Is It Too Early to Pause?

0:08Good afternoon, everyone, and welcome to the Real Vision Daily Briefing. It is today Wednesday, the 20th of September, and we are sending to you live hot on the heels of the press conference of the Federal Reserve just a few minutes ago, basically. And today we're going to digest the message from the Federal Reserve in great company. And remember that this is an extended version of the Real Vision daily briefing. The first 30 minutes will be live for everyone. And after 30 minutes, we will move exclusively to the Real Vision platform for members only. you can use the QR code on the screen on a running basis to join us behind the paywall after 30 minutes.

0:50But today I'm joined by one of the best analysts I know on liquidity and central banks, Michael Howell, founder of Cross Border Capital. It's great to see you, Michael. Thank you for joining us here at Real Vision Daily Briefing. Great to be, Andres. Great thrill. Thank you. Michael, you watched the press conference from the Federal Reserve just as I did. And thankfully, we do not need to spend the next 60 minutes just discussing what Paul just said. But what are the key takeaways from what you just saw? Is it a Federal Reserve planning on hiking interest rates to a larger extent? Well, I think it was one of the FOMC meetings or press conferences that you actually had the sound of because I don't think you learned an awful lot from it.

1:33I mean, broadly, I think what they were saying, and they pretty much flagged this ahead of the FOMC statement, was it's a question of higher for longer. And I think that's the sort of the message that's been coming out for several weeks now. And I think it's a pretty decent message. And that's more or less what the markets are pricing in. Look at the way that the two-year yield jumped after the press conference. I think that pretty much says it all. And what we've got in terms of the predictions for the next two years is the FOMC on average put what 50 basis points on their projections for Fed funds for the long term.

2:06So that pretty much says it all. So it's just a message of stability here, higher for longer. Will there be another rate hike? I doubt it. It's possible. Anything's possible. But I would think it's basically keeping rates up at these levels. But Michael, does it even matter whether they hike interest rates one more time ahead of New Year's or is the long-term message of higher for longer more important for markets here? Well, my view is that what really matters is that sort of forward guidance, if you like. I mean, something that the Fed used to emphasize a lot. They sort of downplayed that, obviously, in the last year or so.

2:45But I think the forward guidance is important. And that's the direction that the Fed is pushing us towards now, higher for longer. And I think the other thing that's important is basically flows of liquidity. I mean, that's my remit. And at the end of the day, I mean, despite what the Federal Reserve has said today and pretty much despite what they've said over the last 12 months, the reality is that they seem to be targeting money market flows and basically the level of bank reserves. You know, I've been saying for a long time that, you know, if it's yellow and quacks, it's a duck. And, you know, this thing has been quacking quite a lot for the last 12 months now.

3:22If we look at liquidity and the decisions taken by the Federal Reserve over the past, say, three, four quarters, what's the connection between the policy rate of the Federal Reserve and liquidity? Are those two connected at all, Michael? to a limited extent i think you've got you've got to treat both very separately i think i mean one is that if you look at policy rates i mean clearly they're fixing to a large extent the front end of the curve and then if you start to look at liquidity conditions the liquidity conditions tend to come in much more of the back end what they do is they affect term premium now term premium are probably well they're a very wonkish concept for many investors but the fact is they're absolutely critical if you want to understand the long end of the market.

4:08And term premium at the moment have been hugely depressed. They are beginning to be elevated and they pose a significant threat to US long-term bond yields. Michael, I know you've brought a chart with you today on the term premium in the 10-year bond in the US. And I'd like you to go through your thinking on why we see the levels that we do at this juncture and how the Federal Reserve impacts this exact term premium in the 10-year space of the bond yield curve. Yeah, if you look at that term premium chart, which I think is the second one I sent you, what that's looking at is the long-term history of the US term premium.

