expecting, but it does look like there’s a lot of firmness in goods prices right now. I would say in PPI, if you look at the headline number, it looks like there was some goods price inflation there, but according to the BLS, about 80% of that was from eggs. So it’s not really the kind of disinflation that I would expect.
Bilal Hafeez (16:40):
I feel like there’s an Instagram post about eggs somewhere. On the Manheim prices, are you surprised by the strength? I mean the last, I think, is it three months? It’s gone up every month, hasn’t it, I think for three months or three, four months in a row or something?
Lindsay Politi (16:53):
I kind of thought that on level terms we might stabilise and we did start to stabilise around the levels where I thought we might. Because I think a lot of the pandemic charts, you almost need to look at them on a level basis where you get these blow-off tops and it distorts a lot of the changes, but if you look at them on a level basis, you can kind of see where the blow-off tops were. What surprised me is that we didn’t just level off, that we were actually re-accelerating. And that part of it has definitely been a bit of a surprise and I think that February sort of confirmed that that’s really the trend and it wasn’t a one-month blip in January.
I think it’s something that people should really take note of where there does seem to be more underlying economic strength than I think was previously assumed and it seems relatively broad based. I guess Atlanta, their GDP now is coming in at 3.2 for the first quarter right now. So there’s something going on there in terms of a level of economic strength that I think was not anticipated by a lot of people for the first quarter.
Trends in Other Inflation Components
Bilal Hafeez (17:55):
And the Fed is breaking down inflation into three broad buckets: goods, which you already talked about, shelter we’ve talked about, and then there’s services ex shelter. So we’re really splitting hairs here. But number one, do you think that’s the right way of looking at inflation? And then number two, what is your view on services ex shelter?
Lindsay Politi (18:16):
So services ex shelter is kind of a weird metric, especially in PCE because it’s dominated by healthcare services and the way that that’s measured in CPI and PCE is a bit different. My real question is, is if that’s really what they meant, where I feel like that’s sort of been put out as a proxy for wages where they’re kind of saying that they want wage inflation to come down, but politically they can’t say that.
And if that’s true, I was at an inflation conference in January and we had someone from the, well, not we, but Barclays had someone from the BLS there and he was asked an interesting question and that was, what segment of CPI do you think best reflects wage increases? And he said food away from home. So basically restaurant prices. I thought that was a really interesting answer, doubly interesting because that’s not even included in core CPI. But if you look at that, don’t have the exact numbers in front of me, but that’s trending 8%. If that’s really what the Fed is trying to get at, it’s well above their 2% target. If they’re really trying to get at this sort of micro healthcare services inflation, that’s still trending well above their target around four and half-ish percent. But I secretly kind of think that’s not really what they’re trying to get at with that metric.
Bilal Hafeez (19:40):
Yeah, I think you’re right. I mean all the language they use around it seems to say wages in reality. But on medical costs, I mean there was a big fuss toward the end of last year when you had the annual readjustments and then medical costs, I think they dropped. Should we pay attention to healthcare costs or not or is it just too technical and arbitrary to really tell us anything about the underlying inflation trend?
Cost of Living Adjustments to Social Security
Lindsay Politi (20:04):
I think the way that it’s measured, so it’s measured a bit differently in CPI and PCE where in CPI, it’s really about out-of-pocket consumer expenses, more sort of like your co-payments in PCE. It’s a broader metric of inflation. I think what’s interesting there more generally, I don’t think the nuances are, yeah, I think a little bit more technical. I think what’s interesting is the government payments and the Medicare payments and how those have been shifting. And I think another one that I’ve just found very interesting is the lack of attention given to some of the cost of living increases and inflation adjustments that are embedded in a lot of government spending. So if you look at social security, 66 million Americans receive social security. It’s inflation adjusted. All those payments starting in January went up, I got it written down 8.7%. So it’s one of those things that-
Bilal Hafeez (21:03):
Is it linked to CPI or PCE? Just out of interest.
Lindsay Politi (21:05):
It’s linked to CPI.
Bilal Hafeez (21:09):
Okay, great. The higher one as well.
Lindsay Politi (21:11):
Yeah, and it’s just interesting to me where a lot of people talk about how we’re not going to get a 1970s style wage spiral because labour unions don’t have the kind of power to force cost of living adjustments. Whereas, again, 66 million Americans, that’s about 40% of all workers are getting an almost 9% increase because CPI was higher last year.
Bilal Hafeez (21:37):
And then more generally on the labour market, we had a recent payroll report, the payroll number itself was quite strong, average hourly earnings, a proxy for wages came in a bit lower than expected, but there’s always these arguments about compensation, bonuses, over time, all of these sorts of things, what the true measure is, and then the unemployment rate picked up. So really a mixed report. I mean, what’s your view on the labour market?
Lindsay Politi (22:01):
My view on the labour market is that it still looks very strong and it’s a lagging indicator to be sure, but to me we’re just not seeing the kind of weakness that would be indicative of an imminent recession in this kind of labour data so far. And wages are still increasing, there still appears to be more job openings than workers. Sort of an interesting, related in the Beige Book, I’m not sure if you saw there was a snippet about a construction company paying to fly in workers from other places because they couldn’t find workers locally. And that’s just, to me, a statement of where wages and where labour is. If it’s more economical for you to pay to fly workers in, it’s just, we’re not in a weak labour market right now.
Bilal Hafeez (22:51):
Yeah. Does anyone need inflation experts? Are they flying you in anywhere?
Lindsay Politi (22:56):
Well, thankfully I can Zoom.
