Matt King on the Hidden Forces Driving the Market Selloff

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1:23Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, it's my favorite time of year. It's August. I didn't know that. Why is it your favorite time of year? I like August, too. I love summer. But what's your reason? Well, actually, it's exactly that. I love summer. But... This is why we get along. There's an added layer. Can you just say, I don't like people who have favorite seasons other than summer. I'm skeptical of that. You know what? I used to be... I judge people. Okay, that's fine. I used to be exactly like that. However, I found that as I've gotten older, I've kind of come...

1:56Maybe as I've gotten older and acquired a house without air conditioning, I have also come to appreciate winter a little bit more. OK, I didn't actually mean to start talking about the weather, but there's another reason I like August, which is I feel like that's the month when weird things in markets start to happen. Yeah. August through October feels like that's the three month stretch where anything can happen. Yeah. In August, especially, you know, people are on their like mandated two week leave. If you're a professional working at a bank or something like that, you have to go on leave for, I think, two weeks or something like that every year.

2:35And there's lots of illiquidity in the market. So, you know, tiny little things can end up having a big impact. And I feel like August is when you get some of those strange market moves. And speaking of strange market moves, or at least dramatic ones, in recent days and weeks, we have seen some interesting stuff happening in the market that has been different to the pattern that has played out for the past year or so. Totally. First of all, we've had a little bit of weakness. We've had a little bit of rotation that people are talking about. Some of those red hot tech stocks have come down. We're seeing a lot of moves on the curve.

3:14At the time we're writing this, the 10-year yield is back below 4%. So I was just saying in the OddLots Discord, which people should go and subscribe to and hang out, I literally said this morning, macro feels like it's kind of getting interesting again. Absolutely. Both macro and markets, I got to say. And there is this ongoing conversation about how much of what is happening in markets at the moment is technically driven. So, you know, maybe some of those pod shops having to cut some positioning versus people actually reacting to changes in the macro outlook. And I should just say, we are recording this on August 1st, the day after the Federal Reserve meeting, where, as expected, they didn't cut interest rates, but they certainly telegraphed an upcoming cut.

4:01So lots going on there as well. And the day before recording this, the day before non-farm payrolls. So by the time you're listening to this, we'll know a little bit more about the labor market. Yes, we will. So there's a lot going on. It's August. There's the potential for even more stuff to happen, weird stuff sometimes. And I have to say, when it comes to diving into the intricacies of the market and what's going on there, there's a person that I very much like to speak to. We've had him on the show before. It is Matt King, formerly of Citigroup, and he's now started his own research shop. It is called Satori Insights, and he is the founder and global market strategist over there.

4:43So we're going to talk to Matt about what's going on in markets, what the outlook is right now. Matt, thank you so much for coming back on All Thoughts. Thank you for having me. You're much too kind. Well, we are very excited to be speaking to you again. There's a lot that's happened since we spoke to you last. I think it was in maybe in March of last year. Talk to us about what's happened. So you've set out on your own. You have this new thing called Satori Insights. What are you doing over there? I'm doing more or less what I was doing previously, which is trying to explain what markets have done and what markets are going to do and generally doing it in a rather different fashion from everybody else as far as I can see.

5:22And I love your description of August. In my experience, either nothing whatsoever happens or, as you say, quite big stuff happens. But I think that the biggest puzzles that I see people wrestling with at the moment are frankly making sense of what markets have done year to date. And therefore, and that's the context in which you need to see the change now, because on the one hand, yeah, the economy is much stronger than everyone was imagining. But on the other hand, markets have really done much, much better. And yeah, there's the whole AI story, but it sort of feels as though it's more than that.

5:52And I think the biggest puzzle is why financial conditions have eased so much, even as we've had ongoing QT, even as we've had rates at 23-year highs. And in fact, it was the main thing I was missing in the FOMC last night. Nobody asked Jay Powell about how they consider this easing of financial conditions. On one of the Bloomberg financial condition indices just a couple of months ago, we were showing easier conditions than 2007. And I think you need to get your head around what's been driving all of that before you can then come back and think about the outlook and what markets are doing at the moment.

6:25All right. What's the answer? Tell us the answer for the state of financial conditions, because it does seem weird. And I mean, I think we've probably been talking about this for almost two years on the show. The surprise that perhaps Fed rate hikes and the slow wind down of the balance sheet hasn't had, at least heretofore, more of a deleterious effect. So at the risk of being cheeky, it's exactly that same thing, which I heard you say had been debunked on one of the previous episodes with one of your other guests. So thank you for listening. I appreciate it. I'm glad even though I personally offended your approach, which I apologize.

