Sternberg: Analyzing the “new normal”

Q&A

Menachem Sternberg is an economist and trader whose analysis of the global market environment has allowed his firm, Eagle Trading Systems, to navigate one of the more treacherous periods for global financial markets. He has been a discretionary trader and a quantitative system developer, and he employs those skills with his current strategies. After earning his doctorate in economics from Princeton, he has developed global macro strategies since before anyone knew what that meant and worked at several of the more successful trading firms, including Caxton and Commodities Corp. We talked to Sternberg about markets, economic policy and the “new normal” market environment that has existed since the 2008 global economic meltdown. 


Futures Magazine: Menachem, your history in managed futures goes back to your work with Commodities Corp. in the 1970s. How has the industry changed in that time and how unique is the period we are going through right now? 

Menachem Sternberg: The global environment and the managed futures [world] that we started with have evolved into much more sophisticated and elaborate quantitative strategies quite different from what they were in the early days. It is different primarily by the number of markets, by the number of participants, by sophistication and diversity of what people are doing now relative to what they did [in the past].  It accounts partially for why we see more and more interest in the quantitative space from institutional investors who see it as a legitimate diversifier for traditional portfolios. 

FM: You have extensive discretionary trading experience, but your programs are mostly systematic. Talk about how you approach trading and balance those elements. 

MS: It is always a balance between the fundamental situation in the market, the economic environment [and] how markets are responding to those. As a discretionary trader, you rely on your expertise. Discretionary traders cannot, even if they want [to], have that vast a knowledge and ability to analyze such vast data in many markets. So, their particaption tends to be more focused, more concentrated. [Also], most discretionary trading relies on fundamental analysis of the markets and sometimes markets can ignore, at least on a timing basis, some developments. Today, you are bombarded by endless pieces of information and [that] information is available to everyone. You don’t have any more privileged information. Discretionary traders by nature [are] dependent on their own process and analysis. As a result, when there are major changes they may be slow to adjust.

One of the big advantages to quantitative participation in the market is the ability to analyze in a very balanced way vast information, and to participate with no emotion or no human element. As a result by listening to the markets, [traders using] quantitative strategies can identify a change in the market and adjust their participation accordingly. When you look in the past at key turning points in the market, you see that in those environments quantitative strategies tend to do better because they are [able to be identified] earlier. To me, you cannot participate in the markets only based on quantitative studies or only based on discretion; at end the of the day it is a matter of weighing different factors and trying to put them in perspective.

FM: Your global program has produced strong returns for more than a decade. How have you been so consistent?

MS: The key to consistency is to have diverse experience and use it day in and day out. One of the keys that the current environment has confirmed, is you need to be more tactical in your participation, because markets tend to change what they are focusing on from one period to another. Over the last couple of years we have seen periods of risk-on/risk-off. Markets have been adjusting quickly to news, policy developments and political developments; those change the focus of the markets. The key to participate is to be tactical and know when to move to the sideline and not force [getting] in the markets.

FM: Recently you wrote that markets are starting to reflect concern that central banks will be forced to tighten policy earlier. What have you seen? 

MS: The major thing to remember is that we have been in a major transition in the global economic, financial and political landscapes and the road from the old landscape to the new one, which [is uncertain],  is quite dangerous. We are definitely not at the end of the road. As a result, that environment has created a [market space] with no shock absorbing and a lot of fragility and vulnerability to adverse developments; we have had many of those. The [fragile environment] is being amplified by huge deleveraging on the private sector part, and as a result it has made us vulnerable to a lot of situations. What we have seen in the financial sector in 2008 and what we have seen in Europe [are] all part of the same problem--we basically have reduced the level of liquidity that was available in the economy, growth came down and as a result some of the underlying structural imbalances showed up. Because that process of deleveraging is a long-term [thing] and it is still a work in progress, it has forced us to be in that kind of adjustment process much longer that we are used to.

We have been facing a sick patient that keeps on getting higher and higher dosages of morphine without going through the serious operation…. At some point, central banks were forced to go to extreme measures that weren’t on their menu of policy tools before, like [quantitative easing] (QE). When they saw that they brought interest rates to zero and that did very little, they thought that they would get the global economy going by pushing long-term rates very low, [but] that has led to very little help so far. The reason is that we are still in the midst of deleveraginig; we are still in the process where fear and uncertainty are what are controlling market behavior. A lot of it has been our own [doing]. The regulation, some of it justified, made the banks less likely to lend and as a result we saw little benefit of that very aggressive monetary policy in the real economy.

