#978 - How Long Will the Fed Hold? | With Darius Dale

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0:56Hey, everybody. How long is the Fed on hold? Welcome to the Real Vision Daily Briefing. with me today is Darius Dale, founder of 42 Macro. So if you're listening and you can't see me, I was talking with my mute on. My mouth was moving, but voice was not coming out. So we fixed that. Hey, Darius. Maggie, it's great to see you. It's great to hear you as well, my friend. Yeah, right. I know. We were working on your camera before you went on. It's just one of those weeks when you have, for those of us sitting in the US, when you have a holiday weekend and you are off on Monday, it just feels like the whole week piles up into the four days that you have left.

1:32So it's been a marathon and it's only Wednesday, but on we go, upwards and onwards. So Darius, the Fed really is in focus today because we had the Fed minutes, but it's really been this story over the last couple of weeks once we started to get this hotter than expected data, the inflation surprises, and we've sort of seen this rethink in the markets. And the Fed confirming it seems like a lot of what the market, the conclusion the market had been coming to, and they themselves have been saying, right? They're not in a rush. In fact, they're concerned about going too early. Where do you think we are in this cycle?

2:05How long are they going to have to sit here? Well, thanks again, Maggie, for having me on. It's always a pleasure to be with the Real Vision community. In terms of how long the Fed can be on hold, I mean, I think a higher for longer is certainly something that's kind of been lost out of the market, a narrative lexicon, if you will, over the past couple of quarters. But in our opinion, it's due to come back and perhaps by the second half of the year, come back with a vengeance. One of the things we've been highlighting in our research of late here at 42 Macro is this market regime transition from Goldilocks to reflation.

2:37That's something that's occurred this week. And how we had determined that, Maggie, is through the lens of our global macro risk matrix, which is the primary quantitative risk management system we use to help our buy side clients consistently stay on the right side of market risk. So just really quick, just give me you got a little background on that model. Brian, if you'd go up slide number one in today's chart pack, where we show the 42 volatility adjusted momentum signals that are currently contributing to this newfound reflation regime. In terms of how this process works, we're scoring 42 of the most important asset markets in the world through the lens of our volatility adjusted momentum signal.

3:15And then we're relating that information back to, we're telling that information in accordance to how each of those asset markets have traded historically in each of those regimes. And currently, if you throw a slide two up, Brian, reflation now has the highest share of markets that are confirming it as the market regime. Therefore, we say, this is the new market regime. This is what you should be doing. From the perspective of your portfolio, you're actually already starting to see some of this. In terms of the key portfolio construction considerations in reflation, you tend to want to be long risk gaps over defensive assets, broken stock perform value, high beta tends to outperform low beta.

3:50You think about things like emerging markets, international generally outperform developed market type exposures, credit spread products tend to outperform G10 sovereign debt, foreign currencies tend to outperform US dollars. So there's a whole host of market implications as a function of this kind of subtle regime shift. It's still risk on, and we're expecting risk on market conditions to trend for a while. But that's not to say that we can't continue this correction to help investors get more appropriately positioned for reflation, because ultimately we do believe the thing that's driving reflation really may ultimately turn into inflation, which is the risk-off version, which is above trend inflation, above trend nominal GDP.

4:28Yeah, so that's really interesting. So I think that two really important points in there. One is that you can be in a risk-on environment, but still see pullbacks, because I think that's confusing to people. And it feels like there's so much to worry about, that it feels odd to be thinking for some people about risk on. And we should mention, we've got NVIDIA coming out after the close. You know, that issue of, are we in a bubble? Are things overvalued in tech? Are we going to see a massive pullback because of that? That's one of the worries that's out there. So trying to put those things together, we can talk about that.

5:02I think I also just heard you say, this is the setup now, but it may change. We may be heading to something else too. That's different. So your timeframe is going to matter, right? in terms of what you're favoring. Yeah, 100%, Maggie. And very astute to you to latch on to those two points. I'll address them independently. So in terms of can you see a correction, you very much can see a correction in the context of a risk on a market regime. That's something that happens. Corrections happen all the time in asset markets. We should lose sleep over them unless they're going to morph in a trending change in factor leadership, which is what gets you blown up on the buy side and ultimately gets you blown up even as a retail investor.