7:05I appreciate your listening to Odd Lots and I appreciate you coming back. And I say that nothing is ever debunked in markets because I actually don't feel that way. Joe is open-minded. And just to be clear, what we're talking about in terms of the debunking, it was the idea that central bank liquidity was driving asset prices. That was the idea, which, Matt, is very much your approach to analyzing markets. And I was not offended either. Indeed, you became the subject of a footnote in one of my research pieces making the counter argument. But I think that the standard view of what's been going on is, oh, the economy must be much stronger than everyone thought previously.

7:43It must be that R star and neutral rates are higher. But then there are a couple of puzzles. It's like, oh, well, how come actually desire to borrow and credit growth are really quite limited? There's lots of gross issuance, but actually net borrowing is really rather lackluster. And how come many of the R star models, the most comprehensive ones, don't really show this big pickup in neutral rates? And then how do we make sense of the recent weakness, especially in things like credit and emerging markets? And so, again, the sort of standard explanation is maybe, and there was a nice academic paper on this recently, which maybe QT is just not as powerful as QE.

8:18Maybe there's some big asymmetric effect going on. And it was a lovely argued paper that I happen to think drew all the wrong conclusions. And as usual, I start from not knowing anything about this. I just look at my charts of what markets are doing and I try and make sense of them. But the way it seems to me is that market sensitivity to central bank balance sheet changes really hasn't changed at all. that most of the time when we thought we were doing QT, actually we weren't. And indeed, a lot of the time there was almost this stealth QE effect going on. And this is a lot of the reason why financial conditions have been so easy, notwithstanding all of the rate hikes.

8:55And the right way to think about this is in terms of not the security side of the central bank balance sheet, but the changes in reserves. And once you start thinking in those terms, you look globally and you say, well, since 2009, we added$18 trillion worth of reserves or liquidity, and we've only dialed back about$500 billion worth. And even if we think more recently, as you say, more or less since last time I was on, since the last market trough in October 2022, even with the supposed ongoing QT, US reserves have increased, not fallen by a net$250 billion, and global reserves have increased by$920 billion.

9:33And not only that, but the timing just fits so perfectly. And mostly, I think my charts argue better than I can here, but whenever reserves have actually fallen, so in 2022, markets fell. Whenever they fell in, say, April this year, again, same thing, risk fell back again. And that's a little of what's happened in July as well. Sorry, just to be clear on this, what are you looking at when you say that reserves haven't, Because if I look at just the pure chart of the Fed balance sheet on the Bloomberg, it's clearly gone down. It's lowest since 2020. So when you say reserves haven't gone down, what measure should I be looking at?

10:10So for the Fed, you just want the straight reserves number that you're looking at, and you see a peak in April this year, and then levels have fallen off subsequently. And then I do the same thing globally by looking at reserves. Occasionally, it's slightly different, but basically reserves at other central banks. I make sure I don't introduce FX effects to the total. and I look at the changes in those reserves. Again, you get a peak in April and then they've come off a little bit subsequently. But most of the time, the near-term market moves correspond really quite well with those. And even though we're getting a little bit of a decoupling at the moment and equities are trying to break away, it's interesting that you look at other asset classes, you look at credit, you look at emerging markets, you even look at things like Bitcoin.

10:52Basically, that correlation with the global reserves numbers carries on. All right, Tracy, just to clarify, if you look at the total size of the Fed balance sheet, it's gone down. But Matt is correct that if you look specifically at U.S. Reserve balances with the Federal Reserve, there was a peak in 2022. It fell and then it picked back up, peaked in April and then gone down. So if you look at that measure, it's correct. And I should just say Matt mentioned his famous charts just then, and we're going to embed some of those in the transcript of this conversation. So if you are listening, then please check out the transcript as well, because we will have those visuals to better illustrate the point.

11:33But Matt, just on the bank reserves point, could you walk us through, preferably in excruciating detail, exactly how an increase in bank reserves translates into higher asset prices? Is it the case that when banks have more reserves, maybe they feel more comfortable lending? Maybe it changes people's risk preferences. How exactly does that translate into concrete market action? Closer to the second than the first. But in general, I'm not sure anybody can do this properly. And I'm mostly looking at the charts and then reasoning backwards. So the most common explanations that you hear, and there's been another paper recently by Nouriel Roubini, try and relate it to interest rate moves.

