#1027 - Higher For Longer… Then What? with Darius Dale? | Inflation, Rates, & The Fed

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2:05did the pet bedges pivot again hi everyone welcome to the real vision daily briefing i'm maggie lake with me today is darius dell founder of 42 macro hi darius how are you i'm doing well maggie how are you i can barely speak because i'm just trying to keep up with what's going on here what a day i I mean, the mood was very nervous going into the Fed. And then the Fed chair started speaking, and we saw markets take off, stocks spiked higher, yields started to drop on what seemed to be a very surprisingly dovish pressure. And then the markets have given it almost all back now here as we close. I mean, we still have to settle up, but it seems to be a really sort of volatile reaction.

2:46What did you make of what you heard? Yeah, absolutely. So thanks again for having me on the program, as always. Great to be here with the Real Vision community. So in terms of what we heard from the Fed specifically, obviously Powell went out of his way to send a dovish message to market participants. They're effectively not two-faced by the backup and inflation that we've observed on an annualized basis. But in terms of the market get back, obviously the rally that we saw on the statement and on the early innings of the press conference was, in our opinion, obviously shorter-dated duration or shorter dated volatility products being covered, causing a gamma squeeze higher in markets.

3:22But once we got through that activity, the market style started to look ahead and start to say, OK, was the Fed dovish enough today to fully and completely and fully offset the hawkishness that we've seen week to date from the Treasury's quarterly refunding announcement? And clearly, with this aggressive giveback that we've seen in the stock market, the answer is no. Yeah, they're not buying it, I guess, which is interesting in and of itself. So there was a lot going on in the presser, first of all, right? He said that it was very unlikely that the next move would be a hike. But then he also gave some details on QT and some of their posturing.

3:59I mean, it really seemed like they're trying to use the verbal messaging to try to fine tune this because they know that people started to really be thinking that we were going to start the day saying hire for longer. What happens now? Or, you know, now we're like, wait a minute. That doesn't seem right. Anything that jumped out at you that was interesting, especially now that we have talk of QT easing up a bit as well? Yeah, so in our opinion, so yeah, I think it's important to kind of unpack the policy rate side and the balance sheet side separately. But just as a general overarching takeaway, in our opinion, this is a Powell Fed that is powtowing to fiscal dominance.

4:42And this is a Powell Federal Reserve institution that really wants to ease monetary policy to the extent that they can. We're just not so sure that based on the data, they're going to be allowed to on a reasonable time horizon to maintain the bullishness that we've seen in asset markets. So if you go to slide 10 in today's chart pack, Ryan, where we show the dot plot relative to Fed Fund futures on various tenors and durations, and we see that relative to where we were in March, we've seen Fed Fund's futures pricing back up in rate terms for 2025, 2024, 2025, 2026, and pretty significantly all the way out the curve until the fuller Fed Fund's rate.

5:22So we are now only pricing in two cuts thereabouts for 2024, another two for 2025, not even a full cut for 2026. And then ultimately a couple more cuts down from there to the terminal to the floor Fed Funds rate at about 4%. So Powell did his best to sort of support that market pricing, that dovish market pricing, even though it's gotten more offish in the margins in recent weeks. And then on slide 11, Brian, where we show U.S. bank reserves as a ratio to various statistics in the economy, nominal GDP, total bank assets, total bank liabilities and bank deposits. And as you can see in the blue line in each of those charts, the ratio of bank reserves to all those indicators has not only stopped going down quite a long time ago, almost a year and a half ago, but they've been gradually trending higher.

6:12really is, in my opinion, is a function of what had been pretty dovish net financing policy out of the Treasury. And so the fact that the Federal Reserve here with annualized inflation running at some pretty ridiculously egregious levels following the heels of a very hawkish ECI print that we got on Tuesday, the fact that the Federal Reserve is trying to slow balance sheet runoff, they're going to reduce the balance sheet runoff pace for Treasury security sum to$25 billion a month,$60 billion a month, while maintaining a mortgage-back runoff at$35 billion. The fact that they're doing that in the face of a pretty resilient economy and increasingly resilient inflation, to me, again, goes back to this idea that this is a Powell Fed that wants to count out of fiscal dominance and create monetary space for the fiscal authority to continue supporting the economy.

7:00Yeah, I mean, so, and this issue has come up. In fact, we were talking to Ms. Schneider yesterday, and we had the market selling off, And she pointed out that part of it was also about Yellen talking about all the things she was worried about. I want to run a clip. Ash just had a great conversation with Scott Bessent, longtime macro, managed and worked with George Soros for years, runs his own hedge fund. He just talked to him about how they had a wide ranging interview. But this issue of the debt situation in the U.S. came up. Let's have a listen to what he said, and then we'll talk on the other side.

