Joseph Wang - Global Macro Series - May 25th, 2022

[00:00:00] Joseph

So we are moving into a world that’s becoming increasingly fractured, not just internationally, but also domestically as well. This is especially true in the US. So we are entering a world where people don’t really share or agree on basic values and basic tenants. And that’s internationally, for example, you see, it’s very important for Russia to have Ukraine to feel safe. It’s probably very important for China to have Taiwan to feel unified as well. Internally, in the US, you have very contentious issues. Polarization is extreme. And that actually opens the door to tremendous amounts of social disorder. So, you have a system that’s kind of breaking, but it’s not getting enough information to fix itself so that further cements its role of fractionalization.

[00:00:59] Intro

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Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:49] Niels

A New World Order is emerging. And in our global macro series, I along with my co-host, Cem Karsan, want to dig deep into the minds of some of the most prominent thought leaders to help us better understand what this new global macro driven world may look like. We want to explore their perspectives on a host of game changing issues, and hopefully dig out nuances in the work through meaningful conversations.

Our guest today is a true insider when it comes to what goes on inside the Federal Reserve. As he spent five years of his career on the open market desk. The desk sits at the center of the dollar system, as its ultimate and infinitive provider of dollars. It has access to virtually all regulatory and financial data, as well as open lines of communications with all major market participants. So please enjoy our conversation with Joseph Wang, aka the @fedguy12.

Joseph, welcome, and thank you so much for joining Cem and I today, for what I’m sure will be a very insightful conversation as part of our global macro series. How are you doing? How are things where you are today?

[00:03:03] Joseph

I’m doing well. Thanks so much for inviting me. I’m a huge fan of your podcast, and I really appreciate being invited today.

[00:03:09] Niels

Yeah, well, that’s very kind of you to say. Thanks so much. Now, since this is your first time on our podcast, perhaps I could ask you to set the stage and provide a little bit of context for our conversation by maybe sharing some of the highlights from your journey to where you are today. Which I think listeners will find very relevant for today’s conversation. And then we will dive into lots of different topics afterwards.

[00:03:34] Joseph

Sure. So I have a pretty unconventional background. I started my career as an attorney. So I graduated, and I worked in a large law firm for a little bit. But I realized that really wasn’t what I wanted to do. I’m not sure if you guys know. But working as a lawyer, it’s basically like writing term papers for the rest of your life. It’s not what anyone really aspires to do. So I got tired of chasing commas, and I wanted to do something different. A

I graduated in 2008. At that time, what everyone was talking about was one, central banking and financial markets. And that was really attractive to me, because, first of all, I felt like law was kind of artificial. Rather than finding some kind of objective truth or how the system works It was really kind of like shaping outcomes the way you want it to be. So I was more drawn to understanding how the world works and being able to understand how the financial system works, how the markets work, seemed much more interesting, exciting to me. That’s the field that I wanted to work in. At the time, it was really difficult to transition from law into finance.

So what I ended up doing after sending out too many resumes, was eventually I went back to school, got a degree in financial economics, and then moved into the private sector. So, I was a credit analyst for a little bit. And ultimately, I found my way onto the open markets desk at the New York Fed.

So for those of you who don’t know, the Fed actually has a trading desk. It’s where they do their QE operations, their repo trays FX, OP Trade and so forth. It’s a phenomenal learning opportunity for people who are interested in markets. I think of the trading desk (the desk, as they call it) as one of the centers of the global financial system.

The desk is basically one of the ultimate and infinite providers of dollar liquidity to the entire world. When, for example, in March, when treasury markets were breaking, it was the desk that was doing trillions of dollars in QE, doing hundreds of billions of dollars in repo and hundreds of billion dollars in FX swaps. So when you’re at the desk, you are one of the first people to hear about when something is breaking. And you hear very loudly; they’ll call you, and you are one of the people who can do something about it. So it’s a really good way to get an inside look as to how the financial system works. And it was a phenomenal learning opportunity.

So I was there for five years. And eventually, I decided that I’m really not learning anything here anymore. So now, I run a blog, and I teach people about how the financial system works. I have books, and I have online courses. And mostly I trade my own book. So that’s what I do now.

[00:06:20] Niels

Yeah, that’s fantastic, great journey. And by the way, I can appreciate your comments about a lawyer, my father was a lawyer, or is a lawyer you could say and my wife is as well. So I’m kind of surrounded by it.

Now. I want to start out by asking you about your thoughts on a paper that was released as recently as on Friday. So I don’t know if you’re familiar with it. But it came from the Minneapolis Federal Reserve president, Neel Kashkari, and it was titled Policy Has Tightened a Lot. Is it Enough? So this is two days after the Fed meeting ended.

Now, my understanding is that Kashkari is without a doubt, the most dovish of the members of the Fed. But after reading his paper, personally, I think that you can take it a step further and say that he is also the most out of touch, perhaps. I don’t know if you had a chance to read the paper, if you’re familiar with it. But I want to give you a few quotes that I received from a friend who did, and I’d love your reaction to it.

So one of the quotes from the paper was, “Because the FOMC has strong credibility with market participants. They take all forward guidance seriously, as they should.” It goes on to say, “Just before the pandemic hit, the 10 year real rate was about 0%. And today, it has returned to about 0%.” And final quote I’m going to give you is, “I believe monetary policy was roughly at a neutral stance shortly before the pandemic, long term real rates have now returned to roughly that level.”

What do you think when you hear someone from the FOMC talking like this, at this time?

[00:08:08] Joseph

So I have not read that paper, but when they talk about credibility of policy, there’s a couple of ways you can look at this, Powell was asked about in this press conference. One is whether they have enough credibility such that their tools work, and the other is whether they can actually achieve their outcome.

Now, I think what they usually do is defer to the former, and that is to say that when they say “through forward guidance” they will raise rates and so forth, you immediately see that priced into the market. So in that sense, the market believes that they have the mechanism, the tools to actually enforce forward guidance and that gets priced into the markets. Now, with respect to actually achieving their goal, I’m skeptical about just looking purely on things like tips or other market based measures, because there’s a lot of distortions in those things. One is that, for example, what the Fed was doing in QE of 2020, they were buying a disproportionate amount of tips, and that, according to studies from BIS, was somewhat distorting the signals that you would get from your rates. So mechanical things like liquidity, they matter.