At one point we will realize that  the use of only monetary policy the way we did it failed to do the job and we may need to [switch] to more fiscal policies.  When you do that, it will be the end of [the] limitless monetary liquidity injections that we have seen so far. Some of the unease is showing itself in the words of central banks themselves. You are starting to hear more dissenting voices within the central banks where they are uncomfortable with the fact that certain banks have been pouring so much liquidity into global domestic economies and have very little success to show for it.

FM: Jim Sinclair told us QE is not a policy choice but the only option on the table given our debt obligation and the size of outstanding derivatives floating around. Do you agree?

MS: It is too simplistic. The reason being is that QE wasn’t on the table a few years ago. It is something that we invented, so to speak, in this economic crisis. When QE didn’t do the job as much as we hoped, we developed a new concept called twist, which again failed to [improve] the real economy. It is not the only option. The right option should have been to have a more proactive policy targeted at supporting  growth. For instance, while monetary policy so far primarily was providing liquidity, especially to the financial sector, which was right at the time to prevent a huge financial meltdown, we could have had a monetary policy with a two-tier system where we provide the banks funds for their own use with high interest rates and [low rates] if they are willing to take some risk and lend to the real economy. So QE is just one tool. You could have been more targeted toward growth.

If banks want to keep [liquidity] and give themselves more cushion, they would have to pay a higher price. QE was a desperate move because they already moved rates as low as they could and saw that it was not doing the job, so they said, ‘let’s affect the real economy through the  long end but how do you affect the real economy from the long end?’ It is by the fact that rates people pay for mortgages are lower and the rates that companies pay for their loans are lower. What happened however, is the real estate market had much bigger problems. [The] exact rates of mortgages and loans from banks to businesses weren’t so much an issue of rates, it was an issue of whether to extend credit--so QE didn’t do the job. It may have given some financial institutions the benefit of playing the carry trade because you had zero rates; it gave banks the [ability] to replenish their balance sheets but when the [longer] rates remained flat there was less and less benefits to those policies.

FM: Would it have been better to stick with the original TARP program, which would have simply bought up the toxic debt of banks and force them to take a loss on them? 

MS:  In hindsight, yes. The sooner we would have been in cleaning the toxic things that are there, [the better]. We continue to underestimate what is still there. We declared victory too early yet the undercurrent was still there. 

To me the Fed made a mistake when earlier this year it declared that they are not going to raise rates until 2014. Right now it seems that they were right, but two months ago when we had a couple of good numbers even Fed members and Bernanke tried to shy away from those kinds of predictions. What we do at the moment is a response to every economic number that comes out; we left the long-term stewardship in terms of policy. We still have a lot of structural imbalances. We don’t have much growth, the liquidity didn’t provide what it was supposed to, and we are in a situation where every development in Europe or in the U.S. has been amplified by political uncertainty, by regulation that keeps putting market participants in some kind of limbo because they don’t know what their tax environment is going to be. When it comes to the U.S. the new health care law created a huge [cost ] to small businesses, which are the major engine of job creation. What you did with all those new regulations and laws is put the real economic engines on hold and as a result we have been suffering from [low growth], which has been amplified because we are [still] in a major deleveraging process.

FM: BlackRock’s Peter Fisher blamed some of Europe’s problems on moving to austerity too soon. Is that a risk here?

MS: That is a great point. The solution always is in a balanced approach. What Europe underappreciated is by going to a huge austerity plan without having political stability, they will have political instability that can derail the whole process. So yes, they moved too strong in Europe because they underappreciated the political [environment]. They did have to move, however.  As you know, in Europe you have different countries with different agendas. When you try to find a common ground, you find something that is [not good] for everyone. Take the UK as an example. The UK went to an austerity plan when there was a lot of political stability to do this. They still are in the midst of this but it will probably put them in better shape, once the cycle turns, than many other countries far behind in putting their fiscal house in order.

FM: What is the risk of keeping central bank policy accommodative for so long? What is the appropriate exit strategy?