7:38Yellen is trying to goose the economy. She's a political appointee. And I would say she has gone from public servant to apparatchik. And she is playing a lot of games. And she has shortened the debt maturity. So not only do we have these gigantic deficits, what is exactly the wrong thing to do is to move the maturities to the short end. So now that the U.S. is becoming like an emerging market, we are rolling 90-day treasury bills. And this goes back to, I believe that Xi and Powell thought that they would be cutting rates now. And obviously this was a terrible miscalculation. The Fed failed the American people with the great inflation of 21 and 22, they were very late getting to hiking rates.

8:47And kind of in the ultimate absurdity is they were doing QE right up until the month before the first rate hike. So anyway, that was a long way of saying, I think the markets, we're seeing this back up in yields, We've seen gold move up versus the dollar. And we are getting we are we are in a very unstable position now. Hey, everyone, we're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing. Today's Real Vision Daily Briefing is brought to you by Chintai, your partner in asset tokenization.

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11:35A really fascinating interview. If you want to see that entire conversation, they touch on a really wide range of topics. Just go over to our website and check it out. And if you are not a member, join. So you can see this kind of great stuff, long form stuff that we don't often get to see or hear from, especially folks like that. Obviously a little politics in there. and Yellen is at Treasury. Part of this fiscal dominance is, of course, comes from Congress. It's not Treasury, right? If you all do your civics class, Congress is the one who passes the bills that increase the deficit, whether they want to admit it or not, which is what they're trying to fund right now.

12:14But that aside, he brings up some really good points, Arias. And I think that this is one of the issues that, and there are two of them, that we're getting to the point where there's a question mark as to whether you can increase rates when you've got these debts and service that amount of debt. And this press conference, I think, plays right into that idea. In fact, there was a great tweet, I think it was by Sven Heinrich, who said that Yellen needs lower rates and she knows it and so does the Fed, that this is basically coordinated action to keep liquidity flowing and to enable further debt sales without accidents, basically putting a ceiling on yields, that sort of idea.

12:59The other issue I think that Scott brings up, which is super important, is does the market go along with it? The market has to have confidence in all of this. And if they think that inflation is a problem, then you get that sort of bond vigilante stuff going on where the market's going to do what the market thinks is right, and they're not going to really pay attention to what the Fed's saying. So how are you thinking about all this? Because these are really big themes. Yeah, I appreciate that, Maggie. So I've known Scott pretty well for a long time, and he and I fundamentally disagree on this.

13:29In our view, the Treasury is moving further away from financing itself in the bill market, as we got the indication from in the Q2 QRA. Brian, if you throw up slide four in today's chart pack, where we show the share of net marketable borrowing in the bills market and the coupon market, and as we see, we're going into heading into Q3, the 34 % share of bills on a 12-month basis through Q3 of this year will be the lowest share of bills since the first quarter of last year. And so the Treasury is moving further out on the curve in terms of its net financing policy. And in our opinion, she's doing that explicitly to send a honkish message to the market participants for two reasons.

14:11One, Brian, if you go up slide seven, where we show the spread between market-observed interest rates relative to their various counterparties on the Treasury curve in segment terms. And we see that if you look at the bill market, where the bill yields are in the market currently relative to the Treasury's weighted average interest rate on bills, that is the only segment of the Treasury market where the Treasury is actually getting a discount to issue. So the fact that she's issuing less bills at the margins on a share basis, in our opinion, is an explicit hawkish signal. And then number two, on slide eight, we just don't see the same kind of rollover refinancing risk in the Treasury market that Scott alluded to.

14:54When you sort of think about the average maturity of total outstanding marketable debt, here we show on slide eight in the top panel, is 71 months. It's almost at an all-time high. It's essentially at an all-time high. If you look at it in terms of the percentage of marketable debt that's maturing in the next one year, two years, and three years, that's 34%, 45%, and 54 % respectively. And each of those shares is lower than its long-term mean. And so this is a treasury market that over the last, let's call it 10 to 15 years, has really termed out its portfolio and taken advantage of what was a historically low era of interest rates to term out its debt portfolio and is now moving in the other direction on a structural basis.