Bilal Hafeez (22:58):
Yeah, of course. Yeah, work from home like collar workers. No, that’s great. And in terms of the Fed then, we’ve been flip-flopping over the course of this year about how high the Fed could go, whether they’re going to cut rates this year, obviously because of the Silicon Valley, the bank crisis, the market’s pricing easing. But leaving aside market volatility, how high do you think the Fed will end up going?
Lindsay Politi (23:19):
Well, I think the real question in my mind that we sort of saw, again, with the UK pension crisis and today with Silicon Valley Bank is how high can they go? There’s sort of a level where maybe they would need to get to bring down inflation and then there’s a limit of where they can actually go. And my concern is that they’re not really going to be able to get to the point where they need to, to actually combat inflation.
Because one thing that I think we did learn from the 1970s is the problem with inflation is that it’s really real rates that matter for the economy, but we tend to focus on nominal rates. So as inflation’s increasing, what kind of happened in the late 1960s, early 1970s, and what happened recently is inflation starts to increase and people don’t believe it because it’s been coming from a period where there was no inflation for so long. So they wait for confirmation and it looks like they’re just waiting at unchanged rates. But what’s happening is because inflation’s increasing, real rates are falling that whole time that they’re waiting.
So then they start to increase nominal rates, but then they’re already behind the curve. So it takes much, much greater nominal rate increases to get to the point where you’re actually above, you’re basically taking real rates to a positive level. And really, if you look around the world, no central bank has even been able to get to positive short-term real rates. And I think that Silicon Valley Bank sort of calls into question whether they’re going to be able to get there, and that just means that they’re not really fighting inflation in any kind of a real way.
Bilal Hafeez (24:56):
And so from an investment perspective, I mean that presumably means inflation is underpriced once you’re positioned for higher inflation over multiple different time horizons perhaps.
Lindsay Politi (25:07):
Yes, and I also think it means that real yields are too high. To me, it sort of leads to two big trades and they’re all kind of in that inflation-like bond space. One is to buy real yields. And two, I agree, if you look out, especially after this volatility, it’s very inexpensive in my mind to buy inflation protection really across any kind of a time horizon.
Bilal Hafeez (25:29):
And on the real yields, would that be something like five year real or 10 year real, just fairly sort of generic benchmarks rather than anything too-
Lindsay Politi (25:37):
Yeah, they’ve come down… I just happen to have them in front of me, but they’ve lagged the move in treasuries certainly, but across the curve they’re still all above 1%. I think there’s reason to think that they could all go back to negative real yields like we’ve seen previously.
Bilal Hafeez (25:58):
Yeah. And then what about other parts of the world, Europe, Japan, any thoughts there on the rates or inflation markets?
Lindsay Politi (26:07):
I think, unfortunately every country is sort of dealing with a very similar problem. The nuances in each country are a bit different. You sort of highlighted the differences in the housing markets between the UK and the US. In some ways that is better for the UK. I think the UK is also a bit more vulnerable because there’s more currency risk there to falling behind on real rates than there is in the US. It ends up being, I would say, very interestingly, a very generalised problem, but also a very specific problem in terms of how it’s manifesting and the extent to which central banks can combat it.
Bilal Hafeez (26:45):
Yeah, that makes sense. Now I did want to pivot to some personal questions. Last time I had you on I asked you for a list of different things, but this time I’m going to ask you about your recent viewing habits or reading habits. So is there anything good you’ve seen on TV or in the cinema recently or any good books that you’ve read?
Lindsay Politi (27:02):
Yeah, so I guess I’ll highlight two that sort of fit into what we’ve been talking about. The first one is I’m a big fan of Frontline on PBS. It’s a documentary show and what I really like about it is they manage to get very good interviews and rather than trying to tell you something, they let people who are involved tell you what they were thinking in their own words. They just released a new one last night called the Age of Easy Money and really all about this. And I thought it was really interesting just to revisit and, again, in the words of central bankers, how we got to where we are. Another addition to that is they also tend to post the full links of their interviews on YouTube. So if you like listening to interviews, and I do, it’s interesting to play in the full context. Some of them are really interesting in detail. This one happens to be about finance, but some of the recent ones about Russia and Putin have also been really interesting.
And then the second one is sort of both a book and, to be honest, I haven’t read the book. I watched a lecture of it by Edward Chancellor’s, and he did a lecture, it’s on YouTube at the Library of Mistakes, is on his new book, The Price of Time: The Real Story of Interest. And I think that to understand our current moment, understanding the dynamics of how interest rates were distorted and what that means is really important. And I think he’s sort of getting at some really interesting points and questions there.
Bilal Hafeez (28:36):
Yeah, that’s great. I’ll definitely look out. That book, actually I’ve heard other people recommend that too, and I need to read that as well. So with that, that’s great. I mean, what’s the best way for people to follow you?
Lindsay Politi (28:46):
So I would say I don’t personally have a big online presence, but our CIO, Eric Peters, puts out a weekly email and he posts it on the One River website too. I happen to sit next to him and we talk most mornings. So sometimes he’ll dedicate it to some things that we’ve talked about around the desk. I think the one, two weeks ago, more just some thoughts that I had on inflation. So I think it’s good in general and if I have interesting thoughts, they’ll often show up there. So it’s a good thing to get on the mailing list for if you aren’t already.
Bilal Hafeez (29:19):
No, that’s great. I’ll definitely include the link to that. So with that, thanks a lot, Lindsay. That was excellent as always and I learned a lot. Thank you.
Lindsay Politi (29:27):
Great, thanks, Bilal.
Bilal Hafeez (29:29):
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