Also there are things like passive investment. There’s actually a very good presentation from TBAC, the Treasury Borrowing Advisory Committee (a couple of years ago), that shows that passive investing is becoming more involved in these inflation protected securities. So that again, those that are buying are not about fundamental views but simply about flows and assets. So when you talk about these market signals, when it comes to real rates, and so forth, I would be skeptical about that.

Also, of course, yields and things like that have never been very good predictors. So I don’t think you could just look at it, as the paper as it appears to, and look at market signals and make a judgment as to what the Fed’s credibility and achieving their goals are.

You can also look at it in another way. If you’re looking at the neutral rate, as the Fed assumes it to be half a percent, and so forth. Now, that’s a really difficult framework for me to use. This whole idea about the neutral rate assumes, in my view, too much about what drives things like growth and inflation. There are many things that drive it, for example, expected demand or changes in technology. To think that pulling this one lever out of a machine that has hundreds of levers actually makes that big of a difference, I think that gives too much importance to what I understand is the only policy lever they have. But it is just one input out of many that determines real economic conditions.

[00:10:49] Niels

Yeah, absolutely. I want to throw in one more question for you and then I’m going to leave it to Cem to take over for a little while here. But just seeing the central bank policies around the world, I have this mental picture, at least that in the beginning, like in the 1980s and 1990s, as globalization really got into gear, that the major economies around the world became more and more synchronized, if I can call it like that. So when the US was doing well, so what’s the rest of the world and vice versa, as opposed to the way it used to be where you could have one part of the world, say Japan, doing well and other parts of the world doing poorly. Therefore, you would see that there was a different kind of monetary policy being pursued by the central banks.

So first of all, I don’t know if you agree with that simple observation. But more importantly, do you think that, as I do at least, that this is changing now, and that we’re actually coming back, and we’re starting to see more divergence in this world of central bank policies and, what consequences that might have?

[00:11:56] Joseph

So I do agree with that observation. I think that’s just a function of both globalization in the real economy. Let’s say there’s more trade, a more integrated economy in terms of things like supply chains, and also open capital accounts. So money flows freely throughout the world. And you can see this very obviously, in the bond market, for example. There is a lot of research work showing that yields basically co-move together now since money can easily move elsewhere.

In terms of things like the real economy, you can again see the close integration. We had tremendous fiscal stimulus in the US that also boosted factory conditions in China since so much of the demand flowed throughout the world. And then again, that flows throughout supply chains globally. I do suspect that is reversing, and it’s reversing both in the real economy sense and in the monetary sense.

In the real economy sense what appears to be happening is we have a world that is in the incipient stages of becoming more fragmented. And you have an axis that seems to be developing between Russia, China, the Middle East, India, and the rest of the Western world. And that’s going to have real impacts because for now commodities and supply chains won’t flow as freely. You will have more divergent economic conditions. Demand shocks in the US may not pass so easily into the rest of the world.

And you also seem to have greater divergences in monetary policy, perhaps in recognition of this. So globally we have much of the central banking community moving towards tighter accommodative policy, but not the Bank of Japan. That’s causing major, major fissures in the FX market. You can see USD, JPY basically going parabolic. So there seems to be more fragmentation in the central banking world as well. So I agree. It seems that is what’s happening in the world. We are reversing several decades of convergence and globalization.

[00:14:08] Niels

Yeah. What’s on your mind, Cem, this morning?

[00:14:10] Cem

Well, I love this. You referenced a little bit earlier here, Joseph, the kind of the machine. And I’d love to just start at the very beginning of painting your picture, as somebody who’s been on the inside of how that machine actually works. I know, it’s incredibly complicated. And I don’t want to go through every pipe, if you will. But if you were to paint a more toy model; one that I have had in my mind. I’d be curious to hear your thoughts.

I’ve discussed a little bit how much monetary policy has moved to a more supply-side tool. In the last 40 years, we’ve seen monetary policy really be something that works through the capital channel towards corporations helping support their growth and a lot less of that used to flow via that economically to labor. But via globalization, via technology and whatnot, we see a lot less trickle down, if you will. So I really think of it as supply-side economics, essentially. But in a world where that supply side trickle down just doesn’t really work because of the system anymore. And that’s driven a lot of inequality because all the money has gone to capital. Again, this is my mental model. I’m just curious to hear your thoughts.

Obviously, there’s still a demand channel, which is primarily through the wealth effect. And I think that wealth effect piece has become an increasing lever, maybe the only lever on the demand side that the Fed has anymore. So that’s my mental model and those are the two primary things. I think it’s primarily a supply-side issue.

Then my follow up question, I guess, once you as we talked about that is that given those levers and given that machine that you see, will reducing liquidity in the system actually be able to address the problem of inflation?

[00:16:13] Joseph

Those are really good questions. I agree with you, Cem. If you look at what monetary policy has done in, let’s say, the past few decades, so monetary policy, basically the way that the Fed enacted it, it’s mostly about interest rates. When you lower rates, you do seem to describe it (as you see it) as having a supply-side policy. And the way that you easily see this is [by asking] who benefits the most from these low rates?

You can see, for example, the corporations, now, that can tap the bond markets at rates that are barely above Treasuries. What do they do with the money though? It doesn’t trickle down in terms of more hiring or more investment in factories or so forth. What it ends up doing is just going to more stock buybacks, or maybe more executive pay and things like that. So it does seem to be pushing capital into industries that really don’t need capital anymore. It just ends up pushing into asset inflation. So it doesn’t seem to have been effective in doing anything other than that.

So there probably is some marginal flow through to the rest of the economy. But it’s disproportionate. So unless you have some kind of values where you just value where inequality and things like that don’t figure in, and every marginal bit of help to the lower income people helps, then that could work. But that does cause socially undesirable distributional effects.