15:34But on a cyclical basis, i.e. what we just learned this week from the QRA, which calls for Treasury debt issuance on a net financing basis to increase to$847 billion from$243 billion in Q2 to$847 billion in Q3, and also an increase in the Treasury general account balance by$100 billion to $850 billion. Those are very explicitly hawkish signals, and she's doing it in a composition manner that suggests that we could see some indigestion in asset markets if Powell is forced by data to get less dovish. Well, wouldn't we have been forced by data to get less dovish now? Because granted, we've seen some of the economic indicators, consumer confidence, some of the PMI readings looking terrible, but most of the inflation data has been coming in above expectations.

16:22We had the employment cost index this week. Are we getting a wrong signal from some of that inflation data? I know some of it's forward looking, some of it's backward looking, and there's a discussion about that. Wouldn't you have thought based on that? He knew that there would be this response today by doing this. You knew that, but I mean, the markets are not following through, but one could have presumed that you'd get a big rally. So how do you think that's playing out? And do we have it wrong? Does the market have it wrong about inflation? No, so in my opinion, I don't think the market's ever really wrong.

16:56It's just the positioning cycles you have to deal with. And so the unwinding and building up of positions causes the market to have awkward prices at different times, but the market's never wrong. It's the market. But let's get back to the question. So in our opinion, how is the last line of defense between hawkish inflation data and hawkish developments in the economy from a forward-looking perspective, which are separate, and a more hawkish overall pivot by the Federal Reserve? So let's kind of unpack a few of those things in succession. Brian, if you go up slide 14 in the chart back today where we show the headline PC deflator, the core PC deflator, and the super core PC deflator on a three-month annualized rate of change basis in the blue bars, six-month annualized in the black line, and the year-over-year in the blue line.

17:37What we see here, if you look at the bottom, we've seen a super core PCE inflation on a three-month annualized rate of change basis. It's now back up at the highs, the highs that we observed in 2021, 2022, and early 2023. And we are now having a what we call a textbook acceleration, whereby the six-month annualized rate of change is faster than the six-month annualized rate of change, which itself is faster than the year-over-year rate of change, which implies the date-time series may be bottoming from a structural standpoint. Number two, so that's the backward-looking data. The forward-looking data, you obviously mentioned this is the ECI print that we got on Tuesday.

18:12The employment cost index on the private sector side of things accelerated to 4.4 % on a quarter-over-quarter SAR basis. That number is 200 basis points faster than its 2015 to 2019 trend. So we are in no man's land with respect to wages. But the final thing I'll call up from a forward-looking perspective is what Powell sort of alluded to today, which in our opinion is the number one reason why he still is so dovish, is the quote-unquote healing of the supply-side economy that he highlighted. So, Brian, if you go up slide 12 in this chart, we show non-farm productivity growth on a quarter over quarter star basis and on a year over year basis in the bottom panel.

18:48As you can see in both metrics, both time series, we are well above trend in those time series. Now, we're going to get productivity at 830 tomorrow morning. And, you know, the early read through is that productivity growth should have slowed pretty much here really, just given that we've seen a pretty big backup backup in hours work and a pretty big reduction in overall output in GDP terms. And so productivity growth slows, as we show on slide 13, that's going to be an issue from a forward-looking inflation signaling perspective, because we know that whenever wage inflation materially outpaces productivity growth, as we show here in this blue line here, that's the spread between wage inflation and productivity growth.

19:23We tend to have these big backups in actual inflation, like CPI and Corp. EC, the black line and the red line in those charts. So if productivity growth goes down and wage inflation stays where it is or continues to get hotter, then that would be a forward-looking indication that some of the stickiness that we've seen in reported inflation statistics over the past few months is not just this transitory blip. We're just settling in at a much higher structural level of inflation. And ultimately, Powell will be forced kicking, it'll be dragged kicking and screaming into or pivoting back to a higher for longer guidance.

19:55And that's what markets are probably latching onto is that, you know, if we start to see less supply side improvement, probably be forced to pivot. In our opinion, that'll be a very ill-time pivot in the context of those quarterly refunding signals. Why? So they could have just said almost nothing today. You know, they could have just left it. They seem like they were taking inflation more seriously. they haven't removed their easing necessarily from the forecast. They were sending out trial balloons saying, we may have to hike actually, when the market seemed to have been too confident about those easings.

20:31They kind of got the market back on equilibrium and worried again about inflation and inflation expectations. So why introduce all of this confusion, I guess? Do you think they are worried about the economy or do you think there are a lot of people, I mean, And you know what Twitter's like. And everybody wants, you know, like we often take a step back and walk through this. But do you think that they're worried about liquidity in the Treasury market, that they did want to, without doing straightforward yield concur, they did want to sort of somehow put some sort of broad ceiling or at least slow down the increase on yields?