MS: You have just asked the $64 million question: What is the exit strategy? When you keep interest rates low for so long, you make the market conditioned and addicted to that liquidity. When that liquidity starts to dry up, any kind of marginal positions that were dependent on those low rates will have to be unwound and I don’t think anyone knows, including the Fed, what the unwinding will do to those. Once the markets sense that a change in the interest rate cycle is imminent, they may run ahead of the Fed and may force the Fed to act earlier than it would otherwise. The exit strategy is to do it gradually and not to increase the doses of liquidity, because the more you increase it or commit to it, the more it creates imbalances and dislocation that will come back to haunt you.

FM: What we are talking about, particularly in fixed income and forex, is pretty heavy handed government action in markets.  Is there a larger risk in how active central banks and government have been in affecting markets? 

MS: I do think so. Governments, primarily in fixed income and currencies, have been more interventionist in their approach. In the past, monetary policy affected the front end of the curve and markets were affecting the long end, when that failed to do for the Fed and other central banks the goal of what they were trying to achieve, then they started to [affect] the long end by those QEs. As a result the yield curve currently is representing something artificial and not necessarily what a free market involvement would do.  Once you start to [remove] some of that government involvement, the markets will have to adjust to that new reality and it can be significant. 

In currencies, no one wanted a strong currency in a world where the global economic pie is shrinking. [Some] countries, like China, like the Swiss and Brazil recently, intervened. The U.S. didn’t intervene but currencies being a relative value concept reflect policies and demand on exports of different countries. So the fact that the Fed has been very accommodative accounted earlier for weakness in the dollar and only recently the dollar found new strength, more  due to the problems in Europe than strengths of the U.S. economy. At the end of the day governments will find it very difficult, especially if it doesn’t achieve the economic growth that they are hoping for, to artificially keep intervening in the market, especially when they do it without a longer term plan or comprehensive coordinated policies globally. 

FM: In 2010 you put together a presentation for a conference in London that talked about the global economy. Much of it was prescient and much hasn’t changed. You talked about the “new landscape.” You wrote, “The global economy has to adjust to sustained economic cycles with less leverage and lower velocity of money.” Has it? 

MS: It is happening, but it is still a work in progress. We are still in the midst of a torturous kind of adjustment process.

FM: You said, “Increased regulation and policy oversight are likely to lead to [a] higher cost of doing business, which will hamper growth.” Has it or are we still waiting on regs?

MS: Some of it did happen. It did happen with the health [care] law, with financial regulation, with Basel III, with talk about tax changes. Some of the new laws need many regulators to [lend] oversight [to it], and that’s still a work in progress. What it means is that many businesses don’t know yet what the landscape is going to be. That tends to hamper growth, innovation and investments. 

FM: Is it worse that the process is taking so long? Would it be better if they said these are the rules live by them now? 

MS: It depends what the rules are. Some rules are bad and the fact that they are not yet [implemented] gives people hope that they can fight them off, but in general to the extent that some rules makes sense, keeping them in limbo is worse than knowing what they are. [We are in a different regulatory environment.] In the past you had occasions when a bank can have a loss but immediately now everything that happens can lead to expectation that there will be more oversight, more intervention, more regulation. We are in a cycle that is more constraining than supporting growth and investment and innovation.

FM: You wrote, “Monetary policy has been redefined for good, with non-traditional methods replacing past policy tools.” Has this flexibility helped?

MS: Definitely. The flexibility prevented a major meltdown but it didn’t support the global economy thriving, for the simple reason that the problems that we were trying to address were much bigger than the policies, and the policies that we did implement were not comprehensive and didn’t sufficiently take into consideration the magnitude of the problems that the global economy was facing. As a result, they achieved much less than policy makers would have hoped for.

FM:  You noted, “The unwinding of central banks’ balance sheets takes them, and markets, into unchartered waters and can lead to unexpected interest rate behavior.” Are we still waiting on the unwind?

MS: It hasn’t played out yet, but when the markets sense central banks need to change policy for whatever reason, it is clear that not only what will happen on the central bank side but what will happen [with]  many financial structures and situations that were counting on the low interest rate environment and how they are being unwound will have a major [impact].

It is clear that the current behavior of the yield curve is more governed by a flight to quality, by fear, and not by economic situations. If central banks try to deal with it by just pouring [in] more and more liquidity, they may get more than they wish for. If they pour [in] enough liquidity to get the global economy going, it will not take much time for that liquidity to turn into an unwanted inflation situation.

