Julian Brigden – Global Macro Series – 14th July 2020

Julian

Here's my big problem: once, when I worked at Medley Advisors, we were on a phone call with a Senator from Texas and it was around the time of Enron’s collapse. We were talking about executives at Enron and what was going to happen. My boss was talking away and we were listening in and this Senator just stopped, at one point, and said, “You don’t understand. I don’t care what happens to Skilling and all these boys I just want them to end up in a big dark hole with a boy called Bubba who calls them Shirley.”

At that point, it just underlined one thing to me and that is the ultimate power of government to dictate your behavior because I’ve loved saying to people in the bitcoin space, “Look, I think it’s a great trade. You can trade this thing. It’s a high beta (if you want to store to value, precious metal, whatever), but the day that it ever becomes a big enough thing that it challenges, the ability of government to control their own currency is the day that you are presented with the option of handing your bitcoin over in the same way that you did with gold in the ‘30s or trying to keep hold of it and if you’re caught ending up in a big dark hole with a bloke called Bubba who calls you Shirley.”

Introduction: For me, the best part of my podcasting journey has been a chance to refine my own investment framework through a series of conversations with extraordinary investors in every corner of the world. In this series, I, along with my co-hosts Robert Carver and Moritz Seibert, want to continue our education by digging deeper into the minds of some of the thought leaders when it comes to how the world economy and global markets really work to try and learn how they think.

We want to understand the experiences that have shaped them, the processes they follow, and the historical events that have influenced them. We also want to ask questions outside our normal rules-based playground. We’re not looking for trade ideas or random guesses about an unknown future but rather knowledge accumulated over the course of decades in the markets to try and make us better-informed investors and we want to share those conversations with you.

Our guest today is a diehard global macro advisor who takes the noise out of the markets and makes calm out of chaos. I'm sure you will enjoy our conversation with Julian Brigden of MI2 Partners.

Niels

Julian, thanks so much for joining us today for this conversation as part of our miniseries in the world of global macro where we relax our usual systematic or rules-based framework to provide you with a broader context as to where we are in a global and historical framework and, perhaps, discover some of the trends that may occur in the global markets in the next few months or even years and, ultimately, how this will impact all of us as investors and how we should best prepare our portfolios.

We are super excited to dive into a few different topics in the next hour or so, not least because you have a strong view on a couple of the key macro themes at the moment. And, on top of this, you are very generous when it comes to sharing your views and analysis on Twitter and other platforms like Real Fish.

So, let me kick it off with a thirty-thousand-foot question which we have asked all of our guests, on this series, just to put everything into context and that’s a little bit about your big picture view right now. [My question is] not necessarily specifically on an asset class, but just big picture what’s going on in the world. A lot of people compare what’s happening right now to events we have seen in the past, whether it’s the thirties, or the Japanese Bubble, the Tech Bubble, The Great Financial Crisis, and of course, on top of all of this, we have something called a Global Pandemic which makes it a very unique time in the world right now.

So, I just want to kick it off and hear how you see the world from where you sit.

Julian

Look, I’m a big believer in history. I do believe that cycles repeat themselves. I do think one has to be careful drawing too close of analogies in there because I do think the world changes. So, we come up with new policy tools, we come up with new economic structures in terms of globalization, in terms of technology. So, things are not always exactly the same, but they are, frequently, quite analogous.

So, I think one of the things that some people have really underestimated (and that has helped us quite a lot since the lows in the market), is that when you look at the economics, for example, around the world this pandemic has been a total train wreck. We are not going to come out of this whole.

But I think people have really underestimated the ability of central banks to play with their new toy, in terms of liquidity. The interesting thing is, actually, it’s not a new toy. It’s a new toy, perhaps for, let’s say, G10 countries to be playing with. Actually, we wrote a piece back in March and reiterated again in April where we drew comparisons to Zimbabwe and Iran and actually got a few people offended when we said, “Really, what is the Fed or what is the ECB, or the Bank of England, or the VHA doing any different than these countries have done?”

The best performing equity market of the year, up until recently, I think, was the Iranian stock market as oil went negative. Well, what did they do? They printed a shit load of cash and you’ve got a closed economy, there’s nowhere for that money to go except for in the equity market and it becomes a safe haven. So you can preserve the value of your cash, because, at the end of the day, an equity is a claim on a tangible asset of one form.

So, while I think there are economic comparisons, I think one has got to be a little careful about drawing out price action and saying, “OK well, just because the economics is poor the price action of the assets has to be poor.” We use the economics, and we model the economics to try and trigger the policy response function. We have done this since, really, ‘08 because it’s really that that’s driving markets. So yes, there are many comparisons you can draw with the past but they’re not always exactly the same.

Niels

Yeah, I totally agree with that even though I will say, on this series, we had Lynn Alden on the show and I think she made a very compelling case in terms of the comparison to the thirties and the forties. But, as we hear all the time, of course, history doesn’t repeat itself but it does rhyme. I think that’s exactly what you’re sentiment is as well.

Since this is a global macro theme conversation, and we will be touching on many different topics, I do think though that you should probably start, if you don’t mind, giving us your view as to why the U.S. dollar plays a key role in all of this and especially when it comes to analyzing and forecasting many of the trends that happen across different asset classes.

Julian

Well, it’s always been my strong view that in a world where the dollar is the reserve currency that it, essentially, dictates the cycle. When Raoul and I launched Macro Insiders, the first video, the teaser video was on the importance of the dollar cycle.

When you look about it from a purely investment perspective (and the dollar is the denominator of most global assets), if you destroy the value of the denominator then (given that it’s a tangible asset, let’s pick something like copper or oil), as long as demand doesn’t shift anywhere in the world, then if you just destroy the value of the denominating currency then that asset should rise in that currency's terms. It may not change in Euros, it may not change in Yen or Sterling, but it should rise in Dollar terms.