I agree with your view that the Fed’s main tool today seems to be through the wealth effect. That has to do with the fact that the wealth effect is the thing that can get you the fastest reaction. So if you were to lower and to raise rates, the way that monetary policy feeds through the borrow system, it’s not easy. There are many mechanisms, it’s not easy to measure them. Sometimes they take time. For example, looking at the context of today, we have a lot of inflation. So the Fed is raising rates.

What exactly does that do? Well, you can think of it as raising the opportunity costs of money. So for example, maybe if rates are 2%, you are less likely to go and buy something. That may be the way that it works. But that takes a long time to filter into the broader economy. So even if we reduce rates to 2% today, deposit betas (which is how deposit rates are affected by the policy rate) are very low. So most people are assuming they could see zero in their checking account.

If you put it in a money market fund, the money market fund is going to take a large chunk for its fees. So that’s really not going to slow the economy down, because it doesn’t feed through at all. If you think of it as a borrowing or lending channel. Higher rates, yeah, I could see that. But that’s going to take awhile as well, because a lot of the borrowing corporations are on fixed rates and until they reset, and refinance their debt, that’s going to take a while. So the most immediate impact that Fed policy seems to operate under is the wealth effect. And that’s already happening. You can see that in the very large losses that fixed income holders have had. Jim Bianco has a very good graph showing how large losses have been historic year to date. You can see that in declining equity prices. And that seems to be the fastest and most effective way to channel that monetary policy operates under. It could be effective but it really does depend on the distribution of those assets in how it feeds into demand. So what the Fed is basically doing in this way is that they’re haircutting wealth or they’re taking money out of the system so that there’s less demand.

Asset prices are unevenly held in the economy. So it could decrease demand more for let’s say, a Porsche, then say a Honda. So it is effective, I think. I suspect that we’ll see its impacts shortly. But it is an unconventional channel. But one that since the GFC, since the Bernanke Fed, the Fed appears to be more willing to deploy.

[00:20:39] Cem

Yeah, I couldn’t agree more with what you just said. If you think about the last 40, some years since we’ve had this monetary policy driven economy, we’ve experienced secular deflation. And again, if you think of it again, in my mental model (which I think you generally agree with), if the wealth effect is the way you’re affecting demand, yet most of the effects of increasing monetary policy is going to supply. that supply is ultimately creating a technological revolution. In my opinion, you’ve funded free money, essentially, to extend duration; corporations are looking at 20 to 40 year outcomes now. That cash flow used to matter doesn’t really matter, or hasn’t for 40 years. And that’s that technology.

It takes time to develop that deflation and globalization that’s driven by more money in corporate hands and the pressures to reduce cost at the corporate level. These have all fed through to a very well documented deflationary environment for the last 40 years which has just led to more monetary policy. And so it’s been a bit of a loop.

Despite all that, we have gotten a wealth effect for clearly for 40 years. Yet that wealth effect hasn’t been enough to counteract that deflationary impulse, I would argue. And so the question is, if you have these two channels, you have this demand-side that’s going through the wealth effect, and everything else is really going to capital, the supply demand forces are really for 40 years, they’ve had to do historic pumping of markets and supporting the wealth effect just to counteract the deflationary forces.

Why would we now say that removing that money off the table is somehow going to create a deflationary effect as well? We’ve had, by pumping money in the system, created a deflationary effect. Now the broad argument is, and everybody seems to think, okay, well, in removing it’s also going to be deflationary. To me it’s counterintuitive that if we’ve had a deflationary environment driven by monetary policy, record monetary policy, that by removing that record monetary policy would somehow counteract the inflation that we’re seeing that’s really been driven from the fiscal side and external forces now? Anyway, I’d love to hear your thoughts..

[00:23:04] Joseph

I agree with that. So if you think one of the components of inflation today is because there’s a negative supply shock, then logically, in the long run, you’d want to have more investment to be able to increase production. Then finally, you could have increased supply. So when I looked through the past 20 years. or the last few decades, I think that there are actually some real economic impacts that are having bigger impacts on inflation and deflation than simply what the Fed is doing.One of them, as you noted, is fiscal policy.

One of the big things that has coincided with a surge in inflation is a fundamental rethink in how fiscal policy is conducted. For the past few decades we’ve had an idea where we should have a balanced budge (well at least some people have), and broadly speaking, the budget deficit has been growing, but compared to standards today, not that much. But in the past couple years, that has completely changed. I think of that, more than anything monetary policy does, as more of a driver than inflation, going forward.

The way that I would look at it is to see that when you are a sovereign, and you’re basically conducting fiscal spending you’re financing it by printing debt. What you’re really doing is you’re basically just financing it by printing money, especially if you’re in the US, because, in a sense, treasuries are just money that pays interest.

Let’s say you have $100. It’s printed by the government, it’s money. If you have $100 in treasuries, it’s also issued by the government. It’s not something that you can use to pay for dinner at a restaurant. But there are some mechanical things in the financial system, like a very deep repo market and a very deep cash market, that make converting that debt into cash really easy. So in a sense, it’s very money-like. By doing that at an enormous pace, so 1 trillion, so we’re expected to have a trillion dollar deficit every year now for the next 10 years and beyond.

If we have additional spending, like forgiving student loans, it’s going to go higher. So that revolutionary shift in how fiscal policy is conducted is probably the bigger driver of inflation. That kind of makes the Fed, as you suggest, not very effective, because the Congress is insensitive to interest rates. So the Fed can raise rates, and it doesn’t really do anything because fiscal spending continues. Unlike private actors, public sector actors are not sensitive to costs. It shouldn’t be that way, but in fact, it is. So I’m not sure if the Fed is actually that equipped to deal with what’s coming in the coming years, even if they raise rates, or even if they lower rates simply because I don’t know if they’re that big of a part of the story.

You also have things that are more fundamental, for example, in the past few decades, we had an increase in the supply of labor from globalization and from younger generations growing up. But going forward, what we have is an aging population. And maybe some people find that to be deflationary. But, I think that if you listen to someone like Charles Goodhart, who has a very persuasive argument, what that is doing is reducing the supply for labor into the world. When we reduce the supply of labor, the price of labor goes higher, and that, of course, is inflationary. And we’re at this inflection point where aggregate speaking, overall, the global population is aging. So we’re going to have to reduce labor supply. In the US, for example, you already know that baby boomers are retiring just about now. So these are all secular trends that cannot be changed by monetary policy. It seems that this is something that’s probably not on everyone’s radar, but will be the big secular trend going forward.

