The Fed's Own Worst Enemy ft. Michael Kao & Harry Melandri

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1:25Hi, everyone. I'm Harry Malandry and welcome to Real vision. With me today is Michael Cowell, CEO of Acanthus Capital Management and co-host of the podcast Chaos Theory. Michael, good to be with you again. It's great to be with you. Yeah, it's been a while. Glad to be back. So I took a look at your recent output before this because like minimum due diligence and all that and you were kind enough to let me pick anything you've recently looked at to discuss. So I'm going to try and take advantage of that and chat a little bit about geopolitics further down in the call, because I know that the subject's pretty much useless for any short-term trading, but it always fascinates me.

2:09And I always want to hear where others are on some of the key questions. But before we go there, can I touch on your Fed views? The phrase you used was, did the Fed pivot too soon? I'm impressed that you managed to avoid using the word premature. Oh, I didn't. I did use premature. That's right. Not only did I use premature, I called it Pusillanimous Powell's premature pivot. As I'm a fan of alliteration. I took a note of the Pusillanimous. You know, I was with you. I looked at that. I was surprised. Most of the economic commentators were surprised. The economists didn't see it coming, which tells you something.

2:51and I'm wondering what where are we wrong on the Fed's reaction function? What should we assume about how the Fed is thinking about the economy? You want to unfuck your shit? Yeah, that's being recorded. Hey listen, if you want to unfuck your future then come and join us in the Real Vision community. Incredible platform, amazing content, some of the smartest people in the world and amazing tools. And guess what? It'll cost you nothing. Come to realvision.com. I'll see you there. Let's help you unfuck your future. I think I go back to a piece that I wrote many, many months ago. I call it the four horsemen of US economic resilience, right?

3:40And I talked about how there are a number of drivers that are making the US economy stronger than the rest of the world. and that presents a problem for the Fed. And real briefly, those four horsemen are, one, there are certain demographic and structural factors behind the stickiness of labor and housing inflation. Two, and probably the most important, is the fiscal impetus here, unmatched by any other country. Three is that both our consumers and our corporations are relatively rate insensitive. And part of the macro confusion that people have been picking out of the macro data comes from the fact that there's a little bit of something for everybody in the data.

4:35If you want to look at what fits your narrative, a predetermined narrative. So if you're thinking that the Fed's too late and we're going into recession, well, guess what? you can find the data in those segments of the macro economy that justify those points. But my point is that if you look at the bigger aggregates, whether it's credit spreads, credit availability, just the overall GDP growth, unemployment, at a macro level, You are just not seeing the cracks to justify a cut now. And then the fourth and final is we have relative energy independence. But I also think that that's been somewhat, that's been a little bit mooted because, you know, given I've had this short term bearish view on oil for some time.

5:34And we can go into that if you want. But anyways, so those are my four horsemen of U.S. economic resilience. And then that Pucillanimous Powell piece that I referenced that I wrote, I think, two months ago, which was a little controversial at the time, but I feel somewhat vindicated in that call that the Fed was premature. sure, because you start to look at some of the, I mean, the last jobs numbers notwithstanding, which was like a big positive surprise. But one thing that I pointed out two days ago is that the five-year inflation swaps have been just roofing. And you're seeing certain commodities, you know, like gold, et cetera, react accordingly.

6:24You're seeing the bond market, which I also predicted in that piece, Lanhamus Powell piece, that if the bond market senses that the Fed is no longer up to its job to containing inflation. And I did this whole research on like the 1980 to 81 analog where a similar thing happened that you would see the long end essentially rebel. And we've seen that happen. So I think the Fed screwed up here. So, you know, we'll see. I mean, at a very, very macro level, to just show you, I mean, to me, this seemed pretty obvious, but I'm looking at a dashboard, a world economic dashboard that Coifin updates basically on a real-time basis.

