The Reality Is Higher Rates Slow Growth

MAGGIE LAKE:

Hi,

everyone.

Welcome

to

the

Real

Vision

Daily

Briefing.

It’s

Wednesday,

June

22nd,

2022.

I’m

Maggie

Lake

here

with

Darius

Dale,

founder

of

42Macro.

Hi

there,

Darius.

DARIUS DALE:

Hey,

Maggie,

it’s

good

to

see

you.

How

are

you?

MAGGIE LAKE:

I’m

doing

okay,

dude.

Okay.

I

think

everybody

are

watching

the

Fed

still,

we

had

Jay

Powell

testifying

in

front

of

Congress

again,

reiterating,

trying

to

be

as

hawkish

as

possible,

committed

on–

strongly

committed

to

inflation.

But

it

was

really

interesting

to

watch.

The

stock

market

seemed

like

it

was

ignoring

for

most

of

the

day,

we

had

what

looked

like

a

little

bit

of

a

rebound

going

on,

but

it

dropped

out

a

little

bit

at

the

end,

they

rolled

over

back

into

the

red,

nothing

huge

in

terms

of

selling

but

just

interesting

to

see

that

negative

sentiment

or

just

lack

of

buyers,

I

guess,

in

the

last

half

hour

trade.

10Y

bond

yield

down

to

3.15.

We

have

crude

prices

lower.

Of

course,

crypto

getting

shredded

again.

What

did

you

make

of

the

market

action

today?

DARIUS DALE:

Yeah,

the

market

action

today

was

pretty

interesting.

So,

it’s

in

the

context

of

what

we’re

observing

here

in

the

process

at

42Macro

as

a

potential

market

regime

transition

from

what

we

call

inflation,

which

is

where

the

market’s

pricing

in

an

accelerating

inflation

and

growth

slowing

to

what

we

call

a

deflation,

which

is

where

the

market

is

pricing

in

these

simultaneous

decelerations

in

both

of

those

factors.

We

saw

pretty

significant

selloff

in

crude

although

we

rallied

off

the

lows,

another

big

drawdown

in

energy

stocks,

a

big

drawdown

in

crypto,

you’re

seeing

emerging

markets

take

it

on

the

chin.

So,

separate

and

apart

from

this

intraday

rally

in

stocks,

which

it

may

itself

be

incrementally

fueled

by

the

post

opex

dynamics.

Don’t

forget,

we’re

two

days

after

a

pretty

chunky

opex,

removed

a

significant

chunk

of

negative

gamma.

I

think

this

market

is

starting

to

sniff

out

this

move

towards

deflation

which

we’ll

unpack.

MAGGIE LAKE:

Darius,

when

you

say

deflation,

because

there’s

this

huge

conversation,

and

it

came

up

today

during

the

testimony

around

inflation,

the

idea

that

they’re

trying

to

bring

it

down.

But

just

because

the

rate

is

lower

or

is

decelerating

or

there

was

smaller

increases,

however

you

want

to

categorize

that,

that

it’s

still

going

to

get

stuck

at

this

really

elevated

level.

That’s

when

people,

especially

those

in

the

inflation

camp,

are

really

concerned

about.

When

you’re

talking

about

deflation,

is

it

possible

the

way

you

look

at

it

that

it

can

be

lower

but

still

stuck

at

a

high

level,

or

do

you

see

this

thing

going

back

down?

DARIUS DALE:

Yeah,

so

just

in

terms

from

a

risk

management

perspective,

our

core

process

at

42Macro,

at

least

on

the

fundamental

forecasting

side,

really

anchors

on

the

rate

of

change

of

primary

economic

variables,

like

the

rate

of

change

of

growth

in

the

economy,

the

rate

of

change

of

inflation,

or

the

second

derivative

is

what

I

mean

by

the

rate

of

change.

So

yeah,

the

trend

it

change

in

those

time

series

will

have

an

important

influence

on

dispersion

across

asset

classes,

both

within

and

across

asset

classes

we’ve

backtested

the

six

ways

this

Sunday.

But

when

you

think

about

it

from

the

perspective

of

the

Fed,

there

are

actual

targets,

levels

that

they’re

concerned

about,

not

just

in

reported

statistics,

but

also

in

market-based

measures,

in

terms

of

expectations,

etc.,

which

Powell

outlined

last

week,

and

further

outlined

this

week,

happy

to

unpack

those

as

well.

MAGGIE LAKE:

Yeah,

what

jumped

out

at

you?

We’re

hearing

this

similar

message

over

and

over

again,

I

know

everybody

parses

everything

they

say

to

look

for

any

changes.

Is

there

anything

that

jumped

out

at

you

today

from

the

testimony?

