#990 - Is This a Goldilocks Market? | with Dr. Sri-Kumar

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0:56Is this a Goldilocks market? Boy, that's a hot topic for debate. Welcome to Real Vision Daily Briefing. It's Friday, March 8, 2024. I'm Ash Bennington, joined today by Dr. Komal Sree Kumar, president of Sree Kumar Global Strategies. Sree, welcome back to the show. Thank you, Ash. Good to be back with you. Well, it's always a pleasure to have you with us sharing your wisdom, but especially today, boy, is this a macro moment that we're having right here. I set it up at the top of the show. Lots happening in markets. Lots of chatter about the Fed chair's testimony yesterday. We got some new numbers out on the NFP data today.

1:31Sri, where do you begin to get your head around these markets? I think where you start with, as you quite correctly said, Ash, you start with the Fed. You start with Powell and his statements. And the big news of this week is the fact, in addition to the jobs report that we got today, the difference between the presentations that Powell made to the House Committee on Wednesday and what he told the Senate Committee yesterday. The difference is that he decided probably that his first speech was not sufficiently positive for the markets. So yesterday, he added on that we are not very far at all from cutting interest rates.

2:13That's a new addition, which didn't exist before. And I think the change now is because he's again switching. He wants to make sure he's recognized as taking the investor's interest into account. But what bothers me here is that that is not his mandate. His mandate is inflation. His mandate is employment. And a Fed chairman, however ambitious you may be, you need to stick with your two goals in the mandate, not create one of your own. Well, this has been one of the hot topics now in terms of what exactly is the Fed's mandate. Is it supporting equity markets? Is it combating climate change? All these other causes.

2:55Lots of folks are very concerned about that. What do you think, how are they going to steer a middle course between the Scylla and Charybdis of the dual mandate, which in itself, forget everything else, is a real challenge? You're absolutely correct. The twin mandate itself in some ways is illogical. We say in logic, when you have one instrument, that one instrument can be used toward one target. You can't have one instrument, namely interest rate changes, and you hope to have an attack on two goals with respect to employment and with respect to prices. But let's set that aside and say somehow we accept it.

3:35But the Fed is being pushed, as we saw in Congress in the last couple of days, by Democrats and Republicans who both want him to do what they want him to do from an electoral point of view. That is adding a new dimension to the whole part. We also have a problem in that Fed chairman typically come from the private sector. This one in particular doesn't come from academia. He comes from the private equity area. He will probably go back there after his chairmanship ends. And so there is an innate bias in terms of how they act with respect to policy. that is in addition to the twin mandates that they have.

4:20Well, I suspect Chair Powell is going to do pretty well after he leaves this appointment. But I wanted to touch on the new news here, which is the nonfarm payroll data out today. It's kind of a confusing, something of a mixed report, I guess you could say. The rate of wage growth is slowing. The unemployment rate jumped from 3.7 prior month to 3.9 % in February. and net increases in non-farm payrolls. Non-farm payrolls came in at 275 ,000 above consensus, above the top of the consensus range, which was quite wide, I must say, 95 ,260 ,000. And above prior month revised, which was revised to 229 ,000 for January, revised down from 353.

5:02I mean, the data just is all over the place. I don't know, you can't make heads or tails of it. You're absolutely correct. Let me put it to you this way. If I were Fed chairman and if I was speaking yesterday to the Senate committee as Powell did, and let's say that I have some prior inkling on what numbers are going to come out today because I'm the Fed chairman and I get some preview on what the information is going to come out like. If that were the case, I would be a lot more cautious in terms of how I'm going to steer the ship. I will not provide forward guidance for fear. That may turn into forward confusion because, again, as we know, Powell has had the situation before when he spoke about transitory inflation and then inflation took off as he doubled the balance sheet and cut the interest rates down to zero.

5:56Once you have done that, and in December, he made the error again, suggesting that rate cuts are coming quickly. By the January 31st press conference, he had to reverse himself. Given the history, given the record, and as you said, Ash, the cloudiness of yesterday's numbers, employment being high, but the past numbers being revised down, wage increase month on month only 0.1%, However, year on year is still running at an unacceptable 4.3%, which means inflation is being fed by wage growth. When I have all of this information, if I were Fed chairman, I would be more cautious, which again was not the case with Jerome Powell.