7:19And if you look at the top several economies of the world, right, you've got the United States with GDP quarter-on-quarter, around 3%, CPI around 2.4%. And you've got, hang on a second, I don't think they have unemployment on here. Yeah, okay, so job unemployment rate, call it, for some reason they have 4.1 % on here. That's totally not right. Anyways, it's a little bit higher than that even. And then if you look at the Eurozone, the GDP compared to the US is 3 % quarter on quarter. It's like 20 basis points. CPI there is like 1.8%. Jobless rate is 6.4%. percent. You look at China, GDP quarter on quarter, it says 70 bps.

8:14And then CPI is like 0.4, although I've seen measures that are showing actually deflation in China. And then the jobless rate there, I don't believe this for a second, it says 5.3%. When you look at the youth unemployment in China, it's like in the mid-20s to maybe even above 30%. You mean, it's all youth or graduate youth? That I have to look into. The last country, though, is Japan, right? So Japan, GDP quarter-on-quarter, 70 bps. GDP year-over-year, negative 100 bps. CPI at 3%. And there, the jobless rate is lower, right? But my point, though, is that when you look at the macro aggregate data, there simply was no reason for the Fed to react in the way in which it did, especially with 50.

9:14And that's the part that was a little bit shocking to me. So I'm currently short the December 25 SOFR futures because I still think that You know, it's currently implying, you know, Fed funds of around like three and a half percent, right, by end of 25. I think it's going to be much higher than that. You know, I'm long of that contract, so we're going to have a sparkling debate. I'm long of it via calls. And the reason I'm long of DEC 25s, you know, it's connected to the same reason you're short of it. My suspicion is we got some kind of policy mistake. But I don't know what's motivating it, because nothing I see could kind of explain the decision on a purely economic basis, which I think is the same conclusion you reached.

10:12So why are you long of it? So I think it pivots around fiscal policy in 2025. I think everything will boil down to my suspicion is that they all know this. Everybody involved in policymaking knows this already. but that for let's call it political reasons there are really good reasons to goose this economy here and now at the margin run it a little hot well you know i i had this discussion with a friend of mine and they accused me of being a conspiracy theorist of course they're right i am a conspiracy theorist but that doesn't mean i'm not occasionally correct in my analysis so what i'm thinking is that we shouldn't think of it as a bigger, broader, like nonsense decision.

10:56We should think of it at the margin. And if you're a Fed official who perhaps is getting irate phone calls from the White House, if it was a question of doing 25 or doing 50 to start, you might well start with a 50. Well, that's, you know, my only rationalization for why Powell did 50, and the minutes showed that he seemed to have strong-armed, uh, folks, uh, into the 50. I have a, you know, I'm disappointed in him because of all the, of the, uh, the, uh, the fed chairs we've had, uh, recently, I felt that he was probably less likely to be political, but I do think that this decision may have been somewhat political in that, um, if Trump wins in a couple of weeks, I think he will, he he will have a harder time uh you know well he he he he i think he wants kamala to win but given given the the issues you've given the uh the threats that trump has uh has foisted on him in the past.

12:13And I feel like he jumped the gun here to basically sneak in that extra cut early on in case, you know, maybe the data don't justify it later. I don't know. It's hard. I think that's exactly it. It's hard to, it's really hard to kind of figure out what's in his head. But I was a little bit surprised that he did 50 initially. But I do think that because he did 50, and especially in that presser, he was extremely dovish, and the markets priced in unreasonable, what I think are an unreasonable set of cuts given the macro circumstances. So we'll see. Yeah, I think that's exactly right. We shouldn't extrapolate from that 50 directly.

13:06but you're tempted to because you can't really reverse engineer it. So you have to adjust your reaction function to some degree. But it's probably a mistake. It's probably done just as a prophylactic because you don't know if you can deliver data. The yield curve is telling you it's a mistake. And so are inflation swaps. I was reading a friend of mine's piece, a friend's Fed watcher. Talk about a weird job to have, but he's been a Fed watcher since 2001 or before. I've known him since then. And he used the word Yankee or Janky with regard to data. And it got me thinking because... Have you ever wanted to trade Bitcoin but haven't dared try?