DARIUS DALE:

Yeah.

So,

from

the

testimony

specifically,

no.

I

thought

he

reiterated

everything

that

quite

frankly,

I

live

tweeted

about

during

last

Wednesday’s

FOMC

press

conference,

which

is,

this

is

a

Federal

Reserve

that

is

content

with

sending

the

economy

into

what

it

hopes

would

be

a

mild

recession

in

order

to

tackle

what

I

consider

and

I

think

Jay

Powell

himself

considers

to

be

an

inflation

disease,

it’s

willing

to

amputate

its

arm

or

its

leg

in

order

to

save

the

whole

body,

if

you

will,

from

the

spoils

of

inflation.

So,

I

think

he

did

a

decent

enough

job

reiterating

that

amidst

a

sea

of

nonsensical–

political

nonsense

around

gas

prices

and

regulation,

etc.,

etc.

These

semiannual

testimonies

are

always

fraught

with

politics.

But

when

you

read

through

the

tea

leaves,

there

wasn’t

actually

much

substance

in

terms

of

incremental

information

relative

to

what

we

heard

from

last

Wednesday.

MAGGIE LAKE:

Yeah.

And

it’s

been

interesting

to

watch

the

data

because

as

you

said,

this

conversation’s

really

turned

very

quickly

and

everyone’s

talking

about

recession,

because

we

saw,

as

many

had

been

predicting,

those

of

you

who’ve

been

worried

about

the

economy,

we’re

starting

to

see

some

of

those

early

warning

signs,

those

more

forward-looking

indicators,

whether

it’s

some

of

the

manufacturing

indicators,

or

some

of

the

early

housing

start

to

turn

really

in

the

last

week.

I

know

that’s

got

everyone

thinking

about

inflation.

I

want

to

play

a

clip

right

now

because

as

we’ve

been

discussing

the

Fed

and

how

behind

the

curve

they

may

or

may

not

be,

Tian

Yang

weighed

in

on

this

subject

in

a

recent

Expert

View

he

did

for

us

here

at

Real

Vision.

Let’s

listen

to

a

clip

of

that

and

then

we’ll

talk

on

the

other

side.

TIAN YANG:

Right

now,

the

market

narrative

is

very

much

that

yes,

the

Fed

is

behind

the

curve.

But

in

terms

of

how

fixed

income

markets

should

be

behaving

in

a

“normal”

hiking

cycle,

I

would

say

the

behavior

is

not

that

bad,

right?

Yield

curves

generally

bear

flatten

in

terms

of

this

hiking

cycle,

which

is

typically

what

you

would

expect.

If

you

look

at

some

of

the

longer-term

things

like

5Y

5Y,

if

you

look

at

term

premium,

these

things

haven’t

really

gone

to

crazy

levels,

so

for

sure,

there

has

been

a

lot

of

adjustment,

clearly,

bond

yields

need

to

reset.

But

you’re

not

seeing

the

typical

panic

that

you

will

see

at

the

federal

level.

If

they

truly

weren’t,

you

will

probably

see

term

premium

rise

a

lot

more,

you

actually

probably

see

a

curve

steepening

in

response

to

Fed

policy

action,

because

generally,

you

see

a

flattening

trend,

it

shows

that

at

least

the

market

is

going

to

give

the

Fed

some

credibility

that

the

Fed

is

serious

about

fighting

inflation,

to

the

extent

that

they

may

be

willing

to

engineer

a

recession,

hence,

you

get

the

curve

flattening.

As

of

right

now,

again,

these

are

things

that

we

want

to

watch

for

in

terms

of

whether

that’s

truly

a

change,

but

the

Fed

still

is

credible,

in

my

view,

because

they

might

be

behind

the

curve,

but

they’re

still

doing

things

to

address

it

and

the

market

is

giving

them

some

credit

for

it.

MAGGIE LAKE:

And

that

full

Expert

View

is

available

to

Essential

Plus

and

Pro

members

on

our

website.

So,

people

taking

the

Fed

at

face

value,

I

suppose

that

they’re

more

serious

about

it.

I

think

it’s

an

open

question

still

there,

is

how

much

they

can

actually

influence

what’s

going

on.

They’re

targeting

the

demand

side,

we

know

there

is

some

supply

side

issues

involved

here.

Where

do

you

come

down

on

this?

And

I

guess

the

question

is,

where

are

we

with

the

bond

market?

The

bond

markets

giving

them

some

credit,

but

is

the

Fed

leading

the

bond

market?

Or

is

the

bond

market

leading

the

Fed?

DARIUS DALE:

So,

right

now,

that’s

a

phenomenal

question.