That’s important as well because even if you’re, say, located in Germany (like all managing portfolios in Germany like Moritz is), you may, frequently have a dollar benchmark. So, even if you’re just managing a normal portfolio the effect of the dollar can have an enormous impact.

The other thing is that we’ve always said that when it comes to the reserve currency (and this is particularly since ’08 when we’ve seen this quantitative easing, call it really what it is ‘monetary debasement’) the power of the Reserve Central Bank is disproportionate to other central banks and the comparison we like to say is, “Look, the market likes its drugs, OK, but the ECB and BOJ and the Bank of England can really only supply methadone to the Feds heroin." As the reserve currency, you literally can create reflation and, ultimately, inflation if you can debase the value or lower the value, let’s say, of that reserve currency.

So, that’s why it’s so singularly important because it does dictate which asset classes you should be looking at, how you should allocate your portfolio within some of those asset classes and that’s why we just think it’s the key thing to watch.

Niels

Yeah, absolutely.

Rob, before you jump in I also, maybe, want to just follow up just again as part of the context for our conversation, and maybe as a natural follow-up to that, and that is, OK, so where are we in the U.S. dollar cycle right now, in your opinion?

Julian

You notice when you look at the dollar cycle (and really we’ve only had a dollar cycle over the last fifty years, right? We’ve only had freely floating exchange rates in the last fifty years), dollar cycles seem to be remarkably consistent in both length of time and amplitude. In fact, I’m staring at a chart, here, in front of me, which shows the rate of change of the dollar in percentage terms. The cycle currently (which has been running from ’91), looks almost identical to the cycle that we ran from ’76 into 2002 (which was the prior dollar high).

So, from a cyclical perspective, the dollar should be in the process of peaking and this should be the end of the up leg of the third cycle. We’ve had three: ’72 to ’79, ‘up into the plaza record, down then into Sakakibara's intervention in dollar/yen when he drove dollar/yen up into the 2002 high, down into the GFC and now up again.

So, if you look at that cycle that would tell you it should be now and, in fact, it’s slightly overdue. I would say that that was down to one thing and one thing in particular and that was quantitative tightening.

Janet Yellen told us that it was going to be like watching paint dry. That was plainly not true. If you look at virtually any dollar chart, from the immediate second that the Fed started to shrink that balance sheet, the dollar went one way. If you look at in TWI terms it sort of went from 106 on the broad dollar trade weighted dollar index up to about 118 when they ended QT. So, it was really very, very powerful. But that’s kind of extended the dollar cycle.

Then we got the COVID 19 funding squeeze, which, then again, further catapulted that caused what we refer to as the Napalm Run. Basically, when you get it is what we refer to as a ‘risk-off dollar rally.’ So, risk is falling, stocks are falling, bonds are rallying, emerging markets are getting tarred and feathered and the dollar is rising at the same time. Because the dollar is rising it really exacerbates that risk-off event and we liken it to a napalm run. Because left to its own devices all you will end up with, at the end of the day, is a bunch of smoking holes and charred bodies. You’ll just literally obliterate everything in its path.

So, that was a classic kind of funding squeeze and what was miraculous is the Fed came in really aggressively and incredibly quickly and went, “No, stop, we know the risk,” and, in actual fact, they even went as far as cooping the IMF to say, “Well, we could do dollar funding as well.” In three days we got, basically, what took them a whole year to do in terms of the swap lines and then we got this whole repo facility which is a completely new concoction.

So, I think what they’ve done is they’ve essentially arrested the Napalm Run. Now, all we have done is that, while we traded it (so we bought Aussie, we bought Cable just above 115, and all this other stuff, and they’ve been great trades), all we’ve really done is just reverse that funding squeeze.

What happens here and now really will dictate the cycle. Because if you’re a trend follower and no matter which trend you look at (whether you look at the Fed’s broad dollar trade-weighted index, whether you look at Bloomberg’s DXY, whether you look at Deutsche Bank’s dollar TWI), they’re all pretty much of a muchness.

We’ve had a very strong trend line since 2011. It’s consistent, it’s touched on multiple occasions, we got very close to breaking it, a few weeks ago, it has bounced back from those levels as we got this little bit of risk-off kind of wobble, even though, frankly, most of this risk-off is a U.S. issue because they’ve been assinine to reopen as quickly as they have done in some places. But, the fact of the matter is you’ve still got this risk-off equals dollar rally. So, we’ve come back to those levels.

Now, when I look at the dollar there are a couple of things, I was a dollar bull and have been a structural dollar bull since we launched Macro Insiders four years ago. I changed very slightly because I just thought FX had become very, very boring at the start of 2019 and we really just didn’t play it, OK.

Then it started to get a little bit more interesting because we had finally got to what I think is that cyclical point of the turn, and so my focus turned to more: could we actually be seeing a turn? Look, I have a lot of sympathy with peers and my colleague Raoul, on the Macro Insider product, when he talks about structural problems and shortfalls with the dollar and why the dollar is very dangerous and why it can do what it does. He’s absolutely right.

The biggest problem that we’ve got is that the U.S. is not running the size of current account deficit that it needs to do in order to support its status as the reserve currency. This is a classic example of what one refers to as Triffin's dilemma and the reason for that is that we’ve developed our own domestic oil industry or expanded the size of our own domestic oil industry and that has meant that our largest single import item is no longer being imported with the same degree of gusto and size.

So, what has filled that gap has been capital account outflows because you have to supply the world with those dollars. The problem with capital account outflows is that they’re bloody fickle. In a world where you can just go click and you can eliminate your Brazilian ETF holdings, you can create this inherent fragility within the system and that’s why you can get the sort of napalm run that we just saw.

That’s why, for example, in 2019 (when we got some of these emerging market tremors) you didn’t see the whole sector wobble, just individual blocks just imploded. And they didn’t just crumble; I mean Brazil just didn’t crumble, it just went overnight. It disappeared because it was just relying on this flux of super hot money to keep it stable.