[00:27:06] Cem

Yeah, I think the big change in the economy, and by extension, how the Federal Reserve’s tools operate is really globalization. It really is the fact that labor, domestically, is no longer truly connected to corporate wellness. At least domestically. And because of that there’s been decreased union strength, and well documented for the last 40 years, very low real income growth here domestically. So that money that goes to corporations ultimately benefits the shareholders and not the people who buy goods; and not demand. That’s why I think the system is very different. And I think that’s important to note, because people, broadly, still are thinking about the system the same way.

I mean, there’s talk about Volcker, for God’s sake. And how this is Powell’s Volcker moment. The reality is Volcker had a very different set of levers to pull. He could dramatically affect labor and unemployment. If the Fed is tasked with maximum employment and price stability, and the maximum employment part is really just marginally tied to monetary policy, it really is this kind of wealth effect that we’ve talked about, which is uneven to individuals, and really flows to goods in a different way. So you’re big point is the one you made, is the reverse in globalization that’s happening and what that means going forward.

[00:28:47] Joseph

There is something interesting I would add to your note about fiscal spending and, let’s say a potential Volcker like Fed. So the strange thing about today’s economy is that the largest borrower is the federal government. So when you raise interest rates, the federal government has to borrow more.

So where did they get the money? They just print it, of course, in the form of treasuries. So you have this dynamic where you could potentially have a doom-loop. Or let’s say, the Fed raised rates; let’s say they really went Volker. 5% or 10% or more. Well, who’s the biggest borrower? How are they going to pay for it? They’re just going to print even more treasuries. It’s a different structure, as you mentioned, and that I think calls for a different set of tools.

[00:29:34] Niels

Can I throw in a couple of questions on that note? First of all, I’m curious, I guess it’s not that long ago where we had record low yields, even in the 10 year and the 30 year, over here in Europe. We saw some countries issuing 100 year bonds, obviously very fortuitous timing for those who issued them, not for those who bought them. Why didn’t the Fed issue a 50 year or 100 year bond at the time? What do you think?

[00:30:03] Joseph

It would have been genius right? So there are always talks about this. So, the way that this works is that if the Treasury wants to issue, let’s say, a longer term, like a 50 year, like you suggested they would basically shop it around to the dealer community and see what they think. The feedback they always get is that it’s not going to work. There’s not going to be enough liquidity or demand for that. Probably should have floated it in Europe, right?

[00:30:31] Niels

Right, exactly.

Now, another thing that I find very interesting, so back in, I think in the fall of 2021, so six months ago, or something like that, there was this senior advisor at the Fed named Jeremy B. Rudd. He published a 27 page paper as part of the Fitz finance and economics discussion series. And in the paper he disputes the idea that people’s expectations for future inflation matter much for the level of inflation experienced today. That’s especially important right now, of course, in trying to figure out whether the current inflation surge is temporary or not. (Even though I think we probably know where that debate is going to land.)

But the Rudd paper is part of something a little bit bigger. It reflects a broader rethinking of core ideas about how the economy works, and how policymakers, especially the central banks, try to manage things. In the first sentence of his paper, he writes something like mainstream economics is replete with ideas that everyone knows to be true, but that are actually errant nonsense. And then to cut a long winded question short, here you have one of the staff economists at the world’s most famous and powerful central banks, who effectively is saying that his employer has been focusing on the wrong things for the last few decades.

I don’t know if you’re familiar with the paper or what are your thoughts on this? Because I think actually, also Jim Bianco, at one point a few months ago mentioned (or maybe you or someone else), that it kind of sounds like the Fed doesn’t really know where inflation comes from?

[00:32:22] Joseph

I think we already know that the Fed doesn’t know. I would frame that as a broader critique of macroeconomics. So just exactly how do you know whether or not the experts know anything? You don’t. The way that you will know if you would put it to the task.

Richard Hanania has a good point, when he looks at this in light of what happened in Afghanistan. You have Afghanistan, you had all these people who are PhD’s on regime change and nation building and so forth. They were there for a long time, had an unlimited budget (like over a trillion dollars) and everything they built basically disappeared overnight. So it’s obvious that these people were frauds ore just didn’t actually know anything. If you look at this in time, to take the same test and look at macroeconomics (let’s say last year), the Fed had basically an unlimited budget, a small army of PhD economists, best data on the world (the private sector doesn’t even get close to), and they were telling you inflation is transitory, everything will be okay. Well, we know how that turned out to be.

So, in my view, I don’t think macroeconomics is a real field. So, when Jeremy wrote critiques like that in saying that the Fed doesn’t really understand inflation, I think he’s spot on.

So obviously, this doesn’t work. Why doesn’t it work? You can speculate. In my own view, it seems like you’re applying the tools of physics to something that is not like a physical science. There’s no underlying reality. There are no unchanging truths.

You’re applying the wrong tools to solve the problem. So, you always get answers that are nonsensical. We see macroeconomics pull up pretty frequently. So I don’t even know why we bother to listen to what they say. So I think it’s a fair critique. Whether or not that works; that changes anything, I doubt it.

One of the things that I’ve learned working in these large bureaucratic institutions is that there’s no consequence to failure. You can think of it as Nassim Taleb’s view that they have no skin in the game. Things can go well, and things can go not well, but for them, they are completely insulated from the consequences. So, for them to say that this is the wrong way of thinking about something. Honestly, for someone who’s very senior in the Fed, it doesn’t really matter because if you get the call wrong, you’re still there. If you get the call right, you’re still there. So I don’t know if it will prompt any actual real change in policy.