And

by

the

way,

I

generally

agree

with

Tian’s

view,

he’s

another

data

driven

investor,

I

tend

to

side

with

a

lot

of

data

driven

macro

risk

managers.

But

just

going

back

to

your

question,

I

think

what

Powell’s

most

concerned

about,

and

he

articulated

this

several

times

particularly

in

the

last

week

or

so,

which

is

very

concerned

about

long

term

inflation

expectations,

and

the

volatility

associated

with

them

becoming

“unmoored”,

if

you

will,

to

borrow

a

phrase

from

our

friend

Jim

Bullard

yesterday.

Brian,

I

sent

you

a

chart

from

one

of

our

decks

that

says

Powell

is

fighting

to

maintain

control

over

the

bond

market.

And

what

this

chart

shows

in

the

top

panel

is

just

the

10Y

3M

yield

spread.

That’s

a

proxy

for

the

growth

expectation

of

the

economy,

if

you

will.

Powell

has

really

got

growth

expectations

at

least

still

reasonably

anchored,

because

we

have

not

seen

a

significant

flattening

of

that

curve

generally

via

bull

flattening,

if

you

will,

which

you

typically

see

into

a

recession.

But

on

the

bottom,

I

think

that’s

the

more

important

part–

or

sorry,

the

middle

panel

is

actually

the

more

important

chart,

which

shows

the

term

premium,

which

is

a

very

wonky

academic

measure

that

really

is

just

trying

to

assess

how

much

premium

investors

demand

for

holding

longer

term

maturities.

Once

you

X

out

things

like

the

expected

growth

rate,

the

expected

inflation

rate,

the

inflation

risk

premium,

etc.,

etc.,

what

you’re

left

with

is

the

term

premium.

And

right

now,

at

minus

six

basis

points,

we’re

only

in

the

eighth

percentile

of

that

on

all

daily

observations

going

back

to

the

early

1960s

on

this

metric.

And

so,

what

that’s

telling

you

is

that

the

bond

market

believes

the

Fed

still

has

credibility

with

the

bond

market

in

terms

of

its

inflation

forecast,

its

growth

forecasts,

and

ultimately,

its

desire

to

maintain

that

control

by

effectively

quashing

out

inflation

really

quickly

and

really

effectively.

Now,

if

at

any

point

in

time,

as

you

can

see

from

the

chart

going

back

to

the

mid

to

late

1970s

all

the

way

through

the

early

1980s,

the

Fed,

starting

with

Arthur

Burns,

really

lost

control,

Arthur

Burns

was

the

Fed

chair

back

in

the

1970s

who

really

let

the

inflation

genie

out

of

the

bottle,

which

obviously

Powell

is

trying

to

avoid.

He

really

let

that

genie

out

of

the

bottle,

and

you

saw

the

term

premium

widened

to

just

under

500

basis

points

over.

So,

if

you

think

about

just

without

any

change

in

growth

or

inflation

expectations,

you

could

have

the

10Y

Treasury

yield

gallop

three,

four

or

500

basis–

not

three,

four

or

five,

but

more

like

200

to

300

basis

points

higher

just

on

a

revision

to

the

term

premium,

which

again,

is

the

bond

market

pricing

in

the

uncertainty

around

Fed

policy.

This

is

what

Powell

is

hyper

concerned

about

because

again,

if

you

let

the

inflation

genie

in

the

bottle,

it’s

really

hard

to

get

that

back

in.

MAGGIE LAKE:

Yeah.

And

that

is

why

that

is

one

of

the

pillars

of

their

mandate,

price

stability.

It

was

last

of

the

four

because

of

the

disinflationary

slash

deflationary

period

we

were

in

but

question

on

bonds,

Gary

from

the

RV

site,

the

10Y

Treasury

rate

peaked

right

at

the

top

of

the

stock

market

in

early

2000

and

mid-2007,

per

the

title

of

this

interview,

why

do

you

think

rates

will

keep

going

higher

this

time?

I

would

say,

do

you

think

we’ve

seen

the

peak?

And

if

not,

what’s

going

to

keep

them

elevated?

Or

what’s

different

this

time

around?

DARIUS DALE:

Yeah,

I

think

that’s

a

difficult

question

to

answer

in

this

particular

juncture,

the

first

part

of

the

question,

which

is,

have

we

seen

the

peak

in

rates?

We’re

going

to

see

new

highs

in

rates

if

inflation

continues

to

misbehave.

We’ve

been

talking

about

this

for

the

past

month

or

so

about

the

potentiality

for

inflation

misbehaving.

It

did

misbehave

in

the

May

inflation

reading,

we

did

see

a

step

function

increase

in

terminal

Fed

Funds

Rate

expectations

and

policy

rate

expectations

across

the

curve.