They are playing a very dangerous game here. For all that matters we may be in a slow growth [environment] for many years, what will we do then? We face a lot of uncertainty once they have to unwind, or start to reverse course. 

FM: You said, “Credit availability and its role in the economy have been re-defined.” How? 

MS: The central banks used to determine all the short-term rates and the banking system and supply and demand, and the real economy determined the whole shape of the curve. A major transition has occurred with banks and other financial institutions. Their role has changed: One, because of their own misdoing and the previous leverage, they need to unwind. Second, because of the high requirement for cash and reserves. We have to find — and we are not there yet — what is going to be  the velocity of money in the new world we are heading to. It is definitely going to be much lower than what it was before.

FM: You noted, “While risk taking still exists in the investment world, risk aversion became predominant in real economic behavior (both businesses and consumers).” Is this still the case? What has it meant? 

MS: What it meant is that the low interest rates gave rise to markets that the lack of returns elsewhere were willing to invest in something [else]. Some of it was going to equities, some of it was going to emerging markets, some of it was going to playing the carry trade; so we saw willingness to take risk due to the support of that liquidity in the financial world. Yet in the real economy, where businesses had to make decisions, they showed a lot of risk aversion, and that hasn’t changed. So while in the real economy we saw throughout the period, going back to 2008, risk aversion, in financial investment we saw more willingness to take risk supported by that liquidity. That is also what gave rise to periods of risk-on/risk-off and to the market volatility.

FM: You said, “The new economic landscape is likely to experience lower growth, weak labor markets and rising uncertainty.” This is true, but how long will it last? 

MS: I don’t have a crystal ball, but a lot of the problems I talked about in 2010 are still outstanding. 

FM: You wrote, “The new economic landscape is more vulnerable to structural imbalances and dislocations and is more likely to experience divergence in growth.” Is this still the case? 

MS: That is still the case. Keep in mind that two major factors serve as a shock absorber to the global economy. One is growth — the higher the growth, the more the global economy can sustain diverse development. The other is liquidity. Currently, with growth at a lower level and with liquidity not [entering] the real economy, it is not serving as a rising tide, [the economy is] vulnerable to any kind of adverse development and we are seeing it increasingly so over the last few months. 

FM: What has changed since 2010?

MS: Just more of the same, but more aggressive. QE became more aggressive, the problems in Europe [increased], the political uncertainty amplified, the interventionist nature of policy makers kept rising. A lot of the things I pointed to just have been amplified. Some will tell you that they needed it to prevent a move into a financial crisis, others will tell you that by acting like that they prevented real solutions, and that is why we are going to be in this hole for quite a long period of time. If we are talking baseball terms, I don’t know if we are in the fourth or the sixth inning, but we definitely are not in the ninth. 

FM: Have you adjusted your trading approach and systems to meet this new landscape?

MS: I always have been a big believer in the way to adjust to changes in the market environment is by building into your systems learning [mechanisms that] keep identifying changes in the dynamic nature of the market. Why is that important? Because when talking to people in the industry you hear, especially on the part of clients, comments like ‘the current environment is so much different from what it used to be.’  When you translate it to what they really meant, you see that one thing that hasn’t changed is the need for markets to be equalization mechanisms. Imbalances, whether they are structural or [because of] policy changes, give rise to prices being the mechanism to which such imbalances and dislocations are being adjusted. Being disciplined in identifying those changes from price behavior is what gives to the quantitative strategies the ability to successfully participate. What has changed, however, is the dynamic path of the volatility pattern in which market prices have done it. That is why you need to constantly keep identifying and adapting to that change in the volatility and the dynamic path of price behavior in order to tactically know when to sit on the sideline and when to enter. For the most part because we built into our programs learning mechanisms [that are] more tactical, they were able to deal with the difficult environment that we faced quite successfully.

FM: So you built them to adapt. 

MS: For us research is one of the things that we thrive on. We constantly try and see what edge we can bring.

FM: Give us your outlook for fixed income and the yield curve.