[00:34:50] Niels

No, and maybe it’s tied to the fact that I know that this was blown up a little bit on Twitter today, actually, with this Fox News. A picture where they showed the lack of experience, essentially, most members of the committee have never worked outside the Fed, maybe a couple of them outside academia. Although I will say I think the credit has to go to Ben Hunt, I think he’s the one who first made that point and not Fox News. But you know, it is a little bit striking that you have these powerful people and none of them seem to have worked in real life except for of course, Powell, who made his 100 million dollar plus fortune in private equity, I think.

[00:35:33] Cem

If you think about it, the Feds mandate is very simple. They’re not actually solving a big complicated puzzle, as far as their mandate. I think the problem is really their mandate. You can point the finger at the people at the Fed, but the whole system is actually the problem. The government in the US was made to make passing laws very, very difficult on purpose, because the founding fathers in the US wanted to avoid the powers of corruption; absolute power corrupts absolutely.

So they didn’t allow for something like the Federal Reserve, because they knew the problems that would cause. They knew that there needed to be crises to actually solve problems. Then there’s a release valve and that’s democracy. The problem just gets bad enough, so you solve the problem and then you reset.

What we’ve done by creating the Federal Reserve (which is extra governmental), in order to solve this business cycle, is essentially remove those minor crisis (that we actually need to solve problems and to keep things balanced). So, the system is really fragile because we’re trying to smooth, with one tool, with an incomplete mandate, the business cycle. They’ve done it. They’ve really smoothed the business cycle in some ways but that has created much bigger problems. That’s the problem with any solution. If you try to oversimplify and contain it, it creates bigger problems down the road. So you don’t get rid of the cycle, you just make it a lot longer and bigger. I think that’s where we are.

I don’t know, I’d love to hear your thoughts Joseph.

[00:37:12] Joseph

Yes, absolutely. So I think cycles serve a purpose. I mean, just to get at to an individual level, failure is important. When you fail, well first of all you learn, and secondly, there are consequences. That means that there are consequences for doing poorly and encourages you to do better. It’s part of life, it’s part of any natural process. When you remove failure you create an epic moral hazard; things become more and more fragile. The system doesn’t have any feedback to learn, so it just gets bigger and bigger until something happens where it just breaks. It’s much better (as you mentioned) to have these periodic issues that are minor rather than to have periodic huge issues that are blow ups.

The accountability issue is very important, as well. So Congress, for example, accountability to elections, present as well, what’s really changed is that I don’t think the Founding Fathers envisioned us becoming so financialized such that a central bank can be very important. The US central bank can be globally important. Yet the people who work there, if you are top brass, yes, you’re not subject to popular mandates; popular elections, but you do get appointed by Congress. It’s indirect, but the people who work there who do the information that filters to the decision makers, those people can never be removed. The are there forever.

You do have this large body of people who are basically insulated and unaccountable, and wielding tremendous amounts of power. That’s good sometimes, if you need people to react very quickly, let’s say in March 2020, boom, they can pull out all the stops and do things that Congress could never do so quickly. But if they make mistakes (and people make mistakes) then there’s not much that we can do to stop them either. I would say that this inflation call, from the last year, was a very large policy mistake. And there’s really no accountability for that. There’s no mechanism for that to be accountable either.

[00:39:15] Niels

Yeah, absolutely, and talk about the stress. You mentioned earlier that some of the work (I think it was Cem who posted the chart about what you’re seeing in fixed income markets) has been the worst start to any year, at least since 1990. Then I think it goes beyond that, because I think Deutsche Bank had a chart out, at some point, where they showed that since 1788, you’d never had a four month period like this where suddenly global bonds are down 11% plus at the time, it might be even more now.

Of course, I started out in fixed income, government bond trader back in the 80s. Clearly fixed income markets are much bigger than equity markets and they’re not designed for these kinds of moves, really. I’m curious to know, whether you think… And of course, at the same time, we have equities now falling, so equities and bonds having a negative year at the same time has only happened twice in 100 years. This could be the third year if we keep going like this, but the wider consequences of that, if we think about potentially another banking crisis, clearly banks have not done particularly well in the last period of time, even though people thought they would once yields were going to go up again.

But also, I’m thinking about the pension funds which would be devastating. Over here in Europe some countries are mandating pension funds to be like 70% or 80% in fixed income, and it’s kind of completely crazy. So is that something you’ve thought about, Joseph, in terms of what the wider consequences could be?

[00:40:54] Joseph

I think so. I don’t really worry about things like pension funds or retirement funds. So if they were to fail that would be really catastrophic. So they won’t fail, there is a solution to this. Government will basically make them hall papered over and so forth. So things like these retirement things are sovereign debts, that’s never going to be a problem.

The problem is always going to be the consequences of the policy actions, and that’s going to be inflationary. So if you have, let’s say, a pension fund, tremendous losses, the government will make it at whole. How does the government do that? It basically just prints money. That seems to be the well trodden out policy path now. We see this happening in the US and in student loans, for example, a lot of people seem to have trouble paying it back. Okay, that’s fine. We’ll forgive it. What does that mean? That means that money that was created, never needs to be paid back again. So the endgame for this is not defaults or deflation or stress. The end game, in my view, is just inflationary, money printing. So that’s basically the consequence of all sovereigns, if you look through history. It’s an easy lever for them to pull. And they’ve shown every willingness to deploy it.

[00:42:09] Niels

I agree with that. I get that. What I’ve been thinking about and certainly sharing, both on the podcast but also when I write my updates to my clients, is that I think we’ve been lulled in this period of time where we’ve lost a little bit of our imaginations in terms of how markets can really humble us. What I worry most about is actually that we’re going to get to a period where we’re going to have those surprises where we all expect that bailout. But it doesn’t show up, or something else.

That’s really my worry, is that the crisis is becoming so big, it’s been brewing for so many years, that we’re going to see decisions made that none of us really thought would happen. So it’s almost like (and I know this is not really that comparable), if someone said to me a year ago that Facebook would lose 25% of its value overnight, I would have said no, that’s not going to happen. But it did happen. Oil was going to go from minus $37 to $137. In 18 months, I would have said, no, don’t think that’s going to happen. But it did happen. So I’m very much for this open mindedness about decisions being made, that we just didn’t expect. I think that’s going to create massive amounts of volatility in global markets. It’s obviously good for Cem and what he does but it’s going to be challenging for most other people.

