• William Bourne


With bonds at historically low yield levels, Linchpin held a webinar on 23rd September together with CrossBorder Capital to look at how investors can best provide protection in today’s unusual markets without paying too high a premium.

In the first part of the presentation, Michael Howell, Founding Partner of CrossBorder, analysed today’s markets using the prism of liquidity flows. He provided a high level explanation of how CrossBorder measures liquidity flows, how the data can provide a framework for investors’ decision-making, and where the main risks to investors lie today.

In 2020 we have seen the largest expansion of liquidity supply ever, some five times larger than during the Global Financial Crisis, and we are now at the top, or perhaps just over the top, of the liquidity ‘cycle’. By contrast economic growth is close to the bottom of its cycle after COVID-19.

He argued that the combination of loose central bank policy and strong private credit creation will inevitably lead to steepening yield curves as term premia normalise. He also noted that cross border capital flows are currently moving away from the US and towards Europe, which caused him concern over the course of the US dollar. In the longer term he highlighted the importance of the recent Federal Reserve change in policy to accommodate further monetary inflation. The clear risk is that it eventually leads on to asset and - eventually - high street inflation.

Michael then showed how equity valuations peak at around 2% inflation. If he is right about the implication of the Fed’s change in policy on inflation, valuations of long duration assets in both equity and bond markets are vulnerable to downward pressure. Gold is an obvious hedge against monetary inflation but carries a considerable opportunity cost for investors within a portfolio.

In the second half of the webinar, portfolio manager Pablo Carbajal explained how CrossBorder provides protection to their clients. Their QFIM macro strategy acts as a long volatility hedge in falling bond and equity markets, which over 11 years has delivered positive alpha alongside a correlation with the S&P of around -0.6.

If yield curves steepen, as Michael predicts, or inflation leads to lower valuations in equities or bonds, QFIM will give investors both diversification and more accurate protection against market falls while still providing a substantial return premium over cash.

He explained that the strategy avoids liquidity and credit risk by investing only in liquid government bond markets, the four uncorrelated sources of return, and the systematic drivers behind the investment process. While the strategy uses options to manage risk, the over-riding principle is always to be positioned to benefit from an increase in market volatility, which is why it is an effective portfolio protection tool.

In conclusion, he proposed it to the audience as an addition to investor portfolios which provides protection against falling bond and equity markets while not – like many other insurance strategies – involving a high carry cost. The strategy has in fact outperformed the HFRX Global Macro universe by about 3% annualised since inception.

In the Q and A session which followed, Michael was asked to define what he meant by private sector liquidity. Michael said that private sector liquidity is defined by CrossBorder from the credit side: it consists of traditional bank lending, shadow bank lending and cash flow generation of the private sector (such as cash flow of private companies).

He was also asked what was behind the slow-down in US Federal Reserve assets over the past few weeks. He agreed that the take-up had been substantially less than the Fed (or CrossBorder) had expected. He thought it was down to, first, repayment of almost all the international swap lines which had been agreed between central banks and, secondly, a better than expected recovery by the US economy, causing the Fed to rein back its proposed activity.

Pablo was asked whether QFIM was entirely systematic. He said that because they use options there is always some human assessment of value but the overall thematic positioning of the fund is done systematically. The option trading is carried out on a delta neutral basis using rules and limits, so is a pure volatility trade. But there is some human qualitative assessment on the actual choice of the instruments.