12:17And similarly, the Fed, when they talk about this, they always focus on the levels of reserves. And they kind of almost ignore changes in reserves once they assume that the level of reserves is adequate. I think that is entirely the wrong way to think about it, intuitive though it may be. And likewise, I think thinking in terms of the impact on interest rates and then looking for that to cascade outwards, again, is wrong. And instead, the way I think you're supposed to think about it is that reserves are a neat way to capture the balance between how much money the private sector has got relative to how many assets are available to absorb that money.

12:59Now, in the case of sort of standard QE or QT, that's kind of straightforward enough. You know that you are both giving the private sector more money in the form of reserves and then giving them fewer government bonds or bills to hold. But I think this is also the reason why it's reserves and not securities that count, because even when it's other factors on central bank balance sheets going up and down, like the Treasury General account at the Fed or like the reverse repro program at the Fed, even when those things are seemingly innocuously moving up and down, they have this same effect. So if the TGA is going up because they have issued more T-bills and you have bought those T-bills, but then the money is locked away at the Fed in a higher Treasury balance, well, that's sort of the same thing.

13:49You've taken money away from the private sector and there's less private money in markets, more securities needing to be absorbed. And as a result, what we get is a drop in the price of risk. And confusingly, where that shows up on all of my charts is not necessarily in a drop in the price of bond yields, where you might have anticipated, or T-bill rates. Actually, instead, it shows up most clearly in the prices of equities, in the prices of credit spreads, and even occasionally in things like the prices of Bitcoin. And for me, the way you make sense of that, that's weird, because it's not like the Fed and the other central banks are buying and selling large amounts of credit or equities or certainly Bitcoin.

14:28But instead, it's this ripple through effect. It's that when they say it's the other way around and TGA is falling and I've just got more money in my bank account because a T-bill matured, but there's no new T-bill for me to go out and buy. Well, I get forced into buying something riskier and you get this cascading effect where the guy that would have bought bonds buys credit. and the guy that would have bought investment grade buys high yield and the guy that would have bought high yield buys equities. And you can't see all of those moving parts. It's sort of frustrating in that respect. But that's the only way I can make sense of these really quite consistent relationships, even from one week to the next, even when reserves are supposedly abundant.

15:05It's this shift in the balance. And in fact, the chart of mine that I'm probably most pleased with this year is the one that then links through from changes in reserves or central bank liquidity globally to changes in the mutual fund flows, the mutual fund and the ETF flows. It's this crowding in and crowding out effect as a direct consequence of changes on central bank balance sheets, which I think has been much more important than is widely recognized. And even as you try and make sense of the mutual fund flows, this year has been the second biggest year on record after 2021. We've had$600 billion of overall inflows.

15:41Again, for me, until very recently, that was being driven directly by this crowding out effect from the global central bank reserves numbers.

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17:45What is the role of rate policy in your thinking? Because again, one of the things we're talking about right now is the timing of possible rate cuts, which doesn't directly impact some of these monetary aggregates, such as the balance sheet or the reserves specifically. But there is a lot of anxiety in the market, particularly today, again about whether the Fed is going to be too late in cutting rates or etc. How do you think about that? Is that just in your view, totally irrelevant? I didn't used to think it was irrelevant, but it's sort of looking that way this cycle, isn't it? How come we've had all these rate increases and then you've not had a massive slowdown?

18:24And I think the way I think about it is, so it's always about money creation. It's always about credit creation. And normally that would be driven by the private sector. It would be you and me deciding to borrow or not to borrow based on whether rates were restrictive or not. And this cycle, on the other hand, has been different. The surge in credit that we had never came from the private sector. It came, if anything, from fiscal policy. And likewise, the surge in, say, things like fund flows and some of these market effects and the M0 or the reserves numbers, again, that was never driven by the private sector.

18:57It was never driven by interest rates. It was driven directly by these central bank balance sheet effects. And so the flip side of what I'm saying is that just as the rate increases maybe had a negative effect that's lurking in the background and there's a bit of a long lag and you begin to see delinquencies picking up. But when we eventually get to rate easing, I doubt that that is going to do very much to stimulate private sector credit growth either. And ultimately, we may end up with more easing than imagined just because we're still extremely sensitive to balance sheet changes, there never was that much desire to borrow on the part of the private sector, even before all of the rate increases.

19:36And when we go back to additional easings, I'm not sure that's going to stimulate lots of private sector borrowing either. And this is part of a longer term shift where even as rates have been coming down for decades, the borrowing that there's been, the money creation that there's been, has in fact come increasingly from fiscal authorities and from central banks directly. And rates themselves have been effectively pushing on a string. Can I play devil's advocate for a second, which is this time last year, the world was alight with talk of a potential recession. And one thing you would hear over and over again is yield curve inversion.