I think the good news is that the Fed, essentially now (through this expanded balance sheet, and through these swap lines), has essentially mitigated that funding shortfall. They’ve closed the gap between global GDP, which has come down, but they’ve closed the gap between global GDP, the U.S. current account deficit, and they’ve essentially filled that hole. Their money is going to be a lot more sticky because I think they’re bloody determined not to allow the dollar to strengthen.

Now, that just gives you stability. It doesn’t dictate what happens next but it is usual if you look at dollar cycles that the end of a dollar cycle occurs with the risk of dollar rally. If you look at a broad trader to dollar index you get crisis (whether it’s Latin American debt crisis in the ‘80s, whether it’s the Asian crisis in the 90s, whether it’s China’s deval in 2015, 2016), and they all pretty much occur at the same level of dollar strength. You then get that final push, the risk-off dollar aided Napalm Run, but that typically is the end of the cycle.

When I look at the U.S. there are a couple of things that make me a little committed to the idea that this could be the top of the dollar cycle. One of them is relative U.S. economic weakness. Even if you believe (and I’m not sure that I necessarily do and I’m not sure it really matters because the numbers would have come down anyway), but even if you believe that U.S. unemployment has peaked and that last number of just over 14% is actually a real number and not some sort of manipulated number because, I’m not saying they did it in a Machiavellian way, but it was manipulated in a sense of how they conducted the survey.

I was “amused” (in inverted commas) when I heard a story saying, “Oh my goodness, German unemployment has hit post-2015 highs.” Well the U.S. just hit (if we believe the number) post Second World War highs, and if you don’t, post Great Depression highs. The point is that we are starting in an economic hole which is, arguably, much, much deeper than many of our peers. And that is in virtue of the fact that we have a super flexible labor market.

Typically, many economic bulls or equity bulls will see that as strength. At times like this it is definitively an Achilles heel because, typically, unemployment doesn’t do Vs. I think if you go back to the late ‘40s the quickest trough, to peak, to trough that you saw was a two-year cycle. So, in other words, even if you believe (and I don’t) most of these people are going to get re-employed over time, I think we have another debate over whether that is the question or the case or not. This thing can just drag out for at least another eighteen months. So, I think the U.S. is going to have a much bigger unemployment problem than many people appreciate. I think that’s going to necessitate a hell of a lot more spending.

The second problem that the U.S. has got is that if you chart U.S. domestic oil production, in other words, this growth of this shale story, particularly since 2011, it correlates very, very well with relative U.S. industrial production outperformance, whether you do that against Euro Zone or whatever.

Now, we’re already seeing that sector shrink and this is the second time that investors have been burned in the shale space, the first one being back in 2015, 2016. I do not believe that we are going to see a shale industry come back with anywhere close to the same strength and output that we had previously. I think that will weigh quite heavily on U.S. relative industrial production. I think that has been partly responsible and will be responsible, for maintaining the industry, collapsing the interest rate differential, say, to the Euro Zone, which is important in terms of currency evaluations. I think that will not come back very quickly.

In terms of the interest rate differential, currencies generally do, over time, despite the fact that if you look at, say, ten-year bonds, ten-year treasury spreads and you put the Euro over it, you’ll see large periods of divergence but increase. Most of those were a function of Central Bank intervention.

So, if you looked at, say, the Euro in ’08, it got all the way down to 125 and then they launched QE1 and then the Euro strengthens and the Dollar weakens and we go all the way back up to 150. In 2010 the Euro got down to 120, they come out with QE2, and off it goes again and reattaches itself to those interest rate differentials. But at the moment those interest rate differentials will tell you 130 for Euro/Dollar. The same is true of the relative current account deficit. That would also tell you 130.

The budget deficit, I think, in the U.S. is only going one way. I don’t see that as a positive. As I said, I think you have got, arguably, a potentially much weaker economy here than perhaps you will have in other countries. That budget deficit is already straining the treasury market.

So, if you look at, say, treasury dealer’s primary holdings, let’s remember that one of the reasons that they launched Not QE, at the end of last year, is because we were starting to run into problems with those primary dealers. Their balance sheets were getting constrained by the fact that they were obliged to take down these auctions. Well, that hasn’t helped at all, the fact that they have done all of this buying because yields have dropped so much. So, the problem now is that you’ve got a ballooning deficit (current account deficit) so a budget deficit, you’ve got a large current account deficit, you’ve got a narrowing interest rate differential, how are you going to detract this cash to fund these deficits?

To my mind the thing that has to give, if the yield curve is not going to be allowed to price in the necessary interest rates, and we know that they can’t do this, We know that they have to introduce some form of explicit or defacto yield curve control. Well, the variable that has to take the strain is the currency. If you look at the relative size of the Fed’s balance sheet and if they’re going to have to backstop this treasury market, their balance sheet is already exploded relative to the ECBs and the BOJs. That has generally been a pretty decent predictor of the value of the currency, and that would also tell you a hell of a lot weaker.

Then I think that there’s a final factor which people don’t appreciate. We’ve talked a lot to clients about what I will call U.S. exceptionalism and U.S. exceptionalism we refer to as a self-reinforcing true (to use Soros’s term) reflective cycle whereby, as you buy the asset the appreciation of the asset from your purchase actually encourages you to buy more and feed strength.

So, if you think about, one of the classic examples was Australia from 2009 to 2013. So, cast your mind back to the beginning of 2009; the world had imploded; then the Americans come out with QE; the dollar starts to fall. As the dollar starts to fall the Aussie starts to rise very slightly. As the dollar starts to fall commodity prices start to stabilize and start to rise. Then the Chinese come out with their big fiscal stimulus. That actually gives a buyer to those commodities.

So, what you get is you get this virtuous circle where the Aussie is rising, money is naturally flooding towards Australia, it’s flooding towards Australia as well because the commodity sector is booming. As that is happening the RBA goes, “Ooo, I actually need to raise rates.” So, they raise rates. More money flows into the Aussie. The Aussie banks borrow that money. They then lend it to their own domestic housing market which overheats the market even more, which causes the RBA to raise rates even further and in flows more money.