6:43And that to me is very puzzling indeed. Well, it's almost like he's just in an impossible position, right? Because he made this statement. This is, I believe, from the House testimony. Reducing policy restraint too soon or too much could ultimately require even tighter policy to get inflation to 2%. True. At the same time, reducing policy restraint too late or too little could unduly weaken economic activity and employment. So you get criticized when you say make a definitive statement. You get criticized, you know, people, the Harry Truman clip about a one-handed economist. I mean, it seems like it's a no-win situation, probably, as you point out, Sri, because he's battling both sides of the dual mandate with tools that you can either optimize for A or B, but not A and B.

7:28Right. He is in an impossible situation. And when you find yourself in a difficult position like that, it pays to be cautious. That's why I say that it is not helpful to investors that he has been swinging to the fences one month, and then he's pulling back the next month and swinging for the fences again the following month. So we have had this switch take place. It is actually bewildering after if you put December through yesterday's speeches all together and you say, what is the Fed view? The answer is no idea whatsoever what they really think. Add to this, Ash, what is happening with the other statements.

8:12December 13th, he came through being very dovish. The very next day, John Williams, who is the president of the New York Fed, often thought to be the second most powerful official at the Fed, he came out and said, oh, no, interest rates are not going to be cut very quickly. Wait a second. The chairman said yesterday they are going to be cut very quickly. You today don't think it's going to be cut quickly. Who is correct and what are you thinking about? So more officials came forth in opposing him. So the Fed is essentially not helping in terms of confusing the picture repeatedly with statements which don't make sense with each other.

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10:46All right, Sri, talking about impossible situations, I'm going to ask you two impossible questions. Based on the data, one, where do you see the balance of risk? in which direction are you more so concerned? And then I've got to ask you the reaction function question, which is like this Keynesian beauty contest situation, which we find ourselves in, which is in which direction do you think the Fed is more concerned going into, obviously, this election season? I'm going to take that as three questions, Ash, and let me tell you why. First, what is going to happen to the Fed? Set aside the election for a moment.

11:22How is the Fed going to act without taking into account elections? They think inflation is going to come down by itself with the weight of all the past rate increases. I do not believe so. And the reason is, take a look at the Fed's balance sheet. It is still 75 % to 80 % larger today than at the start of COVID. This is after so much of QT or quantitative tightening that has already taken place. So that's one reason to worry about it. Second, there are a lot of geopolitical uncertainties with respect to oil and the Middle East, food prices and the Ukraine conflict, transportation problems connected with the Red Sea shootings and the possible problems in the Taiwan Strait.

12:16When all of these are concerned, inflation is an upward side. There is a lot of concern as to which way it can go. Second, what is the reaction function here? I don't think inflation is going to come down automatically by itself. On the other hand, there is going to be a cut in the interest rates, I believe. And I think quantitative tightening before the end of this year is going to be reversed and we are going to have quantitative easing on our hands. Do they both happen because inflation has come to 2 % or lower? No. I think the reason why the changes are taking place is because there are shocks to the system in terms of what we see happening on the banking side.

13:01Before the banking crisis of last March, I had written in my public notes that there is going to be a credit event. It turned out to be the regional banking crisis. Since then, I've been saying there is going to be one more credit even. And that is turning out to be increasingly the worsening problems on the commercial real estate side and how that is enveloping a whole lot of different banks. Another issue, the consumer is overextended. He or she, despite the high wages that they have got, are spending even more than that. And credit card debt, even for the largest banks, are increasing. When you put it all together, I think something is going to break in the system, causing the Fed to abruptly reverse and then cut rates and introduce quantitative easing.

13:55Think September 2008, think March 2003, when both cases, when the policies in 2023 again, the reversal took place with respect to quantitative tightening, which was stopped last March, and we introduced quantitative easing. So those are the two things. Now bring the election in. You have an additional complication. And I think this is where I keep repeating that the Fed likes to say that they don't even know and don't talk about elections. They never come up in their discussions. Well, if you believe that I'm going to make myself a very rich man, I'm going to sell you a lot of bridges to a whole lot of different people because it looks like a very gullible public that would think that the Fed does not have political intentions.

14:50The Fed is very political and let me tell you why. Again, based on factual reasons, a president is elected every four years. The chairman of the Federal Reserve is also nominated for four years, but his or her term does not end with that of the president. It typically ends about a year and a half after the new president comes in. And in this case, because Powell was late in getting confirmed, his term ends in March of 2026. So the president would have been in office, new president would have been in office for about a year and a half before the term comes up. Clearly, Powell has had run-ins with Donald Trump during the final months of the Trump administration.