MS: The yield curve currently is not in the normal market behavior [mode]. It has been manipulated by policy interventions and as a result they don’t reflect the level of debt that is out there, it is not reflecting the economic activity and it is dominated more by fear and flight to quality than by other economic factors. It is quite clear that the front end, Fed funds, are [set]. The Fed told us that they are going to keep it there. The real surprise is if they are forced to move earlier than they predicted. If the front end of the curve is going to be pegged, the real question is what is going to happen to the long end of the curve? The major factor that has been affecting [the long end of the curve] is on one hand QE or the Twist that kept buying the long end and the other part is the flight to quality that absent other safe investments, people are just putting their money there. As long as we will be in that state of mind of flight to quality, the yield curve could go into more threatening [territory] and lower rates. But is it sustainable for the long run? Probably not. How are you going to justify 10-year notes at 1% unless the world is really coming apart?

FM: Treasury markets are rallying sharply today (end of May); we are on all-time highs.

MS: That is flight to quality, the realization that the politics in Europe are not going well and the U.S. economy is not showing any signs of sustained growth.

FM: Many famous bond traders lost money last year because they didn’t gauge the power of central bank interventions. Is it a risk to the market that central banks have been so active?

MS: First, even last year there were opportunities in fixed income. Many of the quantitative strategies did make money last year. It was a difficult market for discretionary traders to try and identify or relate fixed income to fundamentals. But from a price pattern point of view, since the spring of 2011 until the fall, we were in a move toward lower rates globally and then we went into a period of uncertainty. That is why tactical participation is so important. Then over the last couple of months, we started a new round of flight to quality. When the government is that involved and creates basically artificial level of rates, the main trigger is, ‘What is the effect of the policies on the real economy, on the level of confidence, on the level of uncertainty?’ When they are unable to appropriately deal with those factors, we [see] what we are seeing now -- the markets are much more vulnerable. That is the major concern. We spent a lot of ammunition. We manipulated and intervened in many markets and put them at levels, especially in fixed income, that they wouldn’t have been at on their own. At the same time we have very little to show as a real achievement that we were able to get to with those kind of policies. So we spent all that ammunition and have little to show for it.

FM: We are in the midst of a 30-plus-year bull market in bonds. Is that just where we are until there is a recovery and there is going to be an unwind? When it happens is it going to be smooth?

MS: I doubt that it is going to be smooth. What fixed income did 10 to 15 years ago probably isn’t relevant to what it is going to do now. What is important is the kind of structures and the kind of positions that the most different environment of the last three years has supported. That will affect the exit strategy of the Fed. The level of unprecedented and accommodative policy will lead to significant unwinding consequences when they happen. When they happen, no one knows. When the environment will change the market will tell it loud and clear and we will have to respond to it.

FM: Will there be much global divergence? Will the European and Asian markets unwind similar to U.S. markets?

MS: It is uncertain. How the global markets are interconnected to one another is something that keeps being redefined almost every day. Globalization brought about a flow of capital from one country to another and we were not in that kind of an isolated scenario anymore. At the same time that globalization made the fact of one economy [tied to another] that more significant, and as a result when somebody has a disease very quickly it spreads to other areas.  [Remember] in 2008, in the first half, we were still talking about decoupling, how the U.S. problem would not affect other countries and then everyone realized in the summer that the U.S. problems do affect other countries and suddenly it became a global problem. We don’t have that decoupling, the problems affect everyone. And [because] everyone benefitted from those global accommodative monetary policies, if they start to reverse the effect of it will also be global. How it affects different countries depends on their own economic situation at the time. Is there room for divergence? Yes. Will it happen? We will have to wait and see.

FM: So we are still in limbo?

MS: We are still in [these] unchartered waters in terms of policy; we are still in this transition period in terms of [the] economic, financial and political landscape. The world is full of uncertainty.

FM: Is managed futures the best investment for people to get into with all this uncertainty?

MS: More and more investors can look at quantitative strategies and managed futures are included, as being uncorrelated to their traditional portfolios and that relates [to managed futures being utilized] more and more as a diversifier. Many factors contribute to the rising interest. Many traditional portfolios — with 60% in equities and 40% fixed income — didn’t serve as a good investment in the long run and [investors] looked to be more in other strategies that tend to be uncorrelated. Managed futures with its ability to be on the long and short side of markets, ability to listen to the markets and, in the case of quantitative studies, ability to tactically [enter] the market, has proven to be a great diversifier. Investors are seeing it, acknowledging it and responding to it.

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board