• Nancy Davis — the founder and chief investment officer of Quadratic Capital Management — predicted the early-2018 “Volmageddon” meltdown, as well as the near-bear market at the end of 2018.
  • She expresses concern over the Federal Reserve’s gigantic bond-buying program, which she says is creating a new bubble in the bond market.
  • Davis outlines three areas where she sees notable opportunity for investors looking to capitalize on the unsettled environment.
  • Visit Business Insider’s homepage for more stories.

Nancy Davis won’t say she saw the coronavirus market meltdown coming. Few people will. But she does think the investors should be on the lookout for more surprises.

Based on her track record, they should take her warnings seriously. Davis predicted the early-2018 meltdown dubbed “Volmageddon”, warning that investors were piling into short-volatility trades that ultimately blew up. Then she called the near-bear market that ended that year.

Davis is the founder and chief investment officer of asset manager Quadratic Capital Management. She also manages its exchange-traded fund IVOL, which is designed to protect against inflation and volatility in interest rates. Last month ETF.com named IVOL the best new fixed income ETF of 2019 and praised its innovative approach.

That ETF has returns 6.5% to investors so far this year, surpassing the returns of 90% of other inflation-protected bond funds, according to Morningstar.

Asked about her biggest economic concerns facing markets today, Davis said she’s worried that the Federal Reserve’s gigantic bond-buying programs are aimed in the wrong direction. She told Business Insider that by buying long-dated government bonds, the Fed might be impeding its own rescue efforts and creating a bubble.

They really need to stop buying long-duration bonds,” she said. “It’s like (they are) shooting themselves in the foot.”

She’s concerned the Fed might end up following in the footsteps of the European Central Bank and the Bank of Japan. By buying those long-term bonds, she argues, the Fed is failing to encourage lending and is just pushing people to buy and hold those bonds instead of investing in stocks or growth.

“It’s just creating an asset price bubble,” she said. “It doesn’t help people. It just helps people who own very, very long-dated government bonds.”

Also worrying is the thread of stagflation, the combination of meager economic performance and rising prices. US unemployment has spiked and growth has crashed. Davis says there are signs consumer prices are rising because demand for some products is outstripping supply.

In this unprecedented market, Davis emphasizes that investors need to diversify beyond stocks and bonds. She warns that one of the typical alternative assets, credit, is not ideal because its performance is generally going to mirror that of stocks. Here are three areas where she sees notable opportunity.

(1) Inflation expectations

This is one of the key reasons Davis’ IVOL ETF exists. It’s set up to profit when the yield curve steepens while protecting investors against the risk of rising inflation expectations and increasing interest rate volatility.

Right now, with very few investors thinking inflation could possibly increase, she sees that as a smart place to bet on a recovery.

“The asymmetry of owning inflation expectations is quite high because everyone expects deflation,” she said. “It’s very cheaply priced relative to other asset classes.”

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(2) Interest rate volatility

As noted, Davis says investors believe the Fed has suppressed volatility in rates for the foreseeable future. Because they’re so confident rates will stay flat, betting against it is inexpensive and a valuable hedge.

“Vol has gone up pretty much everywhere but rate volatility is still pretty cheaply priced,” she said. “Interest rate vol hasn’t gone up like other asset classes.”

They can place those bets using options. Famed investor Bill Gundlach laid out his own approach to profiting from rate volatility last year.

(3) The yield curve

Davis adds that if the Fed’s bond-buying does slow down, the yield curve would get much steeper because trillions of dollars of stimulus are being pumped into the economy.

“I do think that’s a good opportunity to diversify for investors because it’s different than stocks and credit,” she said.

They can get access to the curve itself in a variety of ways, including buying futures on the Treasury curve, ETFs that invest in nominal Treasury bonds or in ETFs of floating rate notes.

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