5:39So, you know, I liken this period to today to the September and October period of 2020 when we had a 10 % correction in the S &P 500. But underneath the surface, asset markets were actually getting more cyclical, more high beta, more, you know, more reflation-y. And ultimately, that was the precursor to the biggest reflation trade, you know, we've all seen in our lifetime. So, you know, I think this is very similar, particularly if NVIDIA has some sloppy results or the market just reacts sloppy to whatever results they report. This is something that could obviously deepen the correction given the concentration we've seen across all these major U.S.

6:15equity market indices. But ultimately, in our opinion, we think that's a buy the dip for now. Addressing the second part of your question in terms of going back to the original question, how long is the Fed going to be on hold, higher for longer, all that kind of stuff. We've been talking about in our research for a while now. Our clients have benefited tremendously from the confluence of immaculate disinflation and our resilient U.S. economy theme that we authored back in the summer of 2022. to those two things have coalesced to form the Goldilocks market regime that we're just exiting from and profiting from.

6:45But we might have a quarter or two in reflation, but ultimately, we think that the terminal destination for this pivot is to the inflation regime. Inflation is the risk-off version of reflation. It's above-trend nominal GDP growth or with the Fed taking away the punch bowl. Right now, the market is effectively saying the Fed's not going to take away the punch certainly not in any kind of material or draconian manner. And also Treasury issuance policy continues to be quite favorable as well. But we're ultimately thinking that by the second half of the year, it'll be pretty clear that inflation is up unlikely to return to 2 % target without, at the bare minimum, a higher for longer policy by the Fed and more tight fiscal policy by the Treasury.

7:30Yeah, that's super important. So Andreas just dropped his latest report on the platform. And he's also talking about inflation. And he's worried about bonds in this environment. Let's listen to a clip from that, and then we'll talk on the other side. When we look at interest rates, it gets a little bit more tricky. I have a chart on sort of a beta study between interest rates and the ISM manufacturing cycle. And if you look at 10-year interest rates in the U.S. relative to ISM manufacturing, those two charts or lines that were basically glued to each other from 2008 until 2020. And then inflation started wreaking havoc with this correlation.

8:12So inflation was back as a driver of trends in interest rate space. And given that we see this cyclical uptick now with some signs of already sort of accelerating underlying inflation pressures, I think the safest thing to say around interest rates here is that they probably lean upwards in such a scenario here. So I don't see much reason in buying 10-year treasuries as a diversifier in your portfolio here. I would rather look towards the commodity complex, stuff that actually performs in a scenario where manufacturing ticks up, inflation ticks up marginally, and liquidity performs in the dollar markets.

8:57I'll show you one chart on why that is. It's very hard to buy bonds in this scenario if wages re-accelerate, if the price of goods re-accelerate alongside the commodity cycle. And that full interview is available on our website. If you're watching on YouTube or listening on the podcast and you are not a full member, come register at realvision.com so you can stay up to date on all the amazing things and conversations we have going on. So Darius, Andre is saying hard to buy bonds in this environment and talking a lot about commodities. And we had Adam asking, I think you partly answered his question, which was after evaluating all the data, what's your current stance on the market?

9:37How are you positioned in the short term versus the medium term outlook? I think you just talked about short term versus medium term. But how are you thinking about this? Are you finding the bond outlook difficult as well? Yeah, yeah, absolutely. So the bond outlook is quite interesting. And I want to go back to the discussion that Andreas just sort of put in front of us, because I think it's a very important discussion to have. And it's certainly a discussion that I've had many, many dozens of times with our institutional investor clients across global Wall Street. I've had many conversations with some of the most important PMs and CIOs of the world about this very topic, about how, you know, these traditional models like TSGE models and autoregressive tools have really just failed investors and failed economists in terms in this post-pandemic era of above-trend nominal GDP growth and real, you know, true fiscal monetary largesse.

10:28This has been the most unusual business cycle that we have on record. We don't have too many business cycles on record because we only really started tracking the business cycle roughly 100 years ago. But in terms of the, this is by far the weirdest one. We have a lot of asynchrony throughout the various cycles in the economy. We have something that's going on right now that we've never seen before, which is immaculate disinflation. It's obviously been a very powerful force for asset markets. So in terms of, I think we need to, as investors, have an open and honest debate about the tools and models and frameworks that we're using to generate investment insights and ultimately position for as investors.