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14:52They were already thinking there were some weird seasonal effects in the unemployment data. that it was seasonally boosted to higher than it really is. And in fact, the labor market is weaker. They can always hurt. But with the hurricanes we've just seen in Florida, that jankiness of data, is this going to persist? There's going to be more noise. But again, on a big picture level, right? What are we measuring against? Because even if it's 4.5%, let's say, okay, we're measuring against an all-time tight of around what three and a half 3.6 and when you have gdp as strong as it is with with certain measures of core inflation and super core still uh basically around four and a half to five percent what are we doing Because when you think about this, I've been calling this economy we've been having this vodka Red Bull economy where you've got this monetary depressant offsetting this fiscal Red Bull.

16:02And what Powell has done is he's removed that monetary depressant or at least started us on the path of an aggressive removal of that monetary depressant, which leaves you with a lot of Red Bull. And one of the other points that I don't really see most people address that I wrote in that Pusillanimus Powell piece is that there are a number of supply inelasticities here. One or two of them alone isn't a big deal, but the confluence of all of them, I think, is a big deal. And so, as you know, when you've got an inelastic supply curve, the last thing that you want is something that stimulates that aggregate demand curve to right shift because a little bit goes a long ways when you've got a supply inelastic situation.

17:03situation. And so real briefly, the supply inelasticities that I talked about were, let me find it. Well, one of them is housing, right? One of them is housing. One of them is oil, which is artificial, driven by geopolitics and Saudi's unilateral cuts. You've got freight rates driven by geopolitical risk in the Middle East. You've got manufacturing capacity, again, driven by geopolitical choice of near-shoring. You've got some technical bonds, right, driven by Treasury's deliberate QRA gains to restrict duration supply. You've got housing, which we talked about. And then you've got labor. This labor, I believe, the spate of strikes that we have seen over the last two years, that doesn't happen when you've got fundamental labor slack.

18:04Labor has had abnormally high leverage. And I think that's a result of demographic undersupply in certain cohorts. If you look at the demographic pyramid of the United States, and I pointed this out in past tweets, the age cohort between, say, 45 and 59 is a relative trough. That is the Gen X cohort. That's my cohort. That's the cohort that came after the baby boomers. It was a relative trough. And that cohort also happens to be the most highly tenured part of the workforce. And I think because it's a relative trough, I think that's driving some of this labor stickiness. So anyway, I think the confluence of these like six different supply inelasticities is going to shock the Fed, where even a little bit of a right shift in aggregate demand is going to, I think, reignite inflation.

19:11so i used to do a bit of fed watching myself um used to be a real money manager for a while um and what i found recently is when i chat to people i know who are still in contact with fed officials that everything you think is going to shock them they know right as a general rule if you say to them why are you doing this don't you realize x or the inelastics they'll say yeah now we get that and then you say so why and they'll say politically we can't address it right now this is not this is not the moment this is not the time can't do it right now can't do it from here congressional problem you'll hear things like it's in fact shockingly sometimes i think to myself oh the fed are marxist now they're giving me a quoting back marxist dialectic to me on certain issues you know it's that you get really weird effects i saw you wrote something about um what The current situation is not as simple as a K-shape economy, as more nuanced.

20:13And I took a note, you said something like within the US, we have, I generalized it because I think what you were saying is you've got winners and losers, but actually you've got those with market power and those without. And if you... Yeah, I'll address that. I mean, I call it, you know, this bifurcated economy, both. But I parse between the consumer and the corporate, right? Because the K-shaped recovery typically refers to, you know, you've got your richest decile and your poorest decile. And I guess you can generalize from that perspective, at least on the consumer front. But it's a little bit more nuanced than that because there's the matter of who has the leverage in the economy, both on the consumer and on the corporate side of things.

21:06Because on the consumer side of things, obviously, there is this bifurcation between rich and poor. But there are certain wealthy people that are hurting because they are in sectors that are very levered, like CRE, like office CRE. New York CRE. Correct. That's right. Okay. And then on the corporate side of things, it's the same thing where you've got the, to your point about pricing power, you've got the MAG7, the big companies that are flush with cash and having a high Fed funds rate actually helps them. However, you've got a myriad of companies that also have floating rate debt. Generally, smaller cap sub-investment grade companies where their cost of money just went from SOFR plus 500.