4:51Now, this is on the 10-year bond. Now, without being sort of necessarily too complex, what the term premium is basically measuring is the differential that investors require to hold a 10-year bond over the term of the bond. So in other words, it's the difference between the 10-year yield today and what you would expect the coupon to be if you roll it every year for 10 years. So it's that differential. Now, normally that's positive. In other words, a holding duration risk, as it's called, a holding interest rate risk over a 10-year period, investors will expect to pay a small premium. What you're actually looking at, if you look at that chart is they're actually paying a whopping great discount.

5:32They're paying minus 150 basis points. Now, what does that really mean? So what that means is that if you look at rate expectations, and let's assume that the Federal Reserve is true here to its word, and it's not going to change Fed funds over the medium term from current levels, and let's assume that interest rates stay at 5%. percent. So what that would mean is if you add 150 basis points on top of that five percent, you're looking at a 10-year bond of six and a half. Now, that may be a pretty racy forecast. I don't even even I don't think it's going to get to those levels. But the direction of change is very important.

6:10And that term premier has been depressed, if you look, over the last 10 years, really in the wake of the global financial crisis. Now, there are a number of reasons why that term premium has crashed, it's been a significant boost for bond investors in the sense that yields would have been a lot higher without that. And it's really come through probably two or three major factors. One of them was regulation after the global financial crisis. So things like Basel III, Solvency II for insurance companies basically meant all these institutions worldwide had to hold more safe assets. And safe assets really come down to, at the end of the day, US Treasury bonds.

6:52I mean, that's really what most people would accept as a pristine collateral. So there's been tremendous demand for those bonds. At the same time, what you've had as well is China being a very big buyer of US debt until recently. And this is one of the other factors to throw into the equation. China's had a big appetite for US Treasuries, but it's beginning to lose that appetite, actually quite rapidly. So if you look at latest data that came out last Monday, you will actually see that the Chinese dropped their treasury holdings, I think back to levels of about 2009 or something. I mean, it's a significant drop and it's going to get lower.

7:28So you've had one demand knocked out. And then you've had another factor, which is basically the Federal Reserve itself has actually been up to recently buying treasuries. So there's a whole number of things that have actually pushed the demand for treasuries up and caused this term premium to crash. These factors are now unwinding. And on top, just take a look at what's happening to the deficit in the US and the projection for the debt burden on the US. And you can look at the Congressional Budget Office, which is an impartial, non-partisan organization that basically is saying within, what, 25, 30 years, the US debt GDP ratio is going to be 200%, currently about 115, 120%.

8:12So these are big, big numbers. These are significant challenges to markets. And if you start to get those pressures in the market, the term premium will go back or renormalize to where it should be, which is about zero. Michael, to which extent is this term premium connected or related to the decisions taken by the Fed today and in the quarters ahead. Let's assume that the Federal Reserve is actually serious about pausing here. Could you envisage term premiums increasing in such a pause scenario? Are those two contradicting or does it actually make sense that term premiums increase when the Fed pauses interest rates?

8:53Well, traditionally, that's what's happened. And I think the mechanism is, I think one's got to embrace both the Treasury and the Federal Reserve here, because the Treasury clearly influences the supply of coupons into the market. So in other words, notes and bonds, and the Federal Reserve is supplying liquidity. And what you tend to find is if you add those together as the pool of safe assets in the system, if the pool of safe assets increases, then investors basically will decrease their demand for things like government bonds, and the term premium will start to rise. So I think there's a very clear connection going on in this space.

9:30We're going to take a quick break and be right back with more of today's top analysis on the Real Vision Daily Briefing.

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10:42If we look at the decision in November and December, the decisions ahead for the Federal Reserve, We know that they're almost on autopilot on the balance sheet policy. Again, today, it doesn't seem like it's the hot topic. Everyone wants to discuss whether the policy rate will be raised by another 25 basis points. But amidst all of this, the balance sheet policy remains the same. They're trying to bring down the balance sheet size. But are they truly bringing down the balance sheet size? Or rather, are they truly bringing down the size of the liquidity pool available for private markets? Well, in fact, what they're doing is that they're sort of changing their goalposts, because what used to be the case was that, let's say, QE was spoken about in terms of liquidity.