[00:43:41] Joseph

I agree completely. There are going to be crazy policy choices that are made that you would not imagine. I think they’ve already been seeing this for the past year. So, shutting everyone down, giving everyone free money. So I would think that if there are crazy policies, they wouldn’t be on the side of hurting markets too much.

I remember back in 2008, for example, there was a debate in the US Congress about TARP or something like that. It failed in the Republican House at the time because people were talking about responsible government and so forth. In other words it just kind of completely imploded and put the fear of God in everyone and it did pass the next day. So, I think there’s that lever if there is an inclination for erratic policy.

I think it’s right-tailed in the sense that it’s going to be spurred towards things that are increasingly, fiscally irresponsible things. Like for example, maybe forgiving student loans to get more of a bump in the upcoming election and so forth. But it is very difficult to predict because not just on the electoral stage, but on the popular voting stage there are a lot of surprises. If you just look at, for example, what happened in the French election. Again, it was well telegraphed that Macron would win. But if you look at the history (the track record), people who are less predictable, like Marine Le Pen, have been gaining consecutively every election.

If you look at the demographics, it’s actually the young who are actually more inclined towards something that is more nationalistic and so they are gaining in power, whereas the older generation who would be more centrist, are waning in power. So you have more unpredictability. I definitely agree with that. I think that’s really exciting. It makes things like global macro, and for people like yourself, Cem, volatility is going to be a huge bull market.

[00:45:39] Cem

So yeah, now we’ve entered my territory. I have a question related to this, actually. So, the way I see it, monetary policy because of the almost absolute dominance of the American system dollar, exorbitant privilege, has maintained a cage around volatility. It has controlled it because, essentially, the infinite liquidity can contain those tails.

That can be the case, as long as the Federal Reserve has complete dominance. As long as there’s no cracks in that system. That pressure, obviously, as we’ve talked about, of internal risks, has built over 40 some years, and there seem to be cracks. I think that’s the important point.

Now, if that breaks, given the pressure and the leverage and everything in that system I’ve talked about this, we live in increasingly leptokurtic distribution (there’s that word, right?); fatter tails. Because cracks are showing in a system that has added up to sumos going each other, as long as it’s balanced, you’re fine, but the second there’s an imbalance there or a crack in this containing of that potential energy, the the consequences are much bigger, and the tails are much fatter. So I see that as the case.

Now, the big question is, is the Fed losing control? This is now my question for you is what causes the Fed to lose control? I hear, in a lot of your statements, that you think the federal government will ultimately be able to come back in and stimulate and ultimately control the situation. I would argue (and I want to hear your thoughts), is the exorbitant privilege, which ultimately is what I think engenders the Feds complete power, at risk in any way, especially given the things that are happening now?

So I want to hear your thoughts about, if you don’t mind, is there a risk here, particularly given what happened with Russian assets at the Federal Reserve lately? Do you, like Zoltan Pozsar, believe that we’re entering Bretton Woods three? That ultimately is what will increase volatility and release that potential energy is an instability at the Federal Reserve, in my opinion.I’d love to hear your thoughts?

[00:48:13] Joseph

So I think when it comes to things like rates and effects, the Fed has basically complete control. If it comes to rates, an infinite money printer can buy it and protect it. If it comes to FX, it can have coin printed, or they can borrow money from someone else to defend it if the dollars gets too weak. What they don’t have power over is just (oddly enough) inflation. Real economy stuff because that’s stuff that’s not financial, that can’t be printed.

The change in the dollar status as global currency (as you suggested and as Zoltan noted), I think that’s real. That is more of a monetary phenomenon than a real economic phenomenon, in my view. So it’s a monetary phenomenon, because when the dollar is the reserve currency everyone needs to hold dollars; every sovereign needs to hold dollars to support their companies as they do business.

So for those of you who don’t know, the dollar is the currency of international trade. About half of trade in the world is invoiced in dollars. So it’s not just the US selling something or buying something from Japan. But if you’re a Japanese company buying something from Indonesia, or an Asian company buying something from Thailand, it’s probably going to be in dollars. So, dollars are used everywhere as a global currency. And because of that, if you are a Foreign Sovereign, then you hold dollar assets in reserves to support the companies and banks in your country. Those dollar assets tend to be US Treasuries. So the reserve status basically is a way to keep US interest rates low because there’s tremendous demand for them. Now, what happened in the Russia, this, I think, put a crack in that system.

The way that these sovereigns manage their foreign reserves is that it’s very, very important for them that their assets are risk free. They’re not really worried about making money. But it’s very, very important for them to not lose money.Just an aside, the Fed actually has a foreign exchange portfolio. So it’s about 40 billion. It’s from back in the day when they intervene to weaken the dollar.

So if you are Russia, for example, and you suddenly woke up and you figured out that your safe assets were actually not safe. They just disappeared. Now, if you are another country, let’s say China with a very, very large amount of dollar exposure, then suddenly it becomes an existential risk. So what if someday, maybe you have territorial aspirations that the US didn’t like, or maybe you were just using too much coal, and that’s not green enough. That’s kind of like a sword dangling over you and it’s a national security issue, it’s an existential threat. There’s no way that any sovereign is going to be subjugating themselves to that kind of risk. So, I do see them as trying to find a way out. It’s not so clear what the way out will be, but they’ll find a way. That ultimately means that there’s going to be less people buying treasuries. less of a bid for treasuries, which ultimately means higher interest rates.

That though, as I mentioned before, it’s a rate thing. So it’s ultimately still within the control of the Fed. If rates are too high we’ll just buy it all. And if the dollar is too weak, the Fed can figure out a way to work with their partners, borrow, FX, and so forth. But what they can’t do, though, is this manifests itself through higher inflation; higher prices in the real economy.

So let’s say for example, China gets rid of all their treasuries and the Fed steps and just buys it all. Well, that’s going to create a lot of liquidity in the system. So that can manifest as inflation, and the Fed can’t print things like that. So if the Fed loses control, I think, ironically, it will be in its mandate rather than in the things that we think its secondary mandates; things like asset prices.