22:07Essentially, SOFR used to be zero. So that used to be 5 % money. Now it's 10 % money. And that's killing that segment of the economy. But again, because the big and the rich dominate the macro, right, on a macro basis, you are not seeing stress. You're just not seeing the stress in credit markets. Yeah, it's not quite an 80-20 rule, but it's something like a 60-40 rule that 60 % of the consumption is done by roughly 20 % of the population, something like that. And there's one more point here I want to make because I think it's an important one. There was a, you know, I responded to somebody's tweet a couple of months ago about showing the spike in credit card delinquencies as a sign that the Fed is too late.

23:03The low-end consumer needs relief now. And I said, you actually got this all wrong. The low-end consumer that actually incurs 20-plus percent interest on credit cards, they're doing that because they are living hand-to-mouth and they are getting creamed by the most regressive tax of all, which is inflation. It is inflation that's killing them. If inflation weren't a problem, they probably wouldn't be needing to incur and have rack up huge credit card debts and paying 20 plus percent. So I think that is a stark example of where there's certain data. And if you just think on a first order basis, oh, yeah, lowering interest payments will help that consumer.

24:01Well, okay, you're going to lower interest payments 2 % from, what, 21 % to 19%. That's going to help that consumer. But meanwhile, if inflation reignites its head, what happens then? You know, the example that really caught my imagination and really clarified it for me was the longshoremen. Smart cookies. They totally, that Harold, whatever his name, he totally got that this was the time to strike because the administration would lean on his opposite numbers. They have market power. That's right. That's right. But again, that doesn't happen if you have labor slack. No, absolutely. Do you know what I'm saying?

24:43And it's not just the longshoremen. It's multiple industries across multiple sectors. So that's why I wanted to think a little bit deeper and say, okay, what is the commonality here? The commonality, I think, is demographics. I think it's something deeper that is giving labor that type of leverage. And yeah, it's just one of multiple supply and elasticities that I can think of. Yeah, I can see, I take that point completely. I think there's another aspect, mechanistic aspect to this that we should look at, which is when you have, when you're creating an average, like the CPI index, you're going to have some components which are strong and some components which are weak.

25:31The problem in an environment where you have these inelasticities is the strong components are going to be very strong. It's going to be really hard to stop the longshoremen scoring themselves a 60 % pay increase because they have so much market power. And in order for that to offset, you'd need to see someone get what kind of reduction in wages. So here in the Acceler corridor, rents are tight. Right. It's very little spare housing stock. And that's going to because a lot of the defense industry is up and down here and that stuff isn't slowing down. That that bias on inflation is so strong that I think we're going to have this rather unpleasant combination where even if the economy slows, CPI index ain't coming down that much.

26:21No. In my Fusilana S. Powell piece, I wrote that the particular inflation component that I'm most concerned about is the housing inflation. Because that structural undersupply doesn't get solved overnight. And with these clownish proposals of helping with$25 ,000 mortgage assistance down payments... It was fun. Right. I mean, it's just, it's just like completely, are you kidding me? Like you're going to, that's, that's, that's what perpetuates a vicious cycle, right? It's that kind of thinking. And so, yeah, that's, that's a big concern because here, look, I live in LA, right? And, you know, my kids are, you know, just entering the workforce.

27:13And when you look at the rents that they need to pay for a safe building out here, it's almost impossible for a young person, unless you're in certain super highly paid industries, to be able to afford the cost of living right now. um you know and it's and it's uh i i really worry about my kids uh generation because you know what used to be and then and then that's that's just rent but if you know about we had a tailwind we had a tailwind they have a headwind a huge a huge headwind yeah um so let's get to the bottom line on this discussion we there's a lot of common ground um but i'm let's look into 2025 so what is the trade what where do you see this end game where do you see this interest rate where interest rates pan out i told you i was i bought some calls on 2025 uh so for uh deck 25 i still i don't i still don't really understand your thesis there well you think that the fed is despite our common ground on the inflationary aspects of it you are betting that uh that fed funds is going to be lower?

