The Impacts of Higher For Longer

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1:09What are the impacts of hire for longer? Welcome to Real Vision Daily Briefing. It's Wednesday, November 8th, 2023. I'm Ash Bennington. I'm joined today by George Kunkalvis, head of US Macro Strategy at MUFG. George, welcome back to Real Vision Daily Briefing. Thanks, Ash. Pleasure to be with you. It's a pleasure to be with you too. First time the two of us are on this show together. I'm excited to dive in and get started. Look, we teased it a little bit at the top of the show, asking about the impacts of higher for longer. All eyes right now on price and inflation data, global central bank policy and financial conditions.

1:43George, big picture. Where do you see us right now at the 50 ,000 foot level? Well, you know, Ash, I'm old school trained by some of the best global macro strategists, economists over the years and work at some really great places and interact with clients all the time. So I really get the benefit from hearing what's going on throughout the system. And for me, there's really three things that always matter. Rates still matter. There's this kind of notion that rates don't matter. I mean, I think we're like, we can immediately forget that it takes time to show up to where rates actually impact the economy and markets are impatient by nature.

2:18And then at the end of the day, everything is priced on the margin, right? That's true for housing, that's true for stocks, it's true for even bonds, right? So I think on the margin, everything gets set. And ultimately, liquidity rules the day. It rules the trading day. And so those are the three things that kind of really guide me throughout the daily, weekly kind of in and outs of the markets. The bigger picture standing out, I mean, I think, look, we have, we're late cycle in many different ways. But this cycle has been so altered based on the starting point, especially coming out of the pandemic and all this sort of stimulus.

2:55and the way that the Fed reacted and took long, and now it's probably going to take long to go the other way. And I think that, you know, unfortunately, it's going to end up with unnecessary macro vol, and people are just getting used to it. They're not really, they don't like this sort of volatility. They don't understand it, you know, and it's still reverberating through the system. And I think it's going to take a while before we really figure out, can we get a soft landing? Is it a bumpy landing, but we avoid a recession? Or is it truly going to be like kind of a harder drop in And then we know that given past experience, they're probably going to try to come in for the rescue with a lot of stimulus and or Fed easing.

3:32But we have the kind of difficulty that next year is an election year. So I'm of the view that it's going to get tougher before it gets better. And people don't like that message. But the good news is that we'll get through it and then we'll be able to really discern where were the malinvestments, where is there really opportunities and where's value. I think that it's still too early to say that for both risk assets, for fixed income, especially on the leverage side. I mean, there's still a lot of kind of stones to be turned over. Well, we're going to get to your base case in just a second. But I want to ask you this because it's something that you touch on in your most recent research note for MUFG.

4:09And it's this question, you know, what are the things that seems to happen? Like we as human beings seem to tune out things that get repeated again and again and again. Like, you know, please return your tray to its full upright position. Right. You start to lose the ability to understand it or to perceive it. And one of the things that Jay Powell has always said is this phrase, long and variable lags, when talking about the way that monetary policy has a transmission mechanism to the broader economy, and of course, also to risk asset prices. How do you think about that in relation to where we are right now?

4:44Yeah, I mean, that is the trillion dollar question, because this idea that, oh, we can handle higher rates and that we're still, we, I'm just saying, collectively speaking for the marketplace and that, you know, there's pricing power and it's equally distributed and that every, you know, company's going to be able to like live through this higher environment and it's going to be virtuous. And that's like the, like the Goldilocks, super optimistic outcome that we're, that we can now somehow afford high rates. Meanwhile, what's kind of, you know, in the background forming and developing is those long and variable lags.

5:21And it's going to expose those that A, cannot afford for this to persist for long periods of time. But yet, we're being told that higher for longer is going to be the regime that we're in. That's why we dub it a paradox, because the longer you're in it, it's going to expose those weaknesses eventually. But the The faster you get out of it, we'll never really know. It's counterfactual. And so this is where it really gets tricky because I don't think push comes to shove. If we start seeing weakness in the economy and if it really gets to the labor market quickly, the Fed's going to pivot so quick.

5:58And some markets know that. So they're like, CRE, people want to refi their house or wait to get into a home in the first place. Everyone's like, oh yeah, the Fed's going to pivot, so I'm just going to wait. And so it's creating this kind of tension, which eventually has to give way. Yeah, so let me ask you this. What's your base case? What's the probability distribution look like in your mind as we head forward? So our view, we've been flooring between 60 to 75 % chance of a recession over the next 12 months. And it could very well be at our doorsteps right now. So there's a, you know, given like last week's payroll, I think that was a much more honest picture of what's truly going on in the labor market.