[00:52:15] Niels

By the way, just out of curiosity, something I’m not entirely sure of. Did Russia lose their FX reserves or are they just frozen and they can’t get to them?

[00:52:27] Joseph

I would say it’s the same thing?

[00:52:30] Niels

Well, you say it is, but if at some point there is a resolution to the conflict, you would imagine that Russia would want to bring that part into the resolution meaning we want our assets back. This is why, I think, to me it feels like they’ve been frozen, you can’t get to them. It doesn’t strike me as they’ve been taken at this point. I don’t know, I could be wrong.

[00:52:56] Joseph

No, you’re exactly right, Niels. They are frozen. One day if, let’s say, the US installs a good friend there to sit in that seat, I’m sure it’ll be unfrozen. But that day is probably really, really far into the future, if ever.

[00:53:11] Cem

And it’s like the difference between debt and cash. It’s almost the same.

[00:53:15] Joseph

Just as an aside, so the way that treasuries work, treasuries are basically book entries into a system. So it’s like a huge ledger (f you’re into Bitcoin), so ultimately, it’s recorded in the New York Fed, who owns that Treasury, sometimes through different layers. So if the US government wants to get rid of your treasuries, they can do it. If you have a bank account that has dollars, yes, they can get to it. So it’s always within their control, you’re playing in their system. So it’s something that they always have power over.

[00:53:44] Cem

I guess the big question is, where else? Where will money go if it’s not coming to the dollar? I mean, is there an alternative?

[00:53:53] Niels

And can I expand on that actually, because I wanted to ask. It sounds like all three of us agree that we have to reimagine what safe assets really are. I’m curious to know from you, Joseph, what you think is the way for people to preserve capital. I obviously couldn’t help notice Paul Tudor Jones, on CNBC last week, saying that you should know bonds, you should know stocks for the next many years. And the best way, if someone put a gun to his head was to use a simple trend following system which made me smile, of course. But what are your thoughts on what safe assets are (and obviously depends on the investor)? But generally speaking, we’ve always thought that US Treasuries are the safest thing you can get, but who knows?

[00:54:42] Joseph

Yeah, that’s a really good question. I think that’s something that people everywhere are racing to find out. So I think what’s changing in the world is that there’s more political risk, not just on the sovereign level, but on the individual level as well. If you recall what happened in Canada, you disagree with the government, and suddenly you lose your bank accounts. So this political risk is happening everywhere. It’s not super clear what actually is safe right now.

I think the solutions that one can have on the sovereign level are different from the individual level. Zoltan, for example, suggests a commodity based standard. And that could make sense. So the way that I see that implemented would be for example, if you’re China and sort of holding dollars, recycle your surplus into things like oil, gold, or grains. Things that you actually use. So maybe, for example, instead of picking your exchange rate a little bit cheaper to subsidize your exports, maybe you subsidize your exports in different ways by offering cheaper commodities to your vendors. You maintain your competitive advantage and you also get away from the dollar. So maybe that’s a possibility.

I suspect, though, that it’s something that’s yet to be found. For retail, I imagine it’d be just things like real estate, gold; real estate in jurisdictions that I think people have more confidence in the US, maybe states that have stronger property rights? Yeah, I think those are probably what I think of right now. But, again, they’re not ideal. They’re not super liquid, and they’re not easily movable. So I think it’s a solution that we’re still looking for.

[00:56:29] Niels

Yeah, I mean, you touched on a lot of things, and I have to admit, I have no idea what your views are on crypto, but I do want to ask you something because I literally, just half an hour before we went to have our conversation today, I saw something that was quite interesting. Clearly, I would imagine that the crypto world will be cheering their products as an alternative to dollars and safe haven and to gold. We’ve heard the stories and all of that. Then I see this guy come out with a tweet where he basically says, “Listen, I bought Ethereum at 25 cents or 75 cents. I sold all of it today for $2,500. And the reason why was because, he says, now it’s not a non-correlated asset anymore. It’s all correlated to all the other stuff that we have out there: tech, equities, venture capital. So, it’s not doing for me what I thought it would do.” I thought that’s pretty interesting. Then you could say, is it then the solution? Maybe it’s not because now it’s just part of the mainstream correlated basket of assets? I don’t know. I’m just throwing it out there.

[00:57:44] Joseph

I’m surprised that anyone ever thought it was non-correlated.

[00:57:49] Niels

We’re going to get some hate tweets.

[00:57:52] Joseph

Okay. So, I think that crypto was actually quite a dangerous asset because the way that things are unrolling in the world, it seems like it’s going to be regulated and it’s going to be, I think, in competition with government issued currencies. Now, people say this all the time. But if you actually look at what the BIS, so the BIS is the central bankers. They’re kind of like a bank, but they’re more like an Event Planning Association. They get everyone together, they talk and stuff like that. It’s like a big social party. But their communiqués are pretty explicit. They think things like Bitcoin are just speculative things; are really bad. They’re also pretty open that the world is moving, the Central Bank Community is moving towards consensus that we will have government digital currencies.

So, I imagined that what would happen is the US would simply regulate all these private cryptocurrencies and then roll out their own. That is ultimately a political decision. If you hear people like former governor Quarles, you’d say, correctly, that there’s really no need for cryptocurrency. Using digital currency, cryptocurrencies doesn’t really serve any purpose. If you have different politics, I think you will think differently. So, it will come down to politics and who’s in charge, but the trend I think, is clear.

[00:59:16] Cem

I think I have an interesting thought here. In our world I would argue that the extra litigious expropriation (for lack of a better word) of Russia’s assets, in a way actually, counter intuitively is very bullish. Dollar is a very bullish currency. I think that’s not just the short term. I think that’s more long term. And let me paint a picture here (tThis is a metaphor). If you’re in middle school and there’s a bully. Everybody knows the guy, pushing people around or whatever. He wasn’t around before. People didn’t really care about the other big guy who was a more fair guy whenever in the room. But the second that bully enters and starts pushing people around that other guy matters a lot.