28:32It might end up at zero. And that's, so the logic of that is I think that we are, the official sector sees a fiscal problem, a serious fiscal problem that they would like to address, but they've deferred addressing it till post-elections because addressing the fiscal problem will be extremely painful, extremely contentious. And so all of this, this whole question of the appropriate level of US fiscal spending has been deferred after the election. If it's a Trump win, it will be addressed in a certain way. If it's a Harris win, it will be addressed in maybe a different way. But the impression I get is that it's post-election, will turn out, the officials will turn their attention to the appropriate level of the deficit.

29:25And whatever way you cut it, it's going to be much lower. So you think that the fiscal Red Bull gets withdrawn and therefore the monetary depressant can be completely withdrawn? I think if they don't do something about the monetary side, those weak interest rate sensitive sectors of the economy will absolutely collapse. So what you'd need is as they pull back on the fiscal, the Fed will probably have to be very aggressive. And the reason I like that bet is it's really hard to get a geared bet on zero rates. I'm not saying it's my central tendency, it's my most central scenario, most likely outcome.

30:08But I think I'm being paid good odds on options. Interesting. Take that bet. Like it's 21 or 22 cents for a particular strike. I don't want to, forgive me, everyone listening to this, you be careful playing with options, right? Don't be messing with options. Definitely do not sell them. So this isn't, don't consider this a trade recommendation. But I like this as a tail bet for what could happen post-election. I haven't, I don't know, I've got a weird sense that everything's being held together until we get through the elections and then après ça, le deluge, so to speak. The thing is, though, I mean, I love talking to smart people that have different opinions than mine.

30:55I respect that. I don't agree with it just because I feel like both candidates

31:06are profligate spenders. Now, here's the thing. what I, you know, the CBO came out with a whole bunch of, you know, of their predictions, and I don't know what their track record is in predicting this stuff. Talking about, for instance, like a Trump administration being much far more inflationary, far bigger deficit. I actually would take the under on the Trump win in terms of the fiscal profligacy, because I think what people are potentially discounting is that if he comes out with tax cuts that are not offset by spending cuts, and especially what I'm particularly interested in is if he assigns Elon Musk this idea of cutting government agencies and seeing what he did at Twitter X, that's a sort of a once in a generation opportunity to actually cut back on government.

32:14Now, we'll see whether that can actually happen. So I'm with you from that perspective that I think that some of these huge predictions on deficits exploding. I was just mentioning today to some friends that if we wind up having sort of a list trust moment in bonds because of that, I think it would be a fading opportunity personally. But we'll see. There's too many. I don't like to make those types of bets where there are just too many contingent probabilities that need to happen. It's a little too hard for me. now to make that kind of bet? Yeah, it really is a binary because it's either, you know, X or Y.

33:02But I think to address the several points you made, number one, so Trump is Trump. I have no idea what Harris, what she's really thinking on policy, but I assume she'll be continuity to a great degree. But I talked to guys from Political Alpha that do a lot of very focused work on what's happening in DC. And their surprising message is that the transition team for Trump are very focused on the deficit, and that Republicans, the kind of core constituency of Republican reps, are very concerned about deficit trends and would like to do something about it. So the sense I'm getting, and you get that from Fed officials as well, everyone's giving you, let me put it another way, even I, someone as dumb as me, can see that the projections for U.S.

34:00deficit spending are non-sustainable. It really can't continue. So if something can't continue, it will eventually stop, Stein's Law. When does it stop? And I'm thinking that 2025 is when that comes to a head. And I can be wrong, and then I write off 20 cents of option premium on those things. But I think, I suspect that it's when it happens. With regard to the Harris guys, well, everybody is talking about the deficit. You asked about the CBO's track record. Terrible. Consistently terrible. Why? That's what I figured. Because they tell government what they want to hear, right? But CBO is, if you read between the lines on that document, it's a ridiculously big document, by the way, folks.