11:06Brian, if you go up slide five in our today's chart pack, we talked about this before, Maggie, in terms of our macro weather model. This is a dynamic, stochastic system that we built in response to the recognition and the long-form discussions that I've had with our institutional investor clients over the past couple of years to better right-size our portfolios to market risk. The reality is the economy is a lot less, again, as I mentioned, synchronous. The various cycles within the economy, whether they be real economy cycles on the left or financial economy cycles on the right, have broken down and have been less correlated with each other as they ever have been.

11:45And this is why we built the dynamic stochastic system to help us understand, OK, what's actually changing in the economy, as opposed to saying, oh, this thing changed, therefore that thing should change. That's what most investors are still doing. And in our opinion, I think that's going to continue to cause investors to lag broader market returns. 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. Join over 5 ,000 attendees for the largest AI event in Asia at Super AI Singapore, June 5th and 6th, 2024.

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14:00I think that's a really, really good point, Darius. And we've been talking a lot about this and we're going to continue to talk about it next week in some interviews we're doing because it's been confusing, right? But to your point, it's been very different and what's driving it matters. I had a conversation with Paul Hodges today with another small group of our VIPs. And he was sort of saying at some point, well, that would have been true if you're in a capitalist situation, but in many ways, because of all the government spending we've seen, we're not in that situation. So things are happening.

14:33You can't apply the same cause and effect that you may have done in prior years or prior decades. And it was really fascinating. So you're right. It's so important, I think, to kind of reboot and look at that. And that's why we lean on folks like you who are kind of grinding it out down deep in the research and modeling to try to figure out what's accurate now and are we looking at the right things. So it's super important to flag that. Yeah, I appreciate you saying that. And it's not like we have some real clear crystal ball into the future that's clearer than the, you know, it's certainly clearer than the average investor, but not any more clearer than our institutional investor clients.

15:12The reality is we just have the ability to understand and accept the fact that a lot of these traditional relationships, these two-factor models or these even more complicated DSG autoregressive models just aren't working with the same precision and accuracy that they worked in the great moderation. And the reality is, unless we accept that and humble ourselves and accept the fact that markets and the economy are going to be a lot more dynamic and stochastic going forward as a function of this, in my opinion, the fourth turning regime that we're in, and as a function of that, the fiscal monetary largesse we're seeing in response to various cycles of the economy.

15:47If we accept that and humble ourselves and incorporate that humility into our investment process, I think we're going to have much better results than investors that are certainly relying on old tools, but certainly, even if they're not relying on old tools, not having the humility to pivot to new ways of thinking, new ways of assessing economic and market risk. Yeah. That's what we talk about all the time. We all have to sort of keep reskilling and stay on the learning journey because it's not a static environment and things are changing. So we've got a few questions here. Let me see. I want to get to a few of them because they're good.

16:24So the macro butler is asking, Darius, is the bubble not in the bond market rather than the equity market? I think a little English translation here, but are we seeing more of a bubble in bonds, even though everyone's been worried about the bubble in tech? I think that's what he's asking. No, you'd have to have significantly higher. So if you think about how to deconstruct bond yields, you need the trend, nominal GDP trend, and term premia. Term premium are right around flat right now. The mean of the term premium for the, you know, at least if you look at the ACP model, which has a time series going back to late 1960s, you know, the mean of that is around 150 basis points.

16:59So you can argue that, just get back to mean term premium levels that, you know, the 10 year treasury yield is perhaps undervalued by 150 basis points. But certainly I would argue that relative to the Fed's neutral rate target of 50 real 250 basis points nominal, that we are probably, the Fed is a little bit undervalued. And the markets are perfectly priced in that. And if you look at money market curves out two, three years, they're not getting back to two and a half percent, a 50 basis point real. So I think the market is a lot more in line with where we've been, which is, you know, this economy has sustainable juice.

17:32You know, you remember that cheap? I would come on with the 10 things that were contributing to the our resilient U.S. economy theme. And a lot of those things are persistent, structurally persistent. This cash on corporate and consumer balance sheets isn't going anywhere back. You know, we have, you know, I want to say it's about, you know, roughly$5 trillion of cash on household balance sheets,$2 trillion of cash on corporate balance sheets. You know, if you aggregate that, it's six in two. So it's right around$8 trillion of cash on household and corporate balance sheets here in the U.S. combined.

