Beneath the Surface: Risk Premium Expansion with Andy Constan

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0:35will u.s rates stay higher for longer hi everyone welcome to the real vision daily briefing with me today is andy constant ceo of damp spring advisors hi andy it's great to have you back with us hey thanks maggie good to be back so we're looking at uh for the beginning of the trading week here in the U.S., we're looking at an update for U.S. equities. I mean, the Nasdaq managed to gain over 1%, clawing back a little bit. You know, it's been a little rocky for equities. But we had JP Morgan CEO, Jamie Dimon, sort of later in the day sounding pretty bearish, warning that there are many risks ahead for the U.S.

1:11economy. We certainly have some catalysts for that, I guess, today. We have inflation numbers out this week, a Fed meeting next week. What's top of mind for you as you look across these markets? Yeah, I mean, I think there's quite a lot of news this week, and I think that'll affect a portion of the market, but not significant because I don't think there's a great deal of uncertainty about the potential paths that these particular numbers will generate. And that's mostly what will happen at the FOMC at the middle of next week. But, you know, I think the high level point is that we've seen since basically since August 1st, a significant sell off in the long term bond market.

1:54And that's happened for a variety of reasons. But the outcome of that for equities is that it's sort of capped multiples. And so, you know, we sold off a few percent on equities since then. Russell's actually down six or seven percent now. and bond yields are higher. And that combination of things means that what is going to generate equity returns is earnings, improvements in earnings. And what's interesting about that is, you know, there's a lot of people think that we're about to either in a recession or about to have a recession. And yet earnings expectations for 2024 and 2025 are both expected to grow at 12 % a year, which is quite significant growth.

2:46So there's some disconnects there that, you know, are concerning for equities in terms of what will power them higher with bond yields rising and earnings expectations already extremely high. Yeah. So what do you, so when you say there's a lot of certainty, what do you think the path is? I mean, what do you, what are you expecting from inflation in the Fed? Well, I mean, I think the first thing is, I don't know what the inflation number is. I don't think anyone does. I think it's very hard to predict. And even if you did predict it, it's not particularly useful in trading markets short term. So we'll see what the CPI number ends up being.

3:23The headline obviously has energy prices that are going to drive it to a level that's 6.6%, which is 7.2 % year over year if you annualize it. But that's a big, that's not what people are going to focus on. I imagine they'll focus on core. And core at point two is still near the Fed's target. And so there are some people that think that the inflation has been conquered. And the Fed is already expected to skip in this coming FOMC meeting. And so there's really no chance that they're going to cut. And so you could have a 0.1 or even a zero CPI, which isn't going to happen. But if you were to, the Fed isn't going to cut.

4:13So there's really only the possibility for a hot number. And then maybe they hike in September. But I think they skip. And I think that's what the market thinks. And regardless of this number, they're going to skip. And then the question, and we'll get a lot of data from the FOMC regarding their expectations in the Summary of Economic Projections, the SEP or DOT plot. And it'll be interesting to see. And so what I'm focused on for the FOMC is what they do to the DOTs. Right now, with Fed funds at 5.5%, they have penciled in a DOT of 5.6 by year end, which means there's a 50-50 chance that they hike one more time.

5:02They're not going to do it in September, so that leaves November or December. That could change on a very, very cold number. I imagine they could pencil a lower number, but an inline number, I think they're going to give themselves the optionality to hike one more time if they choose to in November or December, and they'll give guidance along that lines. A very hot number, you know, maybe that number, the dot isn't going to go to a certain hike. It's going to just go to a little bit higher chance of a hike. So that's pretty narrow for the next three meetings in terms of what the variance of opinions could be.

5:43But I think the big and much more interesting point will be what happens to the December 2024 dot, because that has 100 basis points of cuts built in. And so 100 basis points of cuts, if the economy is still doing okay and inflation isn't dead, is got to come out. The Fed has to go from 100 basis points of cuts maybe to, You know, I've penciled 60 to 80 basis points of cuts, which would push two-year note yields to maybe five and a quarter at the highs and be a fairly big surprise to the market. So I think that's the risk on the FOMC. Alternatively, it's possible, I guess it's possible, though nothing they've said and no economic data really supports it.

6:42It's possible they could pencil more cuts into 2024. I just don't see that as very, very likely. So probably less cuts penciled in on to 2024, which would have a modest impact on two-year notes. And so what really, to me, is happening right now is that the two-year is anchored. Maybe it's 5%, maybe it's 4.8%, maybe it's 5.25%, but it's pretty anchored. And it's going to stay anchored for a long pause. And so then the question is, what about important markets like long-term treasuries and equities? And I don't expect a lot of information that would affect those two markets in the next. you know, the market will do what it does.