15:40He's still being criticized by him as wanting to cut rates in order to help Joe Biden. On the Democratic side, we saw the questioning take place in the House two days ago, Ash, saying, why don't you take into account the concerns of homeowners, people who want to buy homes? Why don't you cut interest rates? So the pressure is going to be very intense. and I'm not going to believe that he will be able to act in a sense totally dispassionate considering all the pressure around him. Those are the three components of my answer to you. And it's such a clear and direct answer. You really took this head on and tackled exactly what you see coming in terms of sequencing.

16:28I want to talk a little bit about geopolitics, what's happening in the Red Sea, about the credit issue. about the banking system. But first, because you touched on these issues, I want to take a look at a clip from a show that we did here on Real Vision that addresses some of the issues you just mentioned. This is called What Can Derail the NVIDIA Rally? This is Maggie Lake talking to Eric Johnston, head of equity and derivatives cross asset at Cantor Fitzgerald. Let's take a look. Yes. So it's an everything rally. So literally everything from bonds to the other end of the

17:04stocks. Credit is at its tights absorbing a significant amount of supply year to date. So it's made by everything. And I think that one of the factors that could account for that is that there is an expectation, which is certainly our view, that QT is likely going to tail off, that they're going to wind it down, start talking about it, possibly or likely in the March meeting, and that they will wind down QT over the course of the next six months. And so I think that winding QT to zero, the next step, not right away, but the next step is launching QE. Because ultimately, the reason why they are going to be ending QT is not because they necessarily want to, but because they have to based on the supply and demand dynamics that are out there in the debt market.

18:03And so I think that down the road, the market is also thinking not only are they going to end that, but they're going to have to start buying bonds to monetize the debt. Once again, from Maggie's conversation with Eric Johnston from Cantor Fitzgerald, Sri, you and Eric shared this point about the notion of the Fed being forced to relaunch quantitative easing. Talk a little bit about that. I know you touched on that in your earlier points. Yeah, I think quantitative easing is, in a sense, more powerful weapon, Ash, than just cutting interest rates. I think liquidity has a much bigger impact on consumers, on businesses, than even interest rates do.

18:45How do we know that? Take a look at what has happened to the recession. A number of us, me inclusive, have been looking for a recession to take place. It is getting repeatedly postponed because of the amount of liquidity that the Fed provided to the consumers over the years, not only after the Lehman collapse, but again in the last two to three years, how much liquidity has increased by. Now, quantitative tightening is taking place. But despite that, Ash, the total amount of Fed balance sheet is about 85 % higher today than it was at the start of COVID at the beginning of 2020. Think about that.

19:29They are supposed to have been doing quantitative tightening, but yet the balance sheet is much larger than it was before. Now, what they found in September of 2019 was when they had introduced quantitative tightening for two years under the chairmanship of Janet Yellen, they ran into a short -term interest rate spike problem in September of 2019. And the Fed had to intervene. They had to put in liquidity on an emergency basis. And that was the end of QT. They ended it and quantitative easing resumed. We never went back to QT immediately because COVID came and they decided, if anything, to increase the balance sheet even more.

20:17Now they have been doing quantitative tightening for about 15 months, 18 months, and now their pressures are developing. I agree with Eric and what he said fully, Ash. And the reason is Lori Logan, who is the president of the Dallas Fed, and she was the person most responsible for managing the problems as an official of the New York Fed in 2019 with what happened with the short-term money rate spiking problem. She has said recently that quantitative tightening is likely to be slowed down, not eliminated, but slowed down. But if they find out that there is a new banking crisis or a new form of new problem with the commercial real estate situation, I wouldn't be surprised if it is stopped totally and quantitative easing presumes.

21:14There's one more aspect to this. Lower interest rates would be absolutely welcomed by President Biden and Secretary Yellen today. It would reduce the cost of debt service from their point of view, and they can turn around and say, see, I told you, debt service is not a problem. The increase in debt is not an issue at all. Our interest costs have actually gone down. and what contributed to it? A reduction in the interest rate. So there are a lot of political influences today which would also argue for quantitative easing to resume and for interest rates to be cut. Will it be? When will it be? Middle of the year is my guess as well.

22:00But don't expect it to happen because the Fed wins the war against inflation. That's not the reason. We're going to take another quick break and be right back with more of the day's top analysis on the Real Vision daily briefing.