20:12We've never had an inversion without an ensuing recession. This year, there is much, much less discussion about the risk of a recession. Couldn't this all just be people have changed their minds about the macroeconomic outlook, and that is driving asset prices. Like a very simple Occam's razor kind of explanation for what we're seeing. It could be, and that must play some role. But in general, the timing doesn't fit. In general, the rally in the markets has come first, and then the improvement in the economic conditions has come later. I guess you could make an argument that economic surprises went negative, but in general, and the people are starting to worry about a slowdown.

20:58But I'd argue markets are always supposed to anticipate, but it's been stronger than that recently. Even when you take something like earnings revisions, for example, earnings expectations have been gradually increasing, but they seem to be doing so in response to, they're almost chasing the equity market higher by a greater extent than previously. And as I say, I wouldn't expect to have anything like the correlations that I do with the central bank liquidity. I continue scratching my head as to whether the effect could be the other way around. It could be the market that's influencing the central bank numbers.

21:35And while the lags are a bit variable, basically, no, it doesn't work that way. But for me, fundamentals have become very much a lagging indicator. And this, for me, is all part of a longer-term story whereby up until 2012 or so, I placed an awful lot more emphasis on fundamentals because it seemed to be driving the market to a much larger extent. Since 2012, many of my favourite relationships simply broke down. So the lending surveys were no longer a good guide to what spreads were doing and what defaults were doing. If anything, it was the other way around. It was spreads would rally first. And then the lending standards was ease afterwards.

22:14And the defaults that should have been taking place didn't take place. Or same thing in volatility space. There are nice relationships that used to hold with uncertainty. And since 2012, uncertainty has often been quite high on uncertainty metrics, number of references to uncertainty in the news and things like that. And yet volatility most of the time has been super low. And all of these dynamics, to my mind, go together with this money creation led pattern, but where the money creation has come directly from central banks and that shows up in my relationships. And the swings that we've had there are just really big relative to the sorts of swings that we get in money creation coming from the private sector.

22:50And that's why they end up dominating the market. Since you mentioned timing just then, let's talk about that a little bit more. So reserves peaked back in April. It wasn't until relatively recently that we really saw significant market weakness. So why was there that gap? Why didn't we see equities falling earlier on as reserves started to come down? A couple of different things. So one of the reasons why Joe was sounding so skeptical on the previous podcast was because when, if you just look at US reserves alone, sometimes they correlate, but they don't always get a much benefit with the global numbers.

23:27And some of what has been going on is that there have been liquidity additions by the BOJ and then recently from the PBOC that have some impact. I think, though, the bigger story is that the fund flows have been sort of making an effort to decouple, even as the central bank liquidity has faded. To some extent, you often have lags, especially when there's momentum-driven markets, as we've had recently, and there's a little bit of a lag before people realize that the momentum isn't there. And even now, I am impressed by how many inflows we've had, especially to equities. And it is plausible that this could just carry on by itself.

24:01It's plausible that the belief in buying the dip is just so strong that actually this carries on regardless. And although we get a little bit of a liquidity drainage from central banks, even with the quarterly refunding announcement from the Treasury yesterday and a little bit more bill issuance, actually, that could be another factor that drags a bit more money out of RRP and ensures we don't have too much liquidity drainage. Generally speaking, though, I think all of this is on much more fragile ground than it was in the first half of the year. And I think my whole way of looking at it takes you to a very different place from if you assume it's fundamentals driving markets and you assume people have been buying for fundamental reasons.

24:43And what many asset managers tell me is this fits, frankly, much better with where they've been for an extended period, which is they're not buying because they think that equities are cheap or credit is cheap at 2007 type levels. On the contrary, the reason they keep buying is because they keep having another inflow. And as I say, when you start looking at other asset classes or or even assets like Bitcoin that are much more in line with the central bank liquidity numbers than the equity market is, then you reassess the whole narrowing of the market rally and the churn that we're getting at the moment and the effort to rotate.

25:21Is this instead a sign of a natural, fundamental driven strength and the back of a Trump trade that can run and run and run? Or instead, is this actually a sign of a weakening level of support that can push up a smaller and smaller number of assets and ultimately is quite vulnerable to any deterioration in those fund flows? And that hasn't really happened yet. But I think if it does happen, then rate easing in itself is not going to be sufficient to get everyone chasing back into risk again. Joe, Matt just said that the reason funds keep buying is because there's another inflow. I feel like I have to mention here that Matt's work was the inspiration for flows before pros.