11:30So it was the amount of liquidity the Federal Reserve was injecting into the system. QT should be the counterpoint of that, should be the reverse. So in other words, QT should be liquidity coming out of the system. It's been very carefully redefined to basically mean the roll-off of treasury holdings, specifically the roll-off of treasures on the balance sheet. Now, it's true to say that the balance sheet roll-off is continuing, and that more or less is set in stone. But that does not mean that liquidity conditions are moving pari-pursue with that. In other words, liquidity conditions are going in a different direction.

12:04And what you've seen principally since, let's say, September of last year, in other words, about 12 months ago, you've started to see liquidity provision by the Federal Reserve flatline and then around March of this year begin to start rising again. And that's that the March rise was triggered by the SVB crisis, the failure of Silicon Valley Bank, etc. And you've also had, going back to September, the fallout from the British guilt crisis, which I think spooked central banks and Treasury officials worldwide and caused them to be a lot more accommodative on liquidity. And the reality you have in financial markets today is that financial markets globally are very fragile.

12:49They need central bank support. And the main reason they need central bank support is that they've turned the whole complexion of markets has changed from being new financing mechanisms for capital spending, which is what the textbooks always tell us they are, and therefore where interest rates are really important because that represents your cost of capital. But they've turned into refinancing mechanisms, where what they're doing is refinancing the huge debt burden we've got. Now, if you look out there, we've got$350 trillion of debt worldwide with an average maturity of about five years, which simple math says you're going to have to roll over$70 trillion of debt each year, even without the new supply coming on.

13:33So these are eye-watering amounts of money. The US alone, I think, has got to roll and raise about$8 trillion next year alone. So these are daunting challenges. And you need balance sheet capacity among financial intermediaries to do that. And the Federal Reserve basically controls that. So what you should be seeing over the long term is basically a constant ratio between the size of the Federal Reserve balance sheet and the stock of debt in the world economy. And when you get interruptions in that ratio, you get financing crisis. And all I'd say, look back over the last 10 years or even 20 years, and every financial crisis that we can consider has been a refinancing crisis in some form.

14:18And that's what it's about. There may be there almost certainly be another one. But the Federal Reserve and other central banks will come in with alacrity. Interestingly enough, the Bank of England on Thursday, when it comes out with its great decision or whatever, there's a speech which is coinciding with that by Andrew Horzer, who's in charge of markets at the Bank of England, where he's explicitly, his topic is explicitly about the role of central banks in financial stability. And this is a forefront of central bankers' minds now. It's creating stability in the system. But Michael, if we look at the refinancing risks for 2024, given this higher for longer narrative presented by the Federal Reserve again today, probably presented by other central banks tomorrow with a plethora of central bank meetings in Europe, What do you make of the refinancing risks into 2024, given that we do not, at this juncture at least, have the confirmation that rates will be cut into 2024?

15:23Yeah, well, I think if you come back to the refinancing risk, I mean, I think you're right to say there are two dimensions there. I mean, one is rates clearly have some impact, but also the size of the balance sheets are also critical. Now, where you're seeing the biggest, if you like, contraction in balance sheets is in the Eurozone. And I think that's a dangerous policy to run. But we do know when push comes to shove, there is some hasty reversals of these moves. So I think if there are any refinancing problems in Europe, expect to see the ECB row back very quickly on its decisions on contracting the balance sheet.

15:57They'll have to put more liquidity into the system. In terms of the Federal Reserve, I mean, let me just be clear. The Federal Reserve may well have undertaken what on paper is a QT policy, and that's its stated aim, clearly. But in terms of the liquidity injections in the markets, they've basically been going up. And if you want evidence of that, just look at risk assets. Risk assets are highly liquidity sensitive, and they've been going up, particularly looking at tech stocks. Michael, this interview is a part of our crash or boom series here at Real Vision. We have this campaign ongoing for a couple of weeks.