7:36And, you know, anything that sounds dovish, they're going to buy assets. Anything that sounds hawkish, they're going to sell assets. But when you step back and say, you know, where are we? We're basically pausing. And now we'll have to see a significant amount of data to see what how the economy will play out. And that'll drive the relative value of bonds and stocks. Yeah. Yeah. It feels like I mean, people have been saying some volatility, but it kind of feels like we're churning here and everyone's some people have used the analogy of running to the sides of the boat. Right. Because you get you'll you have these sort of you still have mixed data.

8:14And so, as you mentioned, if it comes in softer, everybody runs to the side of the boat. That means that we're going to start to see these cuts. Maybe we're the recession everyone's been waiting for finally is here. And then we'll get something that shows resilience and then everyone seems to pitch to the other side. I think it's now the boat is just much narrower in that you can't really go too far either side because nothing's going to happen until we see a lot more data. Yeah. Well, that makes me nervous because canoes tip for anybody who's a boater. And I know you're by the water, too, Andy.

8:45So that's that comes with some risk. And we've been talking a lot on our programs here about this, these sort of competing narratives, because it's no it seems like everyone's saying it's very hard to see into the future right now. There's just a lot of sort of murkiness. Can't tell what's sort of real in the data or what's maybe just some of these effects coming out from this prior fiscal that we saw. How much of it is here to last? What does it mean for inflation? Because of that, for the next two weeks here on Real Vision, we're going to be running a special series called Crash or Boom, How to Profit from What's Coming.

9:22and really kind of dig into what people feel like the outlook is. Why do they think that? What is the key indicator that they're looking at that's guiding their framework? And how are they positioning for that? Raoul kicked it off for us today. Let's listen to a clip of how he's thinking about rates and we'll talk on the other side. Right now, we're exactly at that spot where the Fed is having to issue debt and the markets don't like it. So bond yields have completely disconnected from inflation, the business cycle and everything, because there's too much debt being issued and there's not enough liquidity around.

10:02And if that continues for this 13 trillion, you're going to blow up the bond market. But of course they won't do that, because what they will do is they are hoping that they can get inflation to undershoot as fast as possible, which I think is baked in the cake, as I showed earlier. unemployment start rising and then they can start monetizing the interest payments and they can start cutting rates. 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.

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11:40For more aware, Raoul sees the best opportunity around that as well as the risks. Head over to our website. You can see the whole presentation there. And if you're not already a member, go to realvision.com forward slash crash or boom to take advantage of some crazy special offers we have on right now. A lot of good stuff coming your way. I'm going to talk a little bit more about it at the end of the show. So Andy, how are you thinking about this issue of treasury supply? I feel like a lot of people got bonds wrong. Raul's talked about the fact that he was wrong on that. And then, you know, kind of keying in, I was really interested in that first line that sort of, you know, they're not correlated to the normal things you would look at because you've got this big issue of supply looming over the market, which everyone's had to kind of now take into consideration.

12:25How are you thinking about that supply issue? Yeah, so that's been my big call this summer. You know, I absolutely nailed bonds in August, sorry, when I wrote the script, which I released to my clients in mid-July and then was on CNBC actually saying, this is what's going to happen and happened. And by the way, that's no small thing because so many people got bonds wrong multiple times. By the way, it's been a really - Oh, I get them wrong all the time. This one just happened to really hit. So I get them wrong all the time. I'll get them wrong again. This one, I had all the things I wanted to line up and they lined up.

13:08So - The importance of having a framework. I think the bigger issue is not that bonds are now dislocated from the economy. I think the bigger issue is bonds have been dislocated from the economy, and now they are getting relocated to the economy because of supply. So let me step back and say, why is that this supply is really big? It's a trillion dollars in Q3, mostly in bills, and$852 billion in Q4, in which there is a significant$338 billion of new bond issuance. And those are big numbers, and they are going to leave a mark. But what's important is that they are, in the first half of this year, when we saw the economy doing better, when we saw equity prices soaring, and bond yields basically staying in the below 4%, what had happened is that because of the debt ceiling, issuance had shrunk to below normal levels.

14:21the spending funded by the government's checking account, the Treasury General account, kept going. And so the economy got all of the spending to either consume and support the economy or to invest and support AI stocks or 10-year bonds. But the issuance was not there to offset the spending. And so the important thing is that for basically about nine months now, the effect of quantitative tightening has been muted by the lack of long-term duration supply. And so you can see that in things like treasury term premiums, which are a theoretical thing, but are deeply negative, and equity risk premiums or equity earnings yields, less treasuries that are at all-time lows.

15:23Well, not all-time. The dot-com bubble was worse. And that suggests that there are just not enough assets around for the amount of savings that are looking for assets. And that all changed on August 1st. And so what I think is happening is not so much so that essentially what that means is that bond prices and stock prices were artificially high due to an imbalance of supply. Now the supply is rebalancing, and so bond prices are now going to where they more normally belong, carrying a small positive risk premium for the volatility you take as a bondholder and reflecting inflation expectations and real yields that are consistent with inflation, which isn't yet dead, and a Fed that is attempting to raise real yields high enough to slow the economy.

