How Long Can the Fed Hold? With Darius Dale

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0:30Darius Dow, founder of 42 Macro. Hi, Darius. Hey, Maggie. It's great to see you. Thanks for having me. How are you doing? Great to see you, too. I'm doing well. Markets are a little all over the place today. The focus continues to be treasury yields. We have that 10-year sitting right below that 5 % level. We saw stocks really swinging around. Jerome Powell is sort of center stage today. As usual, he tried to give everybody something. And we did see that stocks were up and they sold off, they recovered, they went back down. What do you think, as you're looking at your information, is the Fed on hold here?

1:08Great question. Phenomenal question. I mean, based on Jay Powell's commentary today, obviously, the Economic Club of Washington, or is it New York or Washington, who cares? They seem like they're going to be on hold. But I'll say this, the bond market ain't on hold. The bond market is in the driver's seat now. And the thing that is controlling the bond market, I tweeted about this weeks ago, maybe even a couple of months ago, I said, it's no longer about being counting and watching the paint dry on Federal Reserve policy. Our focus needs to shift on the economy, how long it's going to remain resilient and how long transitory Goldilocks in terms of the macular disinflation we were observing was going to continue.

1:46Because once those things stop, we're going to have a whole different set of outcomes in financial markets. Yeah. And we have seen the data coming and stronger than expected. I think someone say, go back and try to find the last time there was a piece of data that was much weaker than expected. But you still have people out there. There is still this argument that, yes, some things, maybe the lagging things are still strong, but underneath you have signs of weakness. So it just depends on what you look at. Bernanke did say inflation is still too high. So how are you thinking about it? You've been saying for a long time that the economy is stronger than people expect, and that was going to be a problem.

2:27Anything change your mind? No, if anything, we're getting incremental evidence of the resiliency of the U.S. economy. This is something you and I have been talking about since August of last year. Nothing's changed on that front. If you go back to Tuesday's data, we got retail sales. We accelerated to about 6 percent, three-month annualized. That's well north of the longer-run mean industrial production, which is something we called out a few months ago in terms of the likelihood that we'd see a manufacturing rebound, at least transitory one, here in the U.S. economy. Industrial production accelerated to 5.2 % through methanolized.

2:59That's the highest number we've seen in several quarters and obviously well north of anything that we saw prior to the pandemic. So we now have the consumer growing at an above trend pace, a sequential above trend pace. We have the manufacturing side of the economy growing at a sequential above trend pace. And oh, by the way, by the way, we have inflation reaccelerating as well. And it ain't just headline. It is a broad based reacceleration and inflation that no one is paying attention to, but they will be by the end of the year. Yeah, I mean, so it seems like the bond market's paying attention to it or no, they haven't really priced that in yet.

3:36Well, on the margins, the bond market is paying attention to that. But a lot of the move we've seen in the back end of the Treasury curve has primarily come through real interest rates and through that primarily through a backup and term premium. So part of the argument is being made as well. One, we just have a higher structurally neutral level of interest rates across the entire Treasury curve as a function of this accepted resiliency of the U.S. economy and the resistance to what is historically thought to be a very high policy rate. But there's also Treasury supply concerns. Don't forget, President Biden yesterday sort of pledged another$100 billion to add to the deficit.

4:14That's right around 9 % of the year-to-date budget deficit we've accumulated thus far. And we're talking about, hey, what's another$100 billion amongst France, literally? And the Treasury market is obviously not liking that as it looks out and sees supply as far as the eye can see in terms of$2 trillion budget deficits for years to come. Yeah. Biden addressing the nation from the Oval Office on that issue, trying to make the case for additional spending to both Israel and Ukraine. For those who haven't seen the interview yet, Peter Zion and I talked a lot about that in the interview that's on the platform.

4:51And by the way, we still are struggling with Congress that still doesn't have a speaker. So getting that stuff through, it's complicated and problematic. You bring up a really interesting point, though. And again, we have been having many conversations. You and I have discussed this about the role of fiscal here now. It's not just monetary, it's fiscal. Roger Hurst sat down with Michael Lotus today and tackled that question about the inputs that are affecting inflation and what that means for long-term inflation. Do we need to think about it differently? Let's have a listen to that clip and we'll talk on the other side.

5:30So I think we're witnessing inflation, which is mostly supply driven. We've seen rates go higher. Inflation has calmed down, but not as fast as the central banks would want. And I think we're here to stay in terms of inflation. I think the 3 % is something we're going to see for some time. I don't think we're going to see 7%, 8%, 10%, 15%. But 2 % to 3 % I think is here to stay. So my view on the macro landscape, I don't think central banks will raise rates more. I think they will keep here and try to see how long they can last at these levels. Because, as you know better than me, we've seen data that shows that the global economy is slowing down, production is slowing down.