So, you get this truly reflective virtuous cycle. But as we saw in 2013 that reflective cycle, which is virtuous, can turn vicious if you get the wrong events starting to unfold and it unwinds. I think that’s a real risk here in the United States. What we’ve had since 2011, if you look at the broad trader rate to dollar index and you put it against the MSCI U.S. versus the MSCI in the rest of the world minus the U.S. you will see the cycles pretty much follow.

So, what we’ve had is a rising dollar, which has made foreigners want to own dollar assets. So, they’ve looked around and what have they bought? They’ve bought high yielding corporate debt because it has been the best stuff. That has then enabled the corporates to borrow that money and buy back their own stock. As they bought back their own stock the equity market has gone up. So, it’s even more sexy to go and invest in the U.S.

The Feds raised rates (no other central banks have raised rates) so even more money floods in and you create this very virtuous cycle. If the dollar starts to break (because now the U.S. isn’t that sexy a place to invest, the domestic economy is, really, arguably worse than some of its peers, now, around the world [with] higher unemployment, a weakening domestic oil industry, the corporations can’t buy back as much stock because, A) it’s frowned upon, and B) some of them can’t fund themselves in debt), you’ve got issues now with the banks. The banks can’t pay dividends, they can’t do buybacks, all these sorts of things. This cycle just suddenly starts to change. And it could turn vicious, but it could just crumble a little bit at the edges, and that generally, slowly turns the cycle.

To go back to your first question, Niels, if you look at the dollar from 2002 to 2008, it dropped 30% in broad trade weighted terms, the CRB rose threefold. So, if you want to see the power of the dollar and where it dictates where you should put your assets, that’s a very classic example. So, that’s kind of where I am.

As I said, we’ve come down to these big long trend lines since 2011, whichever one you want to pick as your poison. We got close to the Deutsche Bank TWI – literally touched it a few weeks ago and then bounced straight off. So, we haven’t broken yet, but I’m kind of thinking we will. Maybe it will take a couple of months. Maybe we’ll have to see a little bit more weakness. Maybe we have to see the Fed come in and do their real QE because it has been interesting that when you listen to a hawk-like Loretta Mester, she came out a few weeks ago, I thought, in a very, very telling speech and said, “Oh, the QE we’ve done so far really isn’t QE, this was just designed to stabilize the financial markets. As the economy starts to recover, that’s when we will come out with old fashioned QE."

I’m like, “Jesus, what’s that? Is that another 80 billion a month, trillion a year?” And the answer is, “Almost certainly.” And it will be masked as a way to probably control yield curve come September to prevent those yields spiking as the U.S. Treasury is just puking out debt.

Niels

Yeah, absolutely. Rob, what’s on your mind today?

Rob

Quite a lot. (Laughter)

Julian

I saw you taking notes, Rob.

Rob

I normally do about half a page of notes for every speaker. I’m up to two pages for you already, Julian, so, I barely know where to start. I do kind of like... Because I originally trained as an economist myself, I do like the fact that you can bring everything back to PPP and essentially the idea that, ultimately, it should come down to interest rate differentials and relative inflation and so on.

I think it’s kind of interest to look at valuations of equity and bond markets between, say, the U.S. and Europe. I’ve felt that the U.S. equity market is overvalued relative to the U.K. and European one for quite some time. The U.K. equity market is kind of famously cheap and seems destined to remain so. So, I can kind of buy the story that everyone has bid up U.S. equities just way too much. It has reached the point, now, where we’re going to start selling them and buying cheaper stuff elsewhere, especially if, as you say, in an economic sense they’re not doing so well.

And I can certainly buy the argument that there is going to be a torrent of cheap money coming from the Fed. If you just look at the raw numbers, the fiscal stimulus, the actual raw numbers of the fiscal stimulus in the U.S. I think it’s running at something like twice what we’ve got in the EU and about three times what we’ve got in the U.K.

The area where I’m a little bit more skeptical (and maybe it won’t affect the FX picture so much but), in terms of the individual markets, if I look at the bond markets I can still get 65 basis points on U.S. ten years, which doesn’t sound like very much until I look across the pond at the ten basis points I can get here in the U.K. and the minus 65 basis points the German government will take off me for the privilege of lending to them. So, I’m just wondering how these evaluations fit together with the FX.

Rob

Look, I do get that, look, definitely if you’re European. You are basically being fined, as we know, to put your money into this thing. I think one has got to be a little careful because, remember, not all of it goes into the solving space, so a lot of it ends up going into some of these other names.

For example, we’ve writing quite a lot and extensively about how the Japanese have been quite big buyers and funders of shale. A lot of the CLO stuff has been owned by the likes of Norinchukin and these sorts of guys. So, they’ve actually taken quite a lot of corporate risk on, there. I think that is going to come home and roost. So, it’s not necessarily just a pure interest rate differential. I think there are some credit concerns in that space.

As I said, I’m a little worried, while we played very aggressively this sort of rebound in the speed of growth, that once the dust settles you’ll actually find that some of these growth numbers in the U.S. are pretty damn poor, and some of the underlying spaces are pretty damn poor. The other thing I would say is that frequently a lot of this stuff is hedged. So, you can reduce that about 65 basis points or you pick up from there. Look, I’m not saying it’s going to happen immediately.

I will say that when I talk to a lot of my big bond clients and big real money guys whose numbers of AUM just make your mind sort of spin. They, as I do, frequently believe that in a world where you’re going to, essentially, distort the price discovery of a rate differential, the FX is where you start expressing your concerns. So, you shift vol, kill vol. They’ve been big buyers and it has worked incredibly well, as we have been advocating as well, of countries with relatively large current account services.