16:22And so that, to me, represents a 4.5, 10-year, maybe a 4.75, maybe a 5 % 30-year. And I think that's the direction we're heading, regardless of the narrative around whether we are or are not, have or have not killed inflation or are not going into a recession. I have a script that I've wrote, which describes what I think has to happen for inflation to be durably killed. And so far, the thing that mattered most is for this normalization of risk premium to happen. And so the first act was higher for longer. We've seen the Fed yank on the interest rate. Now, supply of bonds is a catalyst for bonds to renormalize and yield.

17:23And that will follow with a variety of things, which will ultimately lead to inflation durably returning to target. So Bo's asking, we have an inverted yield curve, but it seems to be reverting by longer term yields increasing rather than short term decreasing. What's your take on this? Yeah. And that's exactly what it is. As we started with the two years stuck, you know, the Fed's going to pause. Are they going to pause at five and a half or five and three quarters? I don't know. Are they going to cut 60 basis points or 100 basis points? And two years not going to do much until there's real signs of a recession in which the Fed then will cut very rapidly.

18:10The two years stuck. So everything's about the long end. And we could, given that, we can either invert more, and that would be a rally in the long end bond prices, or we can bear steepen, which is a sell-off in bonds and a rise in yields. And that's what we're seeing. And it makes sense given the context of prior to August 1st, inadequate supply of these same bonds that had been artificially high in price, low in yield. And now that's normalizing. Yeah. If we are in this environment where we have rates at these higher levels in the two-year anchored, two questions. You know, what changes that?

19:00It sounds like in order or what sort of brings on the recession, do we have to see something break because of those higher interest rates? And is it banks? Yeah. So there's two ways that a recession and inflation is durable. Let's step back. There's two ways inflation is durably returned to target. One is the economy, demand is destroyed. and so the economy slows. The other is a credit event in which money becomes very dear and the Fed reacts. And my picture is, and I called it this in March, is that the banking crisis that we had was a tempest in a teacup, meaning it was three or four banks that went out of business that were badly run and taking undue risk.

19:56My picture on that is if you look at the KRE, which is the regional bank, small and regional bank index, you'll see it's actually up about 20 % since then, still down 30 % from its prior to peak crisis because these banks do have some headwinds. But as a longtime professional, When such a thing like this occurs, the regulators swarm in. They did it with LDI in the UK. And every single bank has a regulator full-time on-premises right now. And the BTFP program gave the banks a vehicle to fund themselves and avoid deposit runs. and regulatory oversight is powerful and I think has gotten banks in shape from a, now there's going to be a couple that are going to blow up.

21:02That always happens. But by and large, the banking system, I think, is in fact strong and stable. Now there's always credit risk, but we're talking about what killed these other banks wasn't people not paying them back. It was them paying too much for the assets they bought, even though the assets remain money good, Treasury, MBS, and U.S. Treasuries, Treasury-guaranteed MBS and U.S. Treasuries. And so we had a duration crisis that took a few banks under. Now we've had both vehicles that allow banks to slow down any train wreck and heavy regulatory oversight. So I don't think banks are in trouble.

21:48And I don't think we have a credit crisis in front of us until the economy really weakens. Then we could have a credit crisis. So the question becomes, when will the economy weaken? What causes the economy to weaken? And that speaks to the different cycle that we're in in this environment, which is not a credit cycle, but an inflation cycle. And for inflation to durably die, you have to cut demand. And the only way you cut demand, unfortunately, is reduce jobs. 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.

22:38Yep. I sadly knew that's where you were going when you said it wasn't banking. But we haven't really seen that yet. No. Do you just think it's a lag or do you think something else might be going on? I think it actually is a mechanical thing. And I've looked at this through history. And in a credit crisis, companies cut workers very quickly, particularly those companies that are in the eye, not the eye of the storm, in the storm of a credit crisis. They fire, they downsize, they shrink. All makes complete sense. And peripheral to them, they begin cutting, the people that provide services to these troubled companies.

23:27But in an inflation cycle, you never know when the next nominal dollar, which is buoyed up by inflation, is going to stop. And so for a company, and you've seen this with what people are calling hoarding of workers, for a company to start firing people preemptively is very unusual. so when do they fire people they typically fire based on two reasons one is their stock price starts to fall but that often isn't enough either it usually has to come with not only their stock price falling but their demand for their products falling and so my script describes a situation where first you normalize the yield curve and term premiums go back to normal.