6:17There are a lot of data points showing that there is a slowdown. However, markets have not gone down. And the reason, in my view, markets haven't gone down is, and I agree with Raul on this, is markets are driven by liquidity. And given all the policies that the central banks have done in terms of reverse policies and MMF functions, this is liquidity accretive for the system. That interview with Michael Nicoletos, I don't know why I was tripping over his name beforehand. There's a lot to hold in our minds these days. That full interview is on the website. They cover a lot of ground. Roger and Michael tackle the question of hard landing or not, market correction or not, how to trade this environment.

7:06It's a master class. If you're not a member or you want to upgrade to Plus, because that is on Plus, just go to our website and you can see all the offers available. So, Darius, you've certainly been talking about inflation for a while, but should we be thinking about a sort of structurally higher inflation situation now? Yes, absolutely. I would definitely agree with the analyst's interpretation that three is the new two. In fact, this is something we've been explaining to our clients at 42Macro for the better part of two years now. Brian, if you could put a slide three on the screen where we show our secular inflation model.

7:41So this model is designed to interpolate the change in 20 features that we know to be correlated or co-integrated, studying various white papers with the underlying trend and core PC inflation. And what we find is that when we interpolate that change on an unweighted basis, we're looking at a new trend of core PC inflation that's somewhere around 2.5%. That's up from 1.6 % in the prior decade. When we interpolate those changes of those variables on a weighted basis, we're talking about core PC trending at 3.1%, again, up from 1.6 % in the previous decade. So according to our math and our models, it suggests that, hey, we're going to be just trending at 3%.

8:22You know, we'll go below when we have a down cycle in growth and the economy will go above it when we start to recover again. But that new mean that we're oscillating around is somewhere between 2.5 and 3.1 percent. And that obviously has significant implications as it relates to asset markets because there's a Federal Reserve that's sort of stuck looking backwards with a 2 percent inflation target. It's our view that at some point in the next, you know, three to five years, we will see the Fed formally adopt a 3 percent inflation target. It's probably going to do that in several steps. First, they're going to accept 2.5.

8:53We're going to be trending back towards 2.5 in this particular business cycle. They're probably not going to get well below 2 without a recession. And when we bounce back up from that recession, it's going to be pretty clear that we're bouncing back up from a level that is inconsistent with 2 % inflation. So they'll accept that as the first step. And then the second step, eventually, the bond market will tell them that they're going to have to accept 3 as a consequence of the fiscal largest that we continue to see in the U.S. economy. Yeah, it's interesting. I love this. chart and we'll share it if you're having trouble seeing it.

9:25But it has so many of the things that go into this conversation about inflation, right? Sometimes we just think energy. And I do want to talk to you about oil because that can feed through and it's something we all feel. But there are so many things and I love seeing them all listed out like this because it is quite complex. But what about energy, especially now that we have tension in the Middle East? I mean, And it's not hitting, you know, Israel's not an exporter of oil necessarily, but still, we just don't know how that's going to game out. What do you see happening with oil? Yeah, great question, Maggie.

9:59So for those who are not paying attention to the data as closely as we try to, at least for our clients, energy inflation in the most recent month of September accelerated to 29.3 % on a three-month annualized basis. That is well north of the year of year rate of change of minus 0.5%. So there is a significant energy inflationary impulse ahead of us in the coming months. One of the things that scares me and keeps me up at night as an investor is obviously the tension in the geopolitical situation in the Middle East. Obviously, it's a horrible humanitarian crisis. But just separating that from the risk management that we have to do in our portfolios, there is a big problem if this spreads to a broader proxy war between the U.S.

10:40and Iran and other Arab nations. And the reason I say that is, Brian, if you throw slide one up on the monitor there, the key takeaway here in terms of how precarious this potential situation is, is that neither U.S. shale nor the SPR are in position to respond to these incremental threats. So we are currently producing a peak level of crude supply here in the U.S. economy. We're doing that on almost peak efficiency when you divide the total amount of barrels that we're producing per day divided by the rig count. And then when you look at the SPR, which Biden obviously used as a political ploy to buy votes ahead of the midterm last year, is now back at levels we haven't seen since the SPR was created back in the early 80s.

11:20So we are now in no longer – the U.S., this big kind of behemoth in this global energy complex, is no longer in position to really respond to these incremental energy supply threats. And that's exactly why – I throw a slide to Brian – that's exactly why we're hearing rumors of rolled back sanctions on Venezuelan crude. And, you know, so it's like we're concerned about atrocities, but there's now this new, bigger atrocity. So we'll stop paying attention to that old atrocity so we can get more crude supply into the market. We'll see if there's anything, any validity to the rumors that they're going to be rolling back sanctions on Venezuela, because that's one thing that could alleviate some pressure through the energy market on inflation.