18:04That's up from$4 trillion prior to the pandemic. That$8 trillion is 5 % of total assets. We haven't seen such a high ratio of liquidity on household and corporate balance sheets in the US economy since going back to the early 1950s. So we don't really know what to make or what to think about the resiliency and sustainability of this above trend nominal GDP environment that we're in. And so I think one thing that's happened in asset markets, dating back to the beginning of this conversation with the subtle regime shift from Goldilocks to reflation, I think that's the market's interpretation of saying, hey, soft landing has peaked in terms of the market psychology, the probability associated with soft landing.

18:41and is losing share and no landing, that scenario is gaining ground as a function of that. And eventually, the no landing will take too much share from soft landing and actually cause problems for asset markets because market participants will appropriately forecast that the Fed and Treasury will start to take away the punch bowl. But in our opinion, we're not there yet, even though we may still be in a correction in that case. So Doug is asking, if reflation is negative for DXY, do you expect commodities to outperform the market? Yeah, absolutely. So commodities are one of the risk assets to not perform defensive assets.

19:16So commodities are certainly one of those plays that tend to work well in reflation. Not every reflation regime is going to look exactly like all the other reflation regimes in history. But what we're trying to do is create a central tendency of the distribution so that we know what kinds of factor bets and factor pivots we need to make to stay on the right side of market risk. When I say that phrase, that should trigger something in your head, particularly as a retail investor, because our buy side clients, the people I meet with every afternoon, they need to stay on the right side of market risk.

19:46They don't have a choice, otherwise they're going to lose their seat. But a retail investor can be long a theme or short a theme. They can be short a raging bull market or long an asset that's drawing down for multiple quarters at a time because they believe in the long-term thesis. The reality is that's how you blow yourself up. But the reality is there's no risk manager to tell a retail investor they need to stop doing that. But if you want to stop doing that and you want to actually start to consistently make and save money, you got to think about incorporating tools that will allow you to stay on the right side of market risk, like our global market risk matrix.

20:16It's a trend-following system that's obviously done quite well for our clients. Yeah. So Adam was asking, in reflation, what does that mean in terms of allocation decisions? Are you favoring certain styles, sectors, geographic areas, underweight, actively short? I think that you, if I remember correctly, Darius, you're not a fan of shorting because of the dynamics of the market, right? Did you say that one time when we were on? I don't believe any retail investor has any business shorting in the world. I don't think most RA investors have any business shorting. Leave the shorting to the market neutral players whose job it is to short.

20:50Shorting is too difficult to risk manage. I'm not saying that you should. I'm not telling people what they should do. I'm just telling them that their goal is to actually make and save money across market cycles. The best bet is to approach investing from the perspective of one side of distribution risk and hedge the other side of the distribution with either trend following strategies or delta or option strategies that allow you to take advantage of pullbacks in the markets that preserve capital and allow you to reinvest. That's the way markets go up over time. With the exception of currencies and commodities, which are stationary time series, the vast majority of asset markets appreciate over time.

21:24So the reality is there's really you're really fighting a lot of a lot of data and a lot of return. You put on short bets. And so, you know, when we're coaching our institutional investor clients on these factor pivots like high beta, long, low beta, short, you know, simple, long, defensive, short, you know, those kinds of bets. EM versus DM, those kinds of bets you would make in reflation, you know, industrial commodities, energy commodities, those types of things are the kind of things you want to be long versus a U.S. dollar or gold in that space. Those are the kinds of bets we're coaching our institutional investors to make.

21:55But as a retail RA investor, just go along the thing that's working and make sure you have some systems in place or some hedging in place to take care of the leftovers. Yeah. Way better, better, better. Again, super important, right? Know what kind of trader you are. The messaging is not the same depending on what your needs are. So if you are retail, you are going to be paying attention to things naturally that others are either not at liberty to or they have different mandates that they're following. Got a question about Bitcoin from Ralph. I can see a bit of a shorter term pullback in Bitcoin and ETH.

22:31What does Darius think of those and the US dollar going forward? Yeah, so reflation, Bitcoin is an asset that works very well in inflation. Again, reflation is a risk-on regime. The difference between reflation and Goldilocks is very subtle. You tend to want to be more exposed to sort of the cyclical components of asset markets. You want to be even less exposed to defensive components of asset markets, things like gold, things like G10 sovereign debt, things like the US dollar relative to a Goldilocks regime. You don't want to be long those things relative to their counterparts anyway, but you want to get incrementally less along those things or incrementally short those things if it's your job, emphasis on job, to be short of those kinds of things.

23:09We'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.