21:08Yeah. So I think when you take a longer term view on this, Maggie, and this is something we've talked about in the context of our second inflation model over the past few years. When we look back on this period, let's call it three to five years from now, in our opinion, we think one dynamic will be very clear, which is the Federal Reserve, rather than go the last mile of disinflation to get inflation sustainably back 2%, opted to save the economy rather than achieve its inflation mandate. When faced with the choice between achieving its price stability mandate or its maximum employment mandate, we think this Powell Federal Reserve will most certainly choose its maximum employment mandate.

21:43And ultimately, that is structurally bullish for the sustainability of the business cycle, which itself is structurally bullish for risk assets. But it's obviously structurally bearish for things like the bond market and perhaps the U.S. dollar as well. Now, that doesn't necessarily mean, you know, risk assets are going to appreciate in a straight line from here or defensive assets like treasuries of the dollar and volatility products are going to depreciate in a straight line from here. Because, again, it's all about where you are in this market cycle. Positioning has gotten way extended and we may be headed into a period where the supply side improvement in the economy stops improving for a while.

22:17That causes Jay Powell to change his tune and really kind of, you know, stop being as supportive in terms of forward guidance for asset markets. And that is a big risk. And in my opinion, I think the giveback that we saw in the markets today very much agree with our fundamentally oriented view here. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

22:44So Boris is asking, you just mentioned positioning. Do you have any insights into the current positioning of investors with regards to bonds and equities? There's been a lot of talk about the 60-40 being broken. And so what do you do if you're worried about valuations on equities, but you've got this continued volatility in the bond market? What are you seeing in terms of positioning? Yeah, it's pretty stretched. So in our positioning model, we track upwards of 10 indicators that all have time series back multiple market cycles, some the furthest back into the late 70s, early 80s. And when you think about this on a tactical standpoint, we've seen a little bit of a reduction in net long positioning across markets.

23:24So that lessens the need for a pullback over the very immediate term. But when you think about this from a structural standpoint, the more stable, stickier positioning indicators are still very much signaling elevated risk of a market crash over the long term. And so that's something that's quite worrisome in the context of, again, the Treasury is very explicitly, in our opinion, trying to tighten financial conditions. and perhaps with the expectation that they can sneak in a few dovish inflation prints between now and the election. But if that does not happen because we stop seeing the supply side improvement in the economy, particularly on the productivity front, then the Fed may be forced to start to tighten financial conditions again as well.

24:01Rhetorically, they're obviously not going to hike interest rates anytime soon, but just pivoting back to explicit higher-front-long-forward guidance with the dot plot and with their words and actions very well could cause funds to flee back onto the Fed's balance sheet in the form of the VersiPo facility. We showed that on slide nine, Brian. You could cause a sort of unwind of a lot of the positive liquidity dynamics that we've had have really aided and embedded asset markets, not just from the October lows of last year, but really all the way going back to the F since the October lows of 2022.

24:32Yeah. So Chris A asking, have we started to enter a risk off regime for gross stocks and crypto? That's a great question, Chris. Yeah. Unfortunately, you've got to be a 42 macro client. See, I want to make a quick shout out here. I'm happy to explain all these sort of critical growth, inflation, and policy dynamics, because I'm really grateful for the opportunity to educate folks on this esoteric institutional finance stuff. But when it comes to making and saving money in asset markets with explicit guidance and explicit portfolio recommendations, that stuff's reserved for our clients at 42 macro.

25:07Yeah, which we respect. So when we see something like this now, Darius, do you have to go back and recalibrate everything based on, or are you just sticking with your signals and this is just sort of market noise in what is a bumpy period we're in? What I will say is that this is not just market noise because the change in market signals that we've observed in the past sort of month or so, if you throw up our macro weather model on slide two, that's one of our more important leading models that gives us an indication of how the market regime might evolve over the next three months. It doesn't tell us if the market regime has evolved, but it will suggest that, hey, we might be in condition A and the probability remaining in condition A over the next three months is increasing or declining.

25:53So I would say the probability of remaining in condition A, which is a risk on regime, as evidenced by the deposit signals here in our macro weather model, which we refresh six days a week for our clients, the probability has declined pretty meanfully. And it's declined based on fundamental reasons that are being captured by those cycles, real financial economy cycles that are being scored daily in that model. If I can think about this from a thematic perspective, so that's on the quantitative side in terms of how to anticipate regime change. and actually more importantly, position for regime change so you can actually make money in financial markets.