11:58We have Venezuelan crude oil experts down 68 percent since their peak back in 2017. So that's definitely a huge boost to crude oil. Don't forget, Venezuela has the largest proven crude oil reserves in the world, and they're effectively offline just because of the U.S. sanctions. 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. Have you ever wanted to trade Bitcoin but haven't dared try? With Plus 500 Futures, you can trade crypto without the hassle of opening a wallet.

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13:24How quickly can they get back online, I think, is an issue. We're going to, I think, yeah, because they've had years of underinvestment. I mean, there is a, you know, but, you know, we're going to, Andreas is catching up with doing a sort of focused energy conversation. We talked about this yesterday in the chat. And as usual, the fantastic team's already ahead of us. We've got that coming as well as another energy. Harry Melandre is doing another energy conversation. And we're going to cover the gamut. So stay tuned for both of those. We will let you know when they're coming, but we're going to do a kind of a deep dive into all of these issues because it is important.

14:05But that's a great stat about that huge increase year over year, because I think sometimes people do lose sight of that. One question. Let's see. Roger is asking because it's sort of right what we're talking about. It's three percent enough. Don't we need at least four percent to make a meaningful dent in the debt? So we're sort of saying it hovers, settles around 3%. Doesn't mean it's exactly 3%. It could be higher. Sovereign economies don't pay off debt. The assumption that we need to pay off our debt is a flawed assumption. As long as we can roll over the debt, we're fine. The issues as it relates to investors and obviously the spillover impacts to the broader economy is when the capital markets no longer allow us to roll over that debt for some perceived reason or another.

14:50So in our opinion, we are headed for that in terms of the work we've done, the empirical work we've done on the fourth turning and our two most recent macro scouting reports. One of the key conclusions is that you should hammer the over on CBO, IMF, and PTJ, Stan Druckenmiller projections on where the U.S. public debt is headed, because that's historically the pattern that we've typically seen in fourth turnings. And I'm not sure folks have done enough research to understand that pattern. So we are headed for something that looks like the U.K. guilt crisis here in America. I'm not sure that it's this particular business cycle, but I do believe that as we progress throughout this decade, we will continue to be dragged into geopolitical consternation.

15:29We'll have domestic consternation and populism here domestically. Obviously, we have a retirement crisis and Medicare crisis here in the US. All those things are going to come to a head in this fort turning and likely drag the treasury market down with it. That was exactly the question Andrew was asking about. Could we see something like that? But what are the conditions that will be required for that to happen and how will it impact our 401 accounts and our cost of living in general? That will not be a good situation. Well, I say if you're on autopilot still living in the previous disinflationary regime and some version of the 60-40 portfolio or some version of that, right?

16:07That worked in the prior great moderation disinflationary era. That was the perfect portfolio construction for that particular time, not just because inflation and nominal growth were falling the entire time, but also because when you get to 2 % inflation, we've done a tremendous amount of statistical analysis on this, is that 2 % inflation is the level of inflation where stocks and bonds are most inversely correlated. They get less inversely correlated when you go towards deflation and beyond deflation. They get less inversely correlated when you go from 2 % inflation to something higher. And that correlation actually flips to positive once you cross the 3 % threshold, which is where we think inflation will kind of trend in this decade according to our secular inflation model.

16:51So this has significant implications for portfolio construction. I've been having conversations like this with institutional investors for nearly two years. And it's now becoming sort of on the tape. It's becoming consensus because of what was happening in the bond market. But this was all very relevant and very easy to see if you were doing the analysis the entire time. Yeah, and it's a big one. And I bet if we ran the numbers, a lot of people are still locked into something that even if they're not realized, it looks a lot like 60-40, even if they've been tweaking it at the edges. And we need to worry about that.

17:25And Maggie, here's the big issue. It's how many people have seen three years. I think this is the first time in U.S. bond market history that we've seen three consecutive down years in the bond market. How many people are sitting on those capital losses and don't want to do anything different because of it? That stasis, in my opinion, is one of the things that's going to keep this train rolling until we get a cathartic type event. Yeah. Timothy asking, fourth turning. So, D.D., where should we be looking? equities, high growth, commodities, energy, all of the above? Risk management is the number one question to answer, number one answer to that question, in my opinion, because we have a view that in response to any sort of crisis in the treasury market, it could be a series of crisis.

18:09It's not to say that we're going to have one big bang crisis. It could be a collection of crisis as we progress forward in time for various reasons. The Fed is obviously going to be the backstop to the treasury market come hell or high water. They're going to have to change their inflation target. They're going to have to move the goalposts in terms of what drives their monetary policymaking decisions. And ultimately, they will be the backstop. They have plenty of scope and ample capacity to financially repress commercial banks into the Treasury market as well. So there are avenues out of this mess, but we have to go through the mess to get to those avenues out of this mess.