And

ultimately,

that

big

shock

higher

in

the

UMich

five-year

forward

inflation

expectation,

which

really

spooked

the

Fed

is

obviously

filtering

its

way

into

the

bond

market.

So,

we

could

continue

on

in

this

process.

I

don’t

need

to

go

into

the

details

on

the

inflation

statistics,

that

will

tell

you

that

that

risk

is

still

very

much

on

the

table.

We

saw

a

broadening

out

of

inflation

data

or

inflation

pressure

in

the

most

recent

meeting,

the

May

reading

just

to

get

those

statistics

at

three-month

annualized

median

CPI,

which

is

everything

in

the

CPI

basket

on

the

median

basis,

accelerated

to

6.4%

on

a

three-month

annualized

basis,

fastest

rate

ever.

So,

the

broad

basis

of

inflation

is

a

real

issue

and

has

not

been

tamed

yet,

at

least

not

according

to

the

data.

As

it

relates

to

the

bond

market,

have

we

seen

the

highs

in

yields?

I

think

that’s

a

50/50

toss

up

right

now,

it’s

difficult

to

ascertain

that

at

the

present

juncture.

And

generally

speaking,

just

to

take

a

step

back

from

a

risk

management

perspective,

it’s

always

difficult

to

catch

falling

knives

in

any

market,

obviously,

catching

the

falling

knife

in

bond

crisis

here

so

just

be

careful

with

these

types

of

questions.

What’s

more

important

is

understanding

the

change,

the

potential

change

in

the

regime

that

could

be

potentially

favorable

for

the

bond

market.

And

that’s

something

we

do

on

a

daily

basis

at

42Macro.

Brian,

if

you

bring

up

that

chart,

deflation

is

now

the

second

most

probable

regime,

so

going

consistent

with

our

GRID

framework,

which

we

use

the

rates

of

change

of

growth

and

inflation

to

identify

what

regime

the

economy

is

in,

we’re

actually

using

market

signals,

core

market

signals

across

42

different

markets,

all

different

asset

classes,

to

nowcast

what

regime

the

market

is

in,

what

is

the

market

pricing

in,

and

it’s

been

consistently

pricing

in

inflation

has

been

the

highest,

most

probable

regime.

And

oh,

by

the

way,

there’s

504

unique

datapoints

that

go

into

that

process

every

day

to

determine

what

that

market

regime

is.

And

now,

what

we’re

starting

to

observe

is

that

deflation

is

now

the

second

most

probable

regime,

which

is

actually

consistent

with

our

forecasts,

which

are

calling

for

a

phase

transition

in

the

economy

to

deflation,

again,

growth

slowing,

inflation

slowing

by

mid

to

late

Q3.

And

so,

to

answer

the

question

just

very

succinctly,

if

we’ve

seen

the

highs

in

bond

yields,

it’s

coming

right

on

time.

I’m

not

certainly

seeing

the

highs

in

bond

yields

because

I

see

a

scenario

where

inflation

continues

to

surprise

to

the

upside

over

the

next

month

or

two.

And

if

that

happens,

we’re

going

to

see

another

step

function

increase

in

terminal

Fed

Funds

Rate

pricing.

But

if

we

don’t

see

inflation

surprise

to

the

upside,

then

it’s

very

likely

we

have

seen

the

highs

in

bond

yields.

MAGGIE LAKE:

Yeah,

and

that’s

what’s

so

hard,

because

this

is

you’re

trying

to

gauge

the

supply

chain

issues

in

some

way,

not

the

demand,

which

was

a

little

bit

clear.

It’s

hard

to

forecast

if

China

is

going

to

close

down

because

of

COVID.

These

are

the

things

that

keep

roiling

us,

I

think,

when

it

comes

to

trying

to

get

a

handle

on

that

and

why

so

many

have

gotten

the

timing

on

bonds

wrong.

There

are

people

who

think

bonds

are

a

good

buy

here,

but

it’s

just

so

hard

to

plug

in

the

timing

part

and

not

matter.

I

think

just

echoing

Darius’

sentiment,

be

careful

in

this

environment,

it’s

just

a

really,

really

difficult

one.

So,

the

same

question

we

get

all

the

time

as

you

know,

Darius,

when

it

comes

to

stocks,

it’s

that

same

feeling.

Are

we

through

the

worst

of

it?

Is

it

time

to

start

buying?

And

the

way

Galan

put

it

in

a

question

here

from

the

RV

site,

I

hope

I’m

saying

your

name

right,

Galan.

The

average

recession

has

roughly

25%

decline

in

S&P

earnings,

S&P

earnings

are

$204

as

far

as

I

can

see,

these

are

the

numbers

he’s

using

or

she’s

using.