6:41So I think in the coming months into the first half of next year, I think we're going to get, you know, really get that impact of those long and variable lags. We're going to see that there's less rate of change benefit from fiscal spending. All that's behind us, not ahead of us. And I think it's going to hit really hard. So our base case is that we're either at this kind of precipice of the recession or sort of really, really weak economic activity throughout the first half of next year. Yeah. So the base case is basically it's going to catch up with us. The hikes are going to eventually kick in.

7:13We're going to see more likely than not. I mean, 75 percent chance of recession fairly high. Absolutely. I mean, look, that's as far as I can go. The other alternative case is that they somehow managed to catch it, but then they open up the other more negative outcome, which I think is actually worse than a recession, which will be the kind of perpetual stagflation. So this is why I think that they want to try to stay higher for longer and then be able to cut quick and avoid a deep recession, but not necessarily trigger inflation or there's inflation expectation. So you kind of have to feel some of that pain to realize that you get some disinflationary, potentially deflationary shocks in certain industries.

7:55And then that will then take pressure off inflation. So they don't have to cut back to zero. Maybe they cut hard, like 100 basis points quick, and then see if it works. And if it doesn't, it cut another 100 basis points. And that can very well happen throughout the course of 2024. And they avoid going back to zero because they don't want to necessarily create another asset bubble either, right? So this is kind of their own dilemma that they're fighting. Yeah, let's talk a little bit about price levels, because we're truly in sort of unprecedented territory here. When you think about the context, the past being prologue, when you see inflation just collapse, obviously, with the pandemic, then you get this massive monetary easing and this huge spring back, then obviously substantial declines from peak on CPI, PCE, pick your indicator.

8:41But how do you think about that now? I mean, are we in a period where it's just very hard to gauge whether prices are, in fact, truly normalizing? Or if we're going to have something that looks, I don't know, maybe 150, 250 basis points elevated above where they want to be? I mean, is that problem that lasts, like when you jump out of a plane and your parachute doesn't open, the first 15 ,000 feet would fine, but it's the last six inches that kill you? Well, that's a really kind of morbid comparison, but I do think it's really hard to tell that or last mile, right? You don't know where you're at the last few inches, whatever it may be.

9:15You don't know where you're at. And I think we're in that ambiguous state right now. That's true for policymakers and for markets. And then that leads to less conviction on the part of traders and portfolio managers and policymakers are just hoping for the best and hoping that they're going to get their glide pack down towards their 2 % target. But while we're waiting, it's a very uncomfortable position to be in. Three is still elevated, but it's better than nine. And the question then becomes, does three become a springboard back to six? And that's what really gets people nervous. And it's the second wave that really gets you the permanent higher inflation expectations.

9:54It's the second wave. So this big first wave that we had in 2020 through 21 to early 22, that's basically behind us now. A lot of it was supply chain driven. And a lot of it just fixed itself on its own and really didn't really require, in my opinion, this much in terms of hikes. I think they overshot by at least 100, if not more. So now we're going to, even if they ease 100, I think it's still going to be tight at 4%, 4.5%. And so if they kind of gradually take down rates over the course of next year, it won't be enough to really create a soft landing. So they would have to be aggressive, in my view.

10:27Yeah, I mean, it's sort of strange. You have this weird effect that you had on the forward rate path where you had prices of hikes being priced in when inflation was too hot and then prices being baked in that it's going to get cut six months further along the line. It's a weird sort of moment, right? I mean, we're past that now, but it was a strange moment when it happened. Sure. And a lot of it was just insurance policies taken out just as a worst case scenario. And it was really a lot of it still earlier in the year during the throes of the regional bank crisis, which in my mind is still an issue out there.

11:01So it was understandable why they were taking place and why we're seeing those deep inversions. But we all know, and it's been well documented on your shows and everybody else and everything that we've written, it's the disinversion that gets you. So once we start to really properly disinvert, then you're counting the weeks and months before the real acknowledgement of the weakness and the economy. We're going to take a quick break and be right back with more of the day's top analysis on the Real Vision Daily Briefing.

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12:32I'll play devil's advocate here. Obviously, yes, 3 or 3.7 is better than 9. But when you have this persistent elevated inflation, the specter that you raised earlier, which is a long period of stagflation, is a risk, a non-zero risk at the very least. That's right. That's why we've been conditioned in a way where, well, if it gets bad enough, the Fed has her back, and therefore, they're going to ease and they're going to eventually come back to QE, which we don't buy that argument. The hurdle for super accommodative Fed is very high. They're going to try to avoid at all costs creating those conditions again.