18:43And obviously, the avenues out of this mess effectively equate to more liquidity, more financial repression, more currency debasement. These are all things that empirically we've determined that are very high probability outcomes in fourth earnings, having done the empirical analysis on that. And so we understand that those things typically cause stocks to go up a lot, gold to go up a lot, Bitcoin to go up a lot, pick your risk asset. So there will be plenty of time to make plenty of money throughout this decade, despite all the negative kind of connotations around the fourth turning that you should expect as a human being and as an investor.

19:18It's not this linear ride down. It's not going to be a linear ride up in terms of your portfolio. So that's why I answered the question, risk management. You're going to need more than ever in the history of your investing life, because most people aren't old enough to remember and weren't investing in the 70s. You will need someone or something that can help you better time asset markets and get in and out of exposures at the right times. And I'm not saying it's us. I'm not saying whoever it is. But I think it's very important to understand that we're going to see a lot of financial market volatility in the years ahead.

19:49It's a great, great observation, Darius. And I think this is why we all lean, I know you do as well, we lean into education so much because we are all going to have to, you know, sort of make sure that we are much more engaged. You want to be able to talk to whatever financial advisor you're using if you're not doing it yourself and make sure that you feel confident that they are engaged and up on the type of risk management. Because let's face it, everything's been passive. So even if you have a 401 advisor, you need to make sure that everything is a lot more active. So I think that's just a really good point to underscore and to let people know.

20:31Can I make one quick plug? Sure, please. If your financial advisor isn't a subscriber of Real Vision or 42 Macro, you need to get a new financial advisor. Because the work we're doing on helping investors understand these long-term dynamics is the kind of work that I fly around the world to talk to institutional investors about. And if your financial advisor doesn't understand these dynamics, God help your portfolio. Yeah, no, it's really true. And we are coming out of this period that it was different. So I think it's a good thing for everybody to kind of check in on. With that in mind, we have a lot more coming on the Academy, including a whole crypto.

21:06I think I'm allowed to talk about that. We talked a little bit about Festival Learning, which is all online, by the way. We've got crypto coming because digital assets are going to be a part of what you need to understand when you're trying to look for opportunities. So be sure to check that all out. OK, so we have some global liquidity. This is always super important. This is another thing that's hard for people who don't have the resources to kind of find this information. We get this question a lot. You have some great charts on global liquidity. I know that you and and Raoul and a lot of other people think this is really important.

21:36You need to pay attention to this. Walk us through what you're looking at when it comes to liquidity. Yeah, thank you, Maggie. I appreciate that intro, because I do believe that we are one of the world's experts at this particular subject matter. I did put together a few charts to help investors understand where we are in the liquidity cycle, at least where I think we are in the liquidity cycle. Other people might have differing views, citing back the conversation I had with Raoul back in June. So if you throw up slide four, Brian, where we show our global liquidity proxy relative to the S &P, and then we show max drawdown studies for both of those indicators in the second and third panel.

22:09For those who are not familiar with our global liquidity proxy, it's the sum of the global central bank balance sheet, global broad money supply, and global FX reserves minus gold. There's all different reasons why those are all in the time series. But what we know is that global liquidity, at least according to our proxy, is highly co-integrated with asset markets. Pick your market. It could be the treasury market. It could be the stock market. But the one thing I'll say is that it bottomed in late 2022. And the recovery that we saw from basically October through the end of March was part of the reason we saw such a sharp rebound in risk assets, particularly crypto, kind of in that time frame.

22:45Well, since April, and I think I was on this program and I called it out in real time, that global liquidity was inflecting lower. And really since mid-April, we've kind of been trending lower in terms of global liquidity. That's the second panel in terms of that max drawdown study on slide four. On slide five, you can see this on an impulse basis. So on the top panel on slide five there, we show our 42 macro global liquidity proxy. This time we show it with global equity market cap. And in the second and third panels, we show the trailing three-month momentum of each time series. And I'll focus your eye on the second panel where we show that the trailing three-month momentum in the global liquidity impulse has been negative for each of the past six months.

23:23And so what you're seeing now, if you just kind of jump to slide six, you're seeing now the stock market, which had run up well in advance of where global liquidity was trending in recent months, is now starting to correct down towards global liquidity. The bond market has obviously been underperforming the moves that we've seen in global liquidity. I would argue Ethereum has been underperforming the move we've seen in global liquidity. Bitcoin has been trading it perfectly. you know, really, you know, really. I mean, you've been trading it perfectly for most of its life cycle. So, you know, in our opinion, part of the reason we're seeing a correct part of the reason, not the only reason, but part of the reason we're seeing at risk assets transition from a buy the dip state to a sell the dip state is because the market is starting to catch down towards the negative impulse that we called out in global liquidity more than six months ago.

24:09We'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.