So, don’t get me wrong. I get it. In a world where you can get some positive carry, in the U.S., I don’t think it’s going to disappear overnight. You have got to balance that against the deficit where it’s just going to keep going, going, going, and going and you’re not really going to be heavily compensated for that. If the curve was allowed to naturally do what it should do, and you were saying, “Oh, I’m getting two and a half percent,” OK, I’ll take that risk. Well, 65 basis points may not be enough to stop a gradual decline.

Moritz

Hey Julian.

Julian

Yes.

Moritz

Not a question, more of an observation, just throwing that in because we were talking about the dollar and I know you’re the dollar bear, and Raoul, for instance, is the dollar bull. One of the things that I have noticed just following markets throughout the day is that the short term correlation between the S&P 500 and Euro/U.S. dollar has become increasingly negative over the past two weeks. I don’t think there has been a single day where, if the S&P 500 is up, the dollar is down; if the S&P 500 is down, the dollar is up. It’s kind of like clockwork for the last two weeks, and it hasn’t been that strongly negatively correlated in weeks prior. It has been a much more independent market. So, there seems to be something going on there. I’m not sure why.

Julian

We like to do something I haven’t done for a while, actually, but you have remind me that I should ask one of my quants to do it, and that is that you look at the price action of the S&P in the overnight session, versus the intraday session.

So, for example, heavily moving into the end of last year what you had seen as the dollar had strengthened, particularly since 2014, is almost all, or the vast majority of the gains had come in the overnight session, as opposed to the U.S. session. What it was, was this U.S. exceptionalism trade, as Johnny Foreigner said, “Oh look, the Euro is going down, yours, oooh I’ve got some dollars, what do I do? Oh, let me go and buy some Spooze,” and you get some S&P futures on and that’s what that did. That then got flushed out horribly, as we saw in March, where we got that funding squeeze and the Euro just exploded because we were carrying with short Euros long S&Ps.

So, I haven't looked at what’s going on with that flow as that might be an interesting factor to watch.

Moritz

Yeah, good point. What I’d like to do and this may get a little spicy here, but… (Laughter) Let’s throw in two more currencies into the mix – quote/unquote “currencies.” I’m not sure… You need to tell us if you think they are currencies – gold and bitcoin.

Rob

Here we go, here we go.

Julian

Here we go.

Moritz

I was waiting for that, Rob. Let’s please start with bitcoin.

Julian

OK, let me… Look, I’m not an expert on bitcoin and I’ll be the first person to admit that I should have taken this thing more seriously. Where I kind of got interested in bitcoin, really, was when it was in the bubble formation. Look, Twitter is a bit of fun, it’s also a bit of advertising, you don’t give too much away, but I do love that you can bait people and you can set them and you get all this Twitter storm that comes through.

So basically, in 2018, early, very, very early 2018 we said, “Ah, this is a classic bubble. This thing is going to burst. It has all the patterns of the Saudi Stock Market, for instance, in 2006, the Nasdaq in 2000, it’s just parabolic. In fact, it’s arguably one of the biggest bubbles you had potentially seen.

Moritz

Oh yeah, tulip, and bitcoin.

Julian

Yeah, it was just… The rate of change on this thing just made some of these other bubbles just look pedestrian, frankly.

So, we got it into there and then I just moved away because here’s my big problem. Once, when I worked at Medley Advisors, we were on a phone call with a Senator from Texas and it was around the time of Enron’s collapse. We were talking about executives at Enron and what was going to happen. My boss was talking away and we were listening in and this Senator just stopped, at one point, and said, “You don’t understand. I don’t care what happens to Skilling and all these boys I just want them to end up in a big dark hole with a boy called Bubba who calls them Shirley.”

At that point, it just underlined one thing to me and that is the ultimate power of government to dictate your behavior because I’ve loved saying to people in the bitcoin space, “Look, I think it’s a great trade. You can trade this thing. It’s a high beater (if you want to store to value, precious metal, whatever), but the day that it ever becomes a big enough thing that it challenges, the ability of government to control their own currency is the day that you are presented with the option of handing your bitcoin over in the same way that you did with gold in the ‘30s or trying to keep hold of it and if you’re caught ending up in a big dark hole with a bloke called Bubba who calls you Shirley.”

Frankly, that’s why I have never, ever advocated it as an investment. I think there are alternatives, most notably precious metals, which I don’t think, this time, will garner the same degree of attention in a weak dollar environment that they will ever be confiscated for want of a better term.

I think we’ve seen the bitcoin, whether it was Facebook’s attempt, whether it’s what the Chinese have done, bitcoin is perceived by governments and Central Bank as a threat. I think that if you are really trying to preserve the value of your money, sticking it in something that could end up getting directly confiscated or end up putting you in a hell of a lot of trouble… I know these guys will say, “Yeah, but this is the whole point, I can keep it off in this server and it will all be safe,” and I’ll be, “Yeah, right, and how the hell are you going to spend it, and what if they catch you and all these sorts of things?” It just isn’t, to my mind, it’s not worth it.

But look, structurally we’ve loved gold and silver for quite some time now. I actually prefer silver. We advocated, in March, to buy… We were long silver from the start of last year from like twelve and a half bucks. We were also long gold, GDX, etc. etc. but silver has really performed very well. In March we doubled down because the RSI between gold and silver had got to fifty-five year extremes and silver has outperformed very significantly.

But I do like them because I think there are protections against this collapse of the dollar and I do like silver because, generally, it will outperform in a more inflationary stroke reflationary environment. In fact, if you look at the ratio of gold/silver it’s pretty much a mirror image of five-year breakevens. So, it really is an inflation play and that’s ultimately where I think we’re going to go if I’m right about this dollar.

