Cem Karsan and Andy Constan | PNL For A Purpose

Episode Summary

Executive Summary: The episode features two macro/volatility managers arguing that the post-COVID regime is shifting from secular disinflation to a longer, more inflationary and volatile period driven by populism, deglobalization, demographics, and persistent Treasury issuance. Jem Karzen emphasizes structural inflation, flatter skew, and tactical opportunities in options. Andy Constan focuses on Treasury supply/QT and argues the real tightening is via long-end rates and issuance, not just Fed hikes, with policy and election-year dynamics likely to support markets short term but pressure assets longer term.

Main Topics: Structural inflation and the return of populism (Priority: 5/5): Karzen argues inflation is part of a long regime change tied to inequality, populism, protectionism, and deglobalization. He sees the 2020s as analogous to the 1968-1982 inflation era, with rising labor power and commodity scarcity pushing prices higher over time. Differences between today and the 1970s (Priority: 4/5): While the macro rhyme looks similar, Karzen highlights major market-structure differences: derivatives, structured products, higher debt, and the post-gold-standard world. These factors may alter volatility behavior and policy responses versus the 1970s. Fed reaction function and election-year policy (Priority: 4/5): Karzen says the Fed is boxed in between inflation and growth, but is politically incentivized to favor growth in an election year. He expects a public anti-inflation stance while policy remains supportive of risk assets in the near term. Treasury issuance, QT, and the long end of rates (Priority: 5/5): Constan argues that the key tightening mechanism is Treasury coupon issuance and long-end yields, not just front-end Fed hikes. He says QT runoff was muted in the U.S. because the Treasury, not the Fed, effectively transmits the tightening through supply. Volatility regime, skew, and cross-asset dispersion (Priority: 5/5): Both guests discuss a market with unusually compressed skew and low volatility in core assets, but rising spasms in FX, gold, and other sensitive areas. Karzen expects flatter skew and mean-reverting equity vol; Constan expects rising portfolio vol from poorer diversification. Election and post-election market behavior (Priority: 3/5): They both expect the election to matter more for policy and flows than for immediate direction. Karzen expects a post-election squeeze/rally, while Constan thinks policy differences will affect sectors, deficits, and the medium-term setup more than the election event itself. China as a potential relative opportunity (Priority: 2/5): Constan closes by saying China may be oversold and could outperform the U.S. over the next year, making it the most interesting underappreciated setup he is watching.

Key Arguments: Karzen argues populism is a reaction to long-term inequality and historically leads to protectionism, deglobalization, higher labor costs, and structural inflation. He believes the current inflationary cycle is not a short-lived shock but a 10-15 year phenomenon that resembles 1968-1982. Karzen says technology is not disinflationary forever; higher rates slow investment, reduce the number of unprofitable growth companies that can survive, and dampen the pace of innovation. Karzen argues the Fed will not openly admit structural inflation because that would become self-fulfilling and constrain policy flexibility. Constan argues the dominant macro tightening channel is long-end Treasury supply and duration, not just Fed hikes; higher coupon issuance pushes up yields and slows growth. He says the Treasury’s issuance choices, especially the mix of bills versus coupons, can materially move markets and the economy, and this cannot easily be front-run. Constan believes long-term rates need to stay above 5% for several months to truly kill inflation; short-lived spikes are not enough. Both guests think skew is too flat/cheaply priced relative to the underlying regime, making downside hedging relatively easy but also potentially delaying and lengthening drawdowns. Karzen expects election-year policy support to keep risk assets buoyant in the near term, even though the broader regime is unfavorable for equities. Constan thinks policy outcomes from either party likely worsen deficits, reinforcing upward pressure on Treasury supply and rates over time.

Data Points: Historical inflation regime: 1968-1982 - Karzen compares the current era to the last major inflationary cycle. Structural inflation horizon: 10 to 15 years - Karzen’s estimate for the duration of the current inflationary/populist cycle. Fed transitory references: 3 times since 2021 - Karzen notes the Fed has used the word 'transitory' repeatedly. Last similar low-inflation era: 40 years - Constan references four decades of structural disinflation/globalization. Market pricing of cuts: 100 basis points over the next ~20 months - Constan says markets price only about 100 bps of cuts across 13 Fed meetings. Treasury issuance timing: Since last summer - Constan says QT/issuance pressure on bond prices has been building since then. Debt ceiling period: Nov 2022 to Jun 2023 - Constan says coupon issuance was constrained during this period. Q3 2023 real GDP: 4.9% - Constan cites growth boosted by Treasury cash spending and muted issuance. Treasury bill demand floor: $325 billion to $500 billion RRP - Constan says the reverse repo balance no longer signals financial-stability concern at current levels. International/market example: 96% - Karzen says 96% of internet companies went bankrupt in 2000. NASDAQ drawdown in dot-com bust: 91% - Karzen cites the peak-to-trough fall during the 2000 collapse. Inflation peak references: 12% - Karzen notes inflation eventually rose to around 12% in the 1970s analogy. 1970s inflation trough: below 2% - Karzen cites inflation falling sharply before the next leg higher. Episode example of vol event: 8-9% decline - Karzen references the 2015 yuan devaluation episode. Example of compressed-skew decline: 12.5% decline - Karzen cites Feb. 2016 as a larger drop with flat skew. Oct-Nov 2018 decline: 19% decline - Karzen cites this as a bigger decline than the volpocalypse move.

Pivotal Quotes: "The core point here is that populism is a reaction to 40 years of inequality." — Jem Karzen: His central framework for why the current inflation/policy regime is changing. "What matters to, um, well you can believe in supply and demand matters. I do." — Andy Constan: Constan’s thesis that Treasury issuance and long-end supply are the key macro drivers. "I think the thing that people really, um, aren't talking enough about is, is skew, um, and how flat and, uh, how, how, you know, compressed skew is in the, in the market." — Jem Karzen: His closing takeaway on the most underappreciated market feature.

Implications: Listeners should expect a regime where inflation, rate supply, and election-driven policy support keep markets fragile but tradable. Short-term rallies may persist, but longer-term equity and bond returns could be challenged while volatility, skew, and relative opportunities by region/sector become more important.