13:11And so they'll just drag their feet. They might be punchy at first and take down rates 100 basis points and see if that's enough to actually stabilize the growth side of the equation. Because if they're cutting, it's because they're worried about growth and the jobs market. Something happened, right? And or if something happens financially, right? But if we're kind of this holding pattern, which it looks like we are, then they're going to avoid doing that. Because if you get it wrong, the risk is, yeah, it's a non-zero percent chance. You're going to flip back up towards 6%, 7 % inflation. And then that's when you get that really sticky mindset amongst the consumer.

13:46And it's really hard to break that, and they know it. So let's talk a little bit more about financial conditions. Obviously, one of the things that we've been hearing is this idea that the 10-year yield is essentially trimming the sales of the economy for you. I think maybe that's an optimistic way of thinking about it. But talk a little bit about what we've seen at the belly of the curve, rising rates there and the impact to the broader economy. So all these things, even that operates with the lag as well, right? So basically, Basically, we're recording one week after the last FOMC, which feels like it was a month ago, because the price action, both risk assets and the bond market have completely flipped.

14:25And we've got more favorable financial conditions as a result of the rally, both in stocks as well as the decline in rates out the curve. But just thinking about what took us up to that point last week, we had rates close to 5%, almost across the curve at certain points. And I think that that matters. I think that putting off home purchase decisions and how that filters through the economy, just any sort of holding back on coming to market with deals, I think that mattered. Now, I think the 450 on the 10-year to 5 % range should be where we settle in much further than that and basically where we are right now as a climate to close.

15:05I think the market's kind of run too fast, too quickly, both on position adjustments and just a euphoria that the Fed is done. I think they are, but we shouldn't just get ahead of ourselves either. But based on that 450, 5 % range, that's still a lot of decent financial conditions tightening, which is going to prevent some of the more interest rate sensitive sectors of the economy to benefit until they actually do start cutting. So as long as we're between 450 and 5%, I think then that's still tightening, even though it's not going to be as bad at 5%. But I think we'll kind of fluctuate in between there.

15:37A move under 450 means something is broken, So I think if we really get under 450, the Fed's not signaling they're going to cut. They actually came out in the last two days really pushing back hard on the rates market and say, look, we're not we don't understand. We didn't give a green light for cuts here. We're going to hold the line and hire for longer. So I think that that means there's a give and take and they could play with stuff during the December meeting. We think they're done, but they could get hawkish again and stay hawkish all throughout December. and then at the meeting signal that those two cuts that we thought we're going to do in 2024, we're going to take those out.

16:11So that's the way that they can kind of try to push back on the market a little bit. I think it's going to be a game of them proving that they're on hold. Yeah, this sort of the jawboning effect, right? Where it's, well, this is a hawkish pause. Yeah, I think like right now we skip twice and if they skip again in December, then we can move towards calling it a proper pause. And then the clock started in July, right? So that, you know, they can be coming rates, March, May, June. That's fair game based on history. Yeah. And by the way, 40 basis points on a yield basis decline off the highs on the 10-year yield for some whatever, 14 days or so.

16:53Yeah, absolutely. So like, yeah, it's decent. And I think that they're not going to want to encourage it. No. Let me talk just a little bit here, shift here to some things that we've been discussing here on Real Vision, just so folks know. Obviously, we're on YouTube and we have a whole platform for people to explore. And I just want to highlight some of these points. Talking about this, we had an incredible day of content here at Real Vision, beginning with trading macro themes with Andrea Steno-Larsen and Alex Campbell. Also, I did a conversation on Real Vision Pro Crypto with Sergey Nazarov, co-founder of Chainlink, where we talk about the merging of the traditional finance system as well as the blockchain space.

17:30So it's an interesting one there. And if you get a chance, I highly recommend taking a listen to our X spaces out today, which I hosted with Raoul Pal and David Matten. You can find a recorded version of that on our website at app.realvision.com. That's app.realvision.com. George, let me ask you this. What are the gauges that you're going to be looking at on your screen as you try to interpret what happens next? In other words, what are the numbers, the levels that you have your eyes pointed on to see what might be breaking in terms of your thesis? Sure. So I think it comes down to the jobs market, the continuing claims, which we get tomorrow.

18:07I think if you look at the unemployed, although the unemployment rate is only up about half a percent or so from the bottom, it's going in the wrong direction, number one. But that is a total of 1 million people that are out of work during that time frame. So once we start getting to four handles on the unemployment rate. Then we're clearly turning the corner. I think the claims data, both the weekly corroborating the continuing claims, which has been a little bit disconnected. But I think that that will probably start to kind of write itself in Q1. And unfortunately, to the downside, we're much more unemployed.

18:44And I do think that there's a big quirks in the inflation data because of the way things are kind of calculated. So there's actually some upside risk for next week inflation, which could pop up rates again. And that might be another opportunity to think about looking at fixed income. But I do think that we're in a broader range. We don't have enough definitive information to draw a conclusion of we should start a rally now before the Fed has even cut rates yet. It's going to be hard because the carry matters still at some point. If they get in their heels for two, three, four months, even six months before, they'll lose a lot of carry just being short.