So yeah, I like them. I think gold, in particular, has come quite a long way. I think we need the dollar to take the next leg down. But I mean if you look at the chart of silver (which I just am pulling up as we speak), if you look at the chart of silver and you take it back all the way to 2002, what you’ll see is the high on the dollar occurred (basically, in March of 2002) with the low on silver which was under four and a half bucks, and then the high on silver occurred with the low on the dollar which was in April of 2011 at fifty. So, you want a high beat of 'balls to the wall' short dollar trade then it’s long silver because it’s a ten-bagger – eighteen and a half to nineteen bucks, big resistance, break that and you’re off to the low twenties, break that and, really, you’re off to the mid-twenties, break that and the sky is the limit.

Niels

Well let’s see if we can’t get you to talk about another market. Now, we’ve talked about bitcoin where clearly there’s a limit of the free float. Another area that seems to be getting into the same are things like German government bonds. [There’s] not a lot of free float [there] anymore as far as I can tell. Of course, I know the U.S. is different, right. So, if the bond community decides that rates are going up, maybe the Fed can’t stop that, but in many other countries, there is not a lot of free float left in bonds. Japan we know and Germany, how will yields go up again?

Julian

I don’t think they will.

Niels

OK.

Julian

I think, to my mind, this is when your real financial repression starts. Financial repression doesn’t start with you buggering around with minus twenty-five, minus fifty basis points at the front end of the curve. It starts when you peg the long end and you end up allowing nominal GDP or ideally nominal GDP made up with real GDP but, of course, nominal GDP has an inflation component and a real component by, perhaps, allowing inflation to go. Let’s not forget that when the Fed ended their experiment with yield curve control in the fifties we had nineteen percent CPI and one and a half percent ten-year yield.

So, I’m afraid that I don’t think, and I have advocated this to my wealth management clients, that the bond market is anywhere where you want to have long term exposure. I think this is where you end up losing inordinate quantities of real money (and when I say real [I mean] inflation-adjusted money) for your clients.

I think everyone knows about the inflation of the ‘70s but what they forget is the vast majority of the money that was lost in the bond market occurred in the late ‘60s as inflation went from one and a half to just under six in 1969. Bond yields went from four to eight, real yields fell, and in inflation-adjusted terms, in five years (five years!) you lost a third of your money in the treasury market.

Long duration exposure, courtesy of convexity, given this level of bond yields, is just going to destroy people if they let it go. Maybe they do a little bit, I don’t think they let it go too far. So, maybe you won’t lose so much money, but you’re going to lose it in inflation-adjusted terms because they can’t allow yields to rise. They’re just going to sit there and destroy wealth.

This is how wealth gets redistributed from the wealthy rich, old to the young millennials who need pay rises so they don’t riot and so they can afford to buy that house. To my mind, this is the way we’re going and if the market doesn’t do it efficiently politicians are going to do it for you. You can already see that happening, emerging even here in the United States.

We’re looking at someone like a Biden who’s talking about all of these policies: reversing the Trump tax cuts, do we get a wealth tax, perhaps do we get higher wages; definitively we've got all these new heroes of COVID. These are basically people on, in many cases, close to minimum wage. So, what does minimum wage go to, twenty bucks and hour, twenty-five bucks an hour?

All of these sorts of things, these are all going to be, I think, highly inflationary in an environment where you’re funding it from government spending which should steepen the curve but they can’t let it happen so they just cap the whole thing and you, as a bondholder, just get obliterated. So, I hate to say it, Niels, I love the fixed income market. We made lots of money for our clients over the year, but the only thing that I want our clients to own now is inflation protection.

Niels

I completely agree with that and it worries me when I see, especially in Europe, the way that, say, pension funds are positioned. In Germany, I think there’s like 80% bonds and 20% something else. Blood is scary because at some point…

The other thing in all of this is, actually, you believe in cycles, you talk about them, there is also, certainly, a cycle that goes from public to private, meaning that at some point equities will become the safe haven and anything linked to a government is going to be trashed, really. Which is also why these conversations are important because I’m not so sure that the…

There’s a lot of wrong information, to say it politely, being fed to investors. Also a lot of us… I started out as a bond trader back in the ‘80s and I remember when the Berlin Wall fell and that led to some interesting times, if you were long bonds, and you realized that you could lose a hell of a lot of money in bonds in a short space of time. So, we forget about these things because a lot of people have not experienced this. The other way to think about it is that a lot of the people who either advise or even trade, today, in the markets, have never seen a real interest rate cycle where interest rates go up.

Julian

I also think, as well, that we’ve got to understand that there are an awful lot of people… This is one of the reasons why I was very keen to join Raoul when he launched Real Vision which he calls this a Democratization of, let’s say, what the smart money is thinking. We forget that the vast majority of people are advised by individuals and institutions whose only real interest is to accumulate assets not to make money. What they really want you to do is continuously be invested in the German bond fund or the German pension fund that is 80% fixed income and 20% other.

They’ll constantly talk around this thing as though it has still got some value where, in actual fact, they lose sight of the bigger cycle. If you can get into these things at the right point then you can make your guys an inordinate amount of money, an inordinate amount of money. I had one guy on Twitter come and say, after our silver call, I paid for my mortgage. I don’t what to consider for a nanosecond how much money he was putting at risk to enable him to pay for his mortgage, which probably wasn’t good money management techniques at all, but these things can make a material difference to people.

That’s why I’m happy to appear on programs like yourself because I really think that, at a time like this, with a massive inflection point, I’ve called this a Generational Inflection Point, in terms of macro, and, actually, in terms of societal changes.

Niels

Fourth turning.

Julian

People forget. You’re sitting in the middle of Europe there, and Moritz is managing money for a German firm, let’s not forget there was this little bloke called Martin Luther who hung around as all the Catholic priests fled out to their country properties when we had the black death, who stayed and helped. Guess what? That was the cycle high of Catholicism.

That was a relatively big turning point in History. Pandemics kind of do that. In 1848 Louie the Phillip fled France and lived under Queen Victoria’s skirt hem until he died in 1870. The Spanish flu, women’s votes, all of these things [point to that] this is going to be a really, really important inflection point, historically and, I think, in markets because we were coming to this inflection point anyway.