16:30And I want to play a soundbite for you from a discussion between the founder of Real Vision, Raoul Pal, and Juliette de Klerk, a French macroanalyst. And she's arguing that if central banks decide to pause now, even amidst all of the trouble that you've mentioned around refinancing risks, etc. for next year, we risk seeing inflation re-accelerating. So let's listen to Juliette and get back to that discussion. I think inflation will be more problematic than currently assumed by central banks, also because they're not at level of rates that are restrictive yet. So I think they're all sort of like pausing at a level that's not yet restrictive.

17:17So they're sort of like pausing, waiting for the past hikes to start feeding through to lower demand. But the problem is when you're posing at levels that are not restrictive, I think it, you know, you setting yourself for like policy errors and that could be what happens in 2020, end of 2023, 2024, 2024, e.g. you know, inflation, disinflation gets disappointing. This interview with Gillette de Klerk is a part of our Crash or Boom series, and you You can go to realvision.com slash crash or boom to find the interview and your good offers right now. Back to you, Michael. If we listen to Juliet here, there's a risk that a pause more or less coordinated by global central banks right now will lead to a reacceleration of inflation trends.

18:10Also, given what we see in commodity space right now with rising prices in oil, for example. What do you make of that inflation risks amidst all of these discussions on a pause or not? Well, I think there are several moving parts here. And I sort of agree and I don't agree with what Juliet is saying. I think the key point is that economies generally have become a lot less rate sensitive. I mean, I think that's clear. And you could even argue sort of somewhat mischievously that actually the rise in interest rates that we've seen so far has actually been a net stimulus to the economy. For the simple reason, if you look at what's happening to the US corporate sector, for example, corporations have funded a term down the curve at low rates.

18:55OK, they've locked in low rates. And those corporations in the US that are sitting on big cash piles, which we know there are a lot of, are actually investing those money market rates, very high money market rates. So there's a net positive benefit from, if you like, an inverted curve at the moment and rising rates. So I think there's mischievously one can actually say that the economy may actually be a net beneficiary here. But I think that if you look at the inflation risks going forward, what I would say comes back to a much larger extent in terms of fiscal policy. And what you've got is at the moment a very loose fiscal policy courtesy of President Biden's programs, infrastructure and green energy, et cetera.

19:37But then you've got other factors that are coming in over the course of the next few years. And those are things like mandatory spending because of aging demographics. So that means Medicare. It means Social Security starts to starts to lift off significantly. Then you've got the defense spending to go on. And, you know, the congressional budget office that I cited earlier on are very pessimistic about the deficit. But then numbers on defense spending are actually quite conservative. I think more realistically, you could see much higher figures. And that would mean you would be looking at significant rises in US debt.

20:13That's the more inflationary backdrop. Now, come back to the issue of inflation and what could happen. I think in the near term, there are lots of disinflationary features in the world economy that are pushing inflation lower. Just got to look at producer prices. Look at what's happening in the labor market. if you drill into the labor market in the US, the cyclical parts are actually shedding jobs. They're not creating jobs. It's basically things like public workers, hospitals, leisure that are starting to pick the jobs up. And that's really because of the hit they took two or three years ago.

20:50So there are structural features that we've got to take account of. So I think the disinflationary process is there. Equally, one of the biggest disinflationary factors in the last few years has been China. China is likely to suffer over the next few months significant producer price deflation. And that's something that will feed through in terms of export prices. So I think you've got a significant factor coming through here, which could be a short-term disinflationary move. Now, countering that, and this is why there's a lot of cross-currents, you've got higher oil prices. Now, the higher oil price factor is going to feed in and confuse the mixture.

21:29And I think one of the things that certainly is at the forefront of my mind is to what extent is this rise in oil prices, a political decision by MBS and Saudi Arabia to try and put a lot of pressure on President Biden next year or his re-election hopes. And clearly it's in the interests of the Saudis, who we know there is very clearly some divide between Biden and MBS. And equally, on the other side, you've got Putin, who is clearly eager for oil prices to go up. So I think you've got forces, maybe anti-US forces that want higher oil prices. This is going to confuse the mixture. But generally, what I would say is, conclusion, you're going to get volatile inflation.