22:17And if you're relatively new to this and you want a visual representation of what Sri is talking about, just type WALCL into your browser and you'll get a look at this chart of the Fed's balance sheet, total assets, less eliminations from consolidation. you can see that curve. You can see the quantitative tightening coming in from about, oh, call it about$9 trillion down to about$7.5 trillion where we are today. But you can see where we are massively above that$4 or so trillion pre-pandemic. And by the way, roll the chart back to 2008 or so. Look before the last financial crisis and you'll see we're below$1 trillion, probably close to around$800 billion.

22:55If you look at that chart, you'll see that trajectory that Sri just described. You touched on something else, which is what's happening in commercial real estate. Sri, I am not a deep thinker about commercial real estate. I'm not a deep thinker about commercial real estate debt. I don't understand how we can essentially change the entire structure of the US economy. I don't know about you, but I have very few friends who are going into work Monday through Friday, nine to five. Real Vision essentially gave up our office space here in Chelsea. Why? Because we're all working from home. We're doing these calls over Zoom.

23:26This is the way the world is going. I just don't understand how there cannot be some knock-on effects from that massive shift in the real economy. I mean, it's just, it's baffling to me how this isn't more of an issue. Absolutely. It is a big issue. And I think we have not seen the end of it, Ash, and I'll tell you why. The problems started actually with COVID and people withdrawing. But let's say if you put the start of COVID as March of 2020, when people realized there was a global pandemic around and stopped going to work, another one year, year and a half passed. We came to the end of 2021 when we realized there's a lot of open space in office buildings.

24:14But it was still not so much of a problem. It was more isolated. And as 2022, 2023 went by, the problem has gathered much more in importance. Every year that goes by, we find more loans are due to the banks. And here again, I think your listeners should be aware that there is a difference between what you pay on your hope mortgage, where whatever you borrow, you're going to be paying amortization as well as interest over the life of the loan. Whereas if you get a commercial real estate loan in order to build an office building, you probably make only interest payments regularly with your principal payment due at maturity.

25:03And at the time of maturity, you're unable to pay. And typically when that happens, we have a practice which has come to be called extend and pretend. That means the banks say I was not paid last quarter. The payments are three months or six months late, but I believe that I will get paid anyway. So I'm going to value that loan at par. So six months go by, one year goes by, then you can no longer continue to pretend that you're going to be paid at par. Perhaps the regulators force you to take it down to 90 cents or 80 cents on the dollar, that is when you have to start thinking. You, the banker, have to start thinking about what you're going to do to your portfolio.

25:54And that is where these uncertainties are starting to show up. And as far as the real estate developers are concerned, they have twin problems. That banker is knocking at their door, increasing the interest rate they have to pay on a loan they took a few years ago, demanding repayment of the principal, whereas on the real estate developer side, as you mentioned, Ash, the tenants are going away. They are working from home. They are working with Zoom. They don't need to go back. And even if you need to go back two or three days a week, your space is probably shared by one or two other people. So they still need less space than when all of you went to work all the time.

26:39So that is the crux of the problem. What needs to happen? I've talked to people and said, how about converting some of the commercial real estate into multifamily homes? I'm told that there is a problem. If you take a Midtown Manhattan building and convert that into residential space, regulations require that all homeowners have windows that they look out. And of course, you cannot get that in an office building. So we have a lot of adjustment to make. Whenever I talk to my real estate friends about this, they're like, you finance guys. You think it's like it's just moving numbers around in a spreadsheet.

27:21We're dealing with the real world, plumbing, electrical, window space, how you get access to this and that, fire codes. I mean, It's not trivial. It's not trivial at all. It is a major issue, which is why I'm going back to your original question, Ash. How does it resolve itself? You have a building and you built a building, the face value of it in, pick a day, January of 2020 or 19, 2019, it was$100 million. Now I'm going to come in and I'm going to buy it from you. and this has happened actually in San Francisco and New York, so I'm not making up stories. I buy it from you for$40 million rather than the$100 million that you paid for it in 2019.

28:08So there is often a 50%, 60 % discount to the price which prevailed five years ago. And forget about inflation. Nominal value has gone down by 60%. the real value, if anything, has gone down even more. So I think that's the way the adjustment is going to take place. If I buy it at a 60 % discount from face value, even if the rent payment to me is less than before, even if only half of the building is occupied, I probably can make money because I didn't pay too much for it. But the ones who did pay a lot of money five years ago, they are going to take a hit. I want to have you back on to talk about just this for an hour and a half, to talk about all the potential knock-on effects, how that debt gets bundled up, who holds the CMBS, what it means for the banking system.