We’d peaked in interest rates, we were already close to zero, we have to come up with a new toy to keep the cycle going and I think, essentially, where we are now we have hit the end of traditional monetary policy. Monetary policy, now, is an adjunct to fiscal spending. So, Central Banks now, basically, are just a supporting act to fiscal authorities, and I think that just changes the whole world that we have lived in since Paul Volcker came in in ’79.

Niels

Yeah, and Rob, before you jump in, that is actually one thing we have spoken about on our podcast even before we did the Global Macro Series and that is that we are in the middle of the fourth turning if you believe in that. We say that history doesn’t repeat exactly, but what they wrote in 1941 is…

Julian

Yeah, the Kondratiev wave, the end of winter, the fourth turning, these factors were coming. I’m putting together a presentation now where you look at social unrest and you look at these pinpricks that have occurred, particularly with these tragic riots and Black Lives Matter protests in the United States. This is emblematic of this sort of societal turning that you would get. Combine that with the macro turning point and this is when people really, really, really need to be careful about their wealth.

Rob

I’m really a bit confused about what to think as I’m both Catholic and also started off as an interest rate options trader, so. (Laughter) So yeah, it’s pretty depressing, isn’t it? All the free money from risk parity is gone because there’s no money…

Julian

It’s remarkable that the strategy has actually done well.

Rob

Yes.

Julian

But people don’t realize that, essentially, the strategy now is walking dead because the underlying philosophy just doesn’t work. Bonds are never going to act as the hedge again.

Rob

Yeah, well, this is it, you’ve got a breakdown both in terms of the fact that one of the assets is definitely massively overvalued, which is the bond component. Of course, they’ve got the fact that correlations are probably going to breakdown because in an inflationary environment bonds and equities tend to become more inflated.

So, let’s go back to the hypothetical man on the street, or woman on the street, who is listening to this podcast and wants to know, “What can I do?” You mentioned silver being an asset that is a good inflationary hedge. I like the fact that you’ve gone beyond the classic of just reaching for gold as the gold standard inflationary hedge if you excuse the pun. Stocks as an inflationary hedge, obviously, we could have a long debate about whether they are or not. Maybe it depends on how volatile the inflation is rather than the actual level as to whether they’re a good inflation hedge. But are there specific sectors we should be looking at or are there other assets we haven’t mentioned that we could hedge with this environment?

Julian

One thing that really marks, I think, inflation is that it’s a tougher trading environment. It’s not necessarily an unprofitable one but it’s a much, much tougher one. So, passive investment, I’m afraid, has peaked if I’m right. This now becomes where you really do start to earn your money.

One of the things, actually, that has been quite interesting in talking to wealth managers is just the dearth of good quality quantitative trading funds out there. I started as a young whippersnapper in my early twenties trading precious metals for Philip Brothers who then bought Salomon and then somehow got management bought out and became part of Salomon Brothers. It was a bizarre thing.

Those guys that I started with who were the most aggressive traders in the most volatile market, they have all gone. Standing in the lunch line and listening to some guy saying, “How did you do, Roger?” “Pretty well, we just bought all of bloody India’s and China’s excess rice and we sell it off in bulk carriers off the coast. They had a bloody appalling harvest, the price doubled, and we sold it back in.” Those sorts of days are gone. The sort of balls that it took to do those sorts of trades have gone.

So, finding people to manage some of this money is going to be, actually, quite hard. It might come down to… And this is where something like systematic trend-following commodity funds actually might start to do pretty well in ones that can go short as well as long in bull markets. But I do think that’s something that you’ve got to have as part of the portfolio.

We have been advocating, even as far as things like some of the agricultural commodities that have yet to take off. I think it’s quite amusing that, in COVID, those got crushed. Precious metals didn’t, last time I looked, we were still eating, in fact probably some of us eating too much during COVID because we have nothing else to do, yet soft commodity prices got absolutely trash. I quite like those. You only have those as a relatively small part, potentially, of a portfolio.

I don’t think you want to have any long-dated solvent risk at all. In the credit space, I think there are really potentially interesting trades, or there were until the Fed distorted price. This I think is the fundamental problem because if you looked at it and you say, “OK, well, look, I think we’re going into a period of inflation. There are two companies out there, they have both got pretty shitty balance sheets but one has, let’s say, pricing power, and one has none (Let’s say the one that has none is a retail chain). I can be long one and short the other and they’re both priced the same, now, in five years' time one will have doubled and one will not exist anymore. Those are great opportunities for credit managers, but it’s much harder now given that you have got Central Banks distorting credit.

But let’s assume they back out of that space a little bit, over time, I do think there is, once again, this opportunity is in credit, once again, it’s going to be a lot harder than just buying the tracker because everything is just not going to go up. I think there are great opportunities for dollar-based investors, potentially, in emerging markets if the dollar does start to roll. Once again, you’re increasing your exposure to that dollar trade and you’re doubling off on your exposure in the commodities space.

Equities just have to be part of the mix. They do have to be part of the mix. But you’re either going to have to accept a hell of a lot higher vol or you’re going to have to run some sort of overlay type product to try and somehow manage that risk-off thing that theoretically bonds were going to hedge you for but won’t anymore.

So, it is a much more difficult environment, going forward. It is a much more active environment, going forward. And I think people are going to have to start understanding that paying for performance, which we used to do before we just aimlessly bought things that went up, is a solution because growth stocks (some of these names will not do well in a higher inflationary environment), they will underperform.

We’re still not at the inflationary inflection point. I don’t think it occurs until… Some of my models are starting to tick up in Octoberish (September Octoberish), some of them start early next year. But I think it’s not really yet that you have to consider it but you’re going to get there quite damn quickly.

Moritz

A final question for me, Julian. This has been great but I want to be respectful of the time that you have given us today. I have watched that great interview between Hugh Hendry, and Richard Verner in Real Vision. I’m not sure if you’ve watched it.