19:23So I do think that's going to constrain the ability of rates to rally until they actually give us the go ahead and actually do the first move and cut. So again, this is a holding pattern. This is a range trading world. In the past, that would be like a vol killer, right? Like vol would come down. But because positioning gets lighter and smaller into year end, and after such a tough year, let's be honest, this has been a really difficult year again for fixed income investors and macro investors in general, that smaller positions and more trading might create the bad vol where you're getting chopped up in both directions.

19:57George, I'm pleased to say we've got a lot of questions coming in and they're all right in your wheelhouse about macro and fixed income. First one comes to us from Scott Larson. And Scott wants to know, how does George feel about the broken 40-year downtrend in 10-year yield? What seems like a reasonable bottom in yields if we get a, and he does this in double quotes, mild recession? But first to the first point, Georgia, obviously anybody who's been watching that chart of 10-year yield knows that it peaked in 1982 and it's basically rolled down until whatever it was, July, August of 2020. And give us a sense of what that means from a big picture perspective as you see it.

20:38Look, I mean, that's close to 40 years and 25 years of my career through that time period. I mean, I always knew lower lows, right? So lower lows, we're always like that, you know what? Rates are always going to rally. So you're always going to get a chance to kind of get straight on your positioning if you hold off for long enough. I think that the fact that lower lows are no longer with us and we're going to see lower highs and then probably end up in a bigger range trading environment again. So, you know, for me, like the criteria, especially last year, is once we had like two or three quarters well above that three standard deviation downward channel.

21:12I know it's a chart that Ralph uses a lot. I use it as well, the kind of standard deviation of that big channel. It got broken. You have to admit it. It's over. So that bond-bull cycle did end last year. So now going forward, it doesn't mean that a bear market starts either. Everyone wants to view that the opposite has to happen because we've had it for 40 years on a down cycle. I think Japan, in that sense, actually kind of gives us a little bit of a roadmap that we're probably going to see bigger range trading. And if it really, really got out of control, at some point, even the Fed might have to go to YCC.

21:49So I think you call it the range 2.5 % to 5%, the days of going back to zero or 50 basis points at the 10-year, it would really be a really bad world. And I don't think we're there. I think that we're going to have this either mild recession or bumpy bottom. The Fed's going to react. And then in 2025, 26, hopefully the world's a better place that we have a more virtuous growth cycle. And that rates between three and five. We're going to take another quick break and be right back with more of the day's top analysis on the Real Vision daily briefing.

22:28George, I got to ask a follow-up there because you slid it in real fast. You said the throwaway line, Fed might go to YCC. What do you think the odds are of that actually happening? Yield curve control, of course. I mean, look, they did it during World War II, right? So they did a version of it during World War II. It really depends on what's the motivating factor and depends on if rates are kind of running away from us, right? I don't think that we're anywhere near that. But I do believe it's part of the tools that the Fed possesses. And I think it would be something, if need be, would be put into place.

22:59And actually, as we saw in Japan, actually, you end up using less QE. You end up doing less because the market kind of respects the levels up to a certain point. So I do think that it's a tool. I don't think it's anywhere near being used, but if they don't get inflation right in the second wave, and if it were to come back with a vengeance, I think that's where the real trouble kicks in. So what does that mean? Like 10 % probability, 20 % probability, less, more? I think five to 10. It's low right now. I think And it's still pretty low. And then they use rate cuts first. Here's a question from TrillionX Macro.

23:36George, what do you think that we are heading into a stagflation period rather than a recession, and therefore gold, not bonds, is the anti-fragile asset? So TrillionX asking about the relative weighting from a portfolio allocation perspective of gold versus bonds. And look, that's a great question. And I think this is one of the reasons why a lot of fixed income investors have moved down the curve just to kind of reduce their duration risk. And either bills are paying off enough and want the three-year sector is good enough, especially in the IG sector, with a little bit of spread. So I do think that gold does play a key role here because the opportunity or the paths out there are so divergent that there's a lot of things that can happen that either go wrong or right.

24:22and therefore, especially on the inflation front, that I do think that having the gold fits part of that high quality liquid asset part, even though it might not be liquid when you need it at that moment, but I think it's going to be part of that kind of foundation for any sort of portfolio. Here's another good macro question about fixed income. Ralph Humphrey asks, has the TLT found a bottom? This is iShares 20 year plus treasury bond ETF. But given the ranges I gave earlier, like 455%, that's maybe 525 or higher on the 30-year. I mean, if we break above that, then something has completely changed.