24:26That increases yields, which puts pressure on multiples, which causes stocks to go down. When stocks and bonds are both going down together, we have a wealth effect. And that hurts demand. And so now, by the time you get to what I call my fourth act, you have stocks down. Call it 10%. Bonds down. They're down 7 % in a month. Call it 15%. And that starts hurting people's expectation of their wealth and hurts spending. And so then you start to see, and I think this happens in Q4 earnings reporting period, so late January, early Feb, or the following quarter in late April or early May, where earnings expectations that are currently at a 12 % growth start coming down, that, along with stock prices falling, starts getting corporate officers to start to wield the axe.

25:37And that's when you have a recession. And so I think those mechanics in this cycle have to play out in that way, or else strong labor is going to continue to create demand, which is going to continue to keep inflation above target, which will continue to have the Fed trying to raise short-term rates after pausing for a period of time. So I think those are the two general outcomes. I think the script will work, but it will unfortunately result in a sort of mid 2024 recession. Yeah. So if that's the case, it sounds like the market, as you said, is expecting those rate cuts. It sounds like there is the potential for some if we go into recession.

26:25Well, now that the most interesting thing about this cycle is, will the Fed respond quickly to a recession? And given the experience they've had regarding ZERP and the impact that they've had, and more importantly, given the relative insensitivity to interest rate cuts, it's not clear to me that the Fed is going to aggressively cut until they're sure. And so I think cuts in 2024 are likely. I think cuts in the first half of 2024 are extremely unlikely. So I guess the point being that as this script plays out, where you have, let's call it a five and a quarter two year and a four and three quarters 10 year, at some point, probably late this year, early next, the two year is going to be a massive buy.

27:31because they're going to cut. Right now, it's way too early. We haven't seen anything that indicates that even I'll be right on this script and that we'll actually have this slowing of demand that's necessary to cool inflation. So in the shorter term, it sounds like it's tough sledding. You've got the potential for pressure on equities. It's too early for the bond move. So is cash the only, I think someone said short-term treasuries are the new Tina. There is no alternative. Well, they're certainly attractive. Bo said that in the chat. Yeah, certainly attractive to have your money in cash. I have two portfolios.

28:13One is beta, which is long-term holdings. And in that portfolio, I'm at the maximum amount of, I hold all assets in a diversified way, very similar to the all-weather or risk parity framework that I learned at Bridgewater. But I'm also at the minimum amount of assets and the maximum amount of cash I allow myself in that portfolio. Because it's supposed to be beta. I'm supposed to always have long assets. But I'm extremely defensive in that I have about 30 % cash in that portfolio. Now, short term, which is my alpha portfolio, I'm aggressively short both long term bonds and stocks, because I think the next six months is going to be really tough.

29:04Which, again, is a blow to that 60-40 that one has to suspect a lot of people are still in, right? You have to understand that's what the Fed needs to cause pain in for there to be firings for the economy to slow and for inflation to be durably killed. So far, we have we felt some pain, but we're almost back to highs and inflation isn't dead yet. So I feel very, you know, they never target assets. They never say they target assets. And their behavior so far in which they handed off the quantitative tightening to whatever whim the Treasury was being influenced on in terms of how they issued, muting it if they issued nothing or bills and causing it to be effective if they like now issue coupons.

30:04And they've hiked interest rates, which it's very unclear to many of us now whether the economy, whether the cash-rich companies like the Magnificent Seven, who have cash that is now earning 5.5 percent, are really going to slow their growth down. And wealthy people who have cash savings are loving this. while the government costs are going up, but the government has a printing press. Mortgage holders are completely unaffected because they're all locked in 300 basis points lower. And corporations, by and large, the bigger corporations that do borrow, borrowed for term years ago and don't need more money.

30:56So it's very unclear to me that this mechanism of raising interest rates is going to be effective to do the job that needs to be done, which is to reduce aggregate demand. Yeah. We're going to end on a – it's a great point, the stimulative nature of hiking, right? Like that's the – it's counterintuitive to what they – the reasons they do it. I want to end – I can't believe we're out of time already, but I want to end with a question from James. Just what do you make of CNY? Are you watching China and how does that fit into your - Very much so. You know, I think the Chinese economy, the Asian time zone, broadly speaking, is struggling economically and needs to stimulate and has, you know, China and Japan both have stimulative monetary policies.

31:44They may be stimulating on the monetary side a little too much. And I could imagine Ueda tightening a little bit, but he's not going to be restrictive. He's just going to be less easy. And so, yeah, I've been very bearish CNY for a long time. And, you know, intervention can always cause jumps back and forth. But, you know, selling a rally in the CNY or the JPY on intervention seems like a sensible thing. I don't have any positions at the moment. Fantastic stuff, Andy. It's going to be a very interesting couple of months coming up. Very fraught waters, for sure. So appreciate you coming on again and sharing your view with us.