Julian

No.

Moritz

You didn't. So, what Richard Verna said is, he said that the ECB is, essentially, the only Central Bank left in the world that is completely and utterly above the law. They don’t report to anyone. I don’t have the feeling that the… I would like to hear your opinion of that, what about the Fed? The Fed used to be independent, at least at what they said, but right now it’s like Donald Trump, the President, is twisting the arm of Mr. Powell and the thing becomes one – the Fed and the government.

Julian

Yes, we’ve discussed this. So, since Trump really got in, we’ve been playing a cycle which, in many respects, was like the mid to late sixties. So, in the early sixties, you have a very stable, super low inflation rate. No one back then was running around going, “Ugh, ugh, the sky is falling, inflation is too low!” [This was] because we didn’t have quite the same debt levels and it really was a halcyon period of economic growth.

Then you got some politically inspired fiscal spending related to the great society at the beginning of the Vietnam War, you push inflation out of its comfort zone being, literally a flat line for almost five years. The Fed's own research said that it could have taken a shorter period of two years of higher inflation for inflation expectations to become unanchored (to use their parlance) and you get quickly into this period where things get out of control.

One of the reasons they get out of control is because the Fed compromised. So, back then we also had an independent Fed and the chairman was a gentleman called William Martin. William or Bill Martin who actually became the longest standing Fed President in history. As this spending kicked off, the Fed initially was quite aggressive at trying to clamp down on that inflation push that you got going into 1966. Then there was a lot of pushback from government, "Wait a second, we’re fighting a war, we’re trying to do these things for individuals, what are you doing?"

Bill Martin went away and he came back and he decided, and he coined this fantastic phrase where he said, “The Fed is independent within government rather than independent of government.” That, basically, meant that if it is the will of the people to elect this government and this government decides that they want to do it, it is not for the Fed to fight against the will of the people. So, I think that’s essentially where we are.

The Fed has decided (and really very willingly, it hasn’t taken much for Powell to get there) that they have a responsibility to support the government if the will of the people (which it clearly is) is for the government to support them. So, I think we have a very complicit central bank. There is certainly no Volcker-esk type tendencies anywhere within this central bank anymore. Those things were taken out, I think, in ’08, taken out to the back of the bike shed and shot through the forehead.

To me, this is setting up, and this, once again goes back to these cycles we talked about, Niels, right? That you go through these periods where you build up extremes, those extremes become unacceptable to voters or to society in general, then you switch the other way. I think we’ve switched the other way. And you’ve got a Central Bank that, I think fundamentally, believes that if inflation ever happens, don’t worry, we will be on top of it. But of course, that’s what they thought in the mid-‘60s. They thought they could run it a little hot, to use today’s type language, and they were bloody wrong because as soon as they tried to do anything to stop it the government came in and said, “Don’t you damn well dare think about doing that.”

So, I would agree, I don’t think the Fed is independent. I don’t think the Bank of England is really independent. We’ve already seen the Bank of England start funding the Ways and Means Fund – this little sort of “fudge” account that they have on the side where they can just top it up with their electronic cash. They said, “Don’t worry, it’s only short term.” Well, if the economy doesn’t recover robustly that short term will become increasingly longer term.

Moritz

The short term is all relative, right?

Julian

Yeah. (Laughter) Yeah, exactly.

Niels

Perhaps my final question to you, Julian is just having done what you do for a long time, does classical macro analysis, has that become harder to do? Because we kind of live in a world where we think some of the things, at least that we’re seeing happening, we’re thinking, “This is completely nuts, this is completely crazy,” or is it really just trying to take out the noise, look at the facts, look at the cycles, and actually it still all makes sense?

Julian

There are days, Niels, where I wake up and I go, “Jeeze, I could have picked an easier job than trying to front-run the global financial markets and get it right,” because that’s ultimately what clients pay for – and get it right. But I will say that I’m somewhat lucky.

Firstly, I’ve got, within MI2, four colleagues who have either… one exec Bank of England, he worked with me at Medley Global Advisors. I think that’s a very important part of my background because I understood, firsthand, as we were policy consultants, the importance of policy – Central Bank or fiscal. I really understood how that started to interplay with markets. I think that has given us a bit of a leg up versus some of our colleagues or peers who might just look purely at the macro.

I have always, as I said earlier, I look at the macro because the macro dictates the policy response. This has certainly been the MO since really 2008. It’s that policy response that drives markets. So, it’s kind of a two-step process opposed to that the macro drives markets, because that isn’t really the case.

We’ve also got a couple of guys who managed billion-dollar portfolios, hedge funds. So, we really then take it and we look at the macro and that gives us a lean, a bias to maybe what the policy response is going to do and then we have guys who said, “OK, if that’s what you think, this is the trade: it’s break evens; it’s bond treasury spreads; it’s the Euro; it’s the Aussie, oh, and by the way, here’s the level breaking today and we should send something out to our clients”. So, I think we are actually moving back into a more macro environment.

I think we are going to see some differentiation between, particularly on the currency side, that starts to drive relative asset performance. I would love to say that I think the bond market is going to come back and we’re all going to be able to make a fortune trading curve steepeners and so on, and so forth, but I’m a little bit more sanguine. I think what we’re really all going to have to do is we’re going to have to dust off some old books about how to trade vacudations, contangos and stuff like that in commodity markets which we’ve all bloody forgotten how to do.

Niels

Absolutely. Well, Julian, thank you so much for spending some of your afternoon with us. We really do appreciate this, as I’m sure all of our listeners do. By the way, make sure to follow and subscribe to Julian’s work on Twitter, MI2 Partners, and Global Macro Insiders.

As you can tell from today’s conversation we’re living in a true global macro-driven world and it is, perhaps, more important than ever before to stay well informed. From Rob, Moritz, and me, thanks so much for listening and we look forward to being back with you as we continue our Global Macro Miniseries. In the meantime be well.

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