22:14Is there very much central banks can do about that? I don't really think so. This really comes down to supply sort of cost factors and the longer term fiscal implications. Now, the conclusion is, in my view, what central banks have got to do is to follow the policy remit that they've given themselves and keep rates higher for longer. There's no point in sort of moving around quickly, hiking rates and then cutting the bank when the economy crashes. Just keep rates up at a level, a higher threshold, and then you will constrain longer term inflation forces to some extent. We're going to take another quick break and be right back with more of today's top analysis on the Real Vision Daily Briefing.

23:00Michael, since we have a guest from the United Kingdom present at the Real Vision Daily Briefing today, I'd like to spend the last five minutes before we move to the Real Vision platform exclusively discussing the UK case and whether we can use it as sort of a gauge for global trends. And this morning, UK time, we received the inflation report from the UK. The first positive report, in my humble opinion, in quite a while, showing that services inflation is no longer there, at least on a monthly basis. So for now, these inflation trends are actually in place in the UK economy. And to a certain extent, I consider the UK economy like a live laboratory of supply chain constraints, protectionism, everything related to the Brexit and all those mechanisms.

23:57So, Michael, inflation in the UK, you've been at the forefront of inflation in a negative sense with very high trends. but maybe inflation is actually disappearing in the UK now. What do you make of inflation in the UK as you see it with boots on the ground? Well, I think the answer is that, you know, I would agree 100 % with what you're saying. As long as I've been in these markets, the UK has been the most inflation-prone economy of any of the majors, okay? If you get an inflation shock, the UK always comes out of this worst for whatever reason, but that's the reality. And I think what you're seeing now is the unwind of that.

24:35So the fact that the UK is seeing inflation pressures ebb quite quickly is a reassuring sign. But I think one can extrapolate globally and saying that a lot of this inflation shock is now behind us. And that's definitely my view. So I think what you've got, as I tried to outline just a second ago, is you've got a lot of cross-currents in the inflation mix. That suggests to me that you're going to see volatility in inflation. I don't think you're necessarily going to see a higher average level of inflation unless these fiscal problems begin to emerge. Now, as far as I can see, looking forward in the medium term, it's very difficult to get out of those.

25:12So you'd have to argue that monetary inflation, which is a key component of high-street inflation, becomes a major force in terms of pushing prices up in the medium term. I think that's just a reality. I think when you come down to the other element of UK policy, what are they going to do on interest rates? I mean, to be perfectly honest, I mean, it's such a muddle in terms of what the Monetary Policy Committee is saying and thinking and whatever. I have a faintest idea what they'll do. I don't think it really matters at the end of the day. But, you know, it really is. It's an embarrassing muddle in terms of what they've been doing.

25:47the Bank of England will decide on interest rates tomorrow. And 24 hours ago, the market was very certain that Bank of England would hike interest rates by another 25 basis points. Now it seems like more of a coin toss after that inflation report from the UK. But let's see. In any case, it seems like we're approaching the quote-unquote pause from Bank of England as well, as was sort of the message given by the Federal Reserve today. In terms of fiscal policy, I'd like your take on UK fiscal policy as well, Michael. I saw Liz Trosson parade on social media over the past couple of days. She obviously left office last year after a disastrous stint in office with her attempt to push forward a fiscal plan, and the markets obviously pushed back on that plan with that big move in interest rates in the UK, was it in September, October last year.

26:49So what do you make of UK fiscal policy right now and UK interest rates in relation to the fiscal policy? Well, I think equally, if you look at the UK, the UK has been a pointer for many other countries. And you can see that reckless fiscal policies in the context of Britain 12 months ago caused the bond market, the sovereign bond market, to sell off very aggressively. And what did the central bank do? What did the Bank of England do? It moved with alacrity to essentially bail out the bond market. It switched from a QT policy equivalent to a QE policy overnight. And I think that's a clear message that one has to sort of, as I say, use globally and say that if there are problems in the sovereign bond markets, central banks and treasury ministries will actually use all the tools they've got to try and do things.