The US, whether you want to call them the bully or not the bully, the fact that there’s instability now, things are at risk, the value of a currency is essentially, is capital protected? That is to outside forces, other bullies, other big entities, and internally, is that person fair? And I think most people are making the oh well, this isn’t a fair argument. But I think the reality is, the US is the strongest place, both because of the military, geographically and it’s self sufficient. There’ are a million reasons, which we all know. At the end of the day, I think the instability that’s being created here ultimately leads to an appreciation for the values that the dollar provides. I think that we’re seeing that with the dollar. I think the dollar strength here is essentially that. You could call it flight to quality but I think it’s a bit more complex than that. There are integral things that make money in the dollar system safe.

Something like crypto, even though it’s fair, in a sense. There is no power to protect it. It can be corrupted, or the biggest entity in the room can in theory, make it inaccessible to most of the world.

Actually (and I think Xian touched on this, Niels), I think the US core strengths; the reason that it is what it is, ultimately, make the dollar stronger during a time of potential bifurcation and risk. Anyway, I’s love to hear your thoughts.

[01:01:48] Joseph

I agree with you. I mean, that’s definitely what’s happening here. You see tremendous flow into the dollar. It has a really strong military, of course. So it is very lucky to be located where there are no adversaries around it. So, it’s definitely an oasis here in what’s happening here today. It is highlighting dollar strength.

But it’s highlighting dollar strength depending on who you are. I mean, if you are part of the inner circle of President Putin, then it’s not where you are running to, you’re running to somewhere else. I would think maybe it is forcing more of what we’re seeing, it might be more forced by bifurcation. So if you’re on the US side, everyone is kind of rushing towards you. And people who are friends of the US have a lot more money. So you see that very strongly.

But if you are not friends with the US, and there are many people who are not friends of us, not good friends anyway. Like the Middle East, or South America, those are not super strong allies, maybe not necessarily will always be allies. So you can see that they would have a different center of influence. So, they aren’t just not as influential, they don’t have as much money. Maybe in the future that will change. So I think, right now, it’s definitely dominated by flow into the dollar.

[01:03:18] Niels

I get that, and obviously, Peter Xian was very, very convincing, and very strong in his opinion. Maybe that’s also the reason why it’s the most downloaded YouTube video we’ve posted so far.

[01:03:35] Joseph

Congratulations.

[01:03:36] Niels

Yeah, it’s great. I think everyone should go and listen to it, because there’s something to take away from it, at least in terms of, okay, I should be aware of what’s going on from a slightly different light. But be that as it may, I think you can find a lot of people who basically can find all the reasons why the US will be dominant, will come out in (as you say, Joseph) the geographics (that Peter also points out), and the military and all of those things. But I don’t know if it’s just the contrarian inside of me. I’m always a little bit worried when everybody seems to only be able to paint that picture of why. Because if we go back in history, there is not one single system that has survived.

There’s always going to be an end point at some point. I don’t know when that’s going to be and maybe it’s not for a long time. But I’m always cautious when people sit down and say, yeah, this is the only way it’s going to play out. I don’t really think we can say that.

Going back to my earlier point about that we’ve lost our imagination of what could happen. And so I’m open minded. Maybe it’s the trend that follows me. I’m open minded to things changing course for sure.

So I want to just start before we round off with you, Joseph. We’ve taken a lot of your time already, and we certainly appreciate that. I do want to ask you just a couple of things. What are the things, if anything, that keeps you up at night when you think about what’s going on in the world right now? And you can be, go as broad as you want, really.

[01:05:12] Joseph

There are a couple of things that I think that are going on in the world. So in terms of the real economy, I think what’s really concerning is that we are moving into a world that’s becoming increasingly fractured, not just internationally, but also domestically as well. This is especially true in the US. We are entering a world where people don’t really share or agree on basic values and basic tenants. That’s internationally, for example, it’s very important for Russia to have Ukraine to feel safe. And it’s probably very important for China to have Taiwan to feel unified as well.

And internally, in the US, you have very contentious issues. What kind of rights people should have, and how we should manage society. The polarization is extreme. That actually opens the door to tremendous amounts of social disorder. And you already had a taste of that in the past couple years, where there was mass rioting. There’s a lot of destruction done in many cities throughout the US. You don’t really see that because a lot of that you could only see in clips on YouTube or on Twitter. But, you have the system where the feedback mechanisms for information is not working properly. So you have a system that’s breaking, but it’s not getting enough information to fix itself. So that further cements its role of fractalization.

I remember, I think maybe 20 years ago, there was a piece in The Wall Street Journal, by a Russian professor, forecasting that one day the US was split apart because of having different regions. Everyone thought it was just absolutely ridiculous. I think it’s a lot less ridiculous today. In fact, I would see that as if you think that things eventually go towards the right solution, if you have people who have fundamentally different views of the world then federalization, that’s a logical solution to this.

I think that kind of political disorder is a very real risk going forward. Listen, if you have half the people in the world in the US thinking that the election was not legitimate, then I think it’s already over. But that’s the political side, the real economy side, also this fragmentation (globally) has opened the door to real distress that we haven’t seen in a long time.

So we operate in a world that has been globally connected for a long time. If I buy something the supply chain just works, energy is there, minerals are there and so forth. If that breaks down, I think you could see (because the system is designed for efficiency not resilience) tremendous amounts of distress. Prices go very high and poor countries will starve. So, you take both of these together, there’s a real chance of global disorder such that what happens in the markets really doesn’t matter all that much because some basic things that we take for granted are being undermined.

So I think that the following few years are going to be tremendously interesting and tremendously eventful, and so huge volatility, bull market volatility. Hopefully, whatever we make still matters, though.

[01:08:30] Niels

Yeah, and I like that answer, because I actually think you’re onto something there with things that are being underreported and what actually is a real risk. So I appreciate that. Anyway, yeah.

[01:08:40] Joseph

Just one more thing. If nothing else happens, in terms of tail risk, I would also watch the Treasury market very, very closely. So, I specialize in the plumbing of the financial system. And so there’s a reason that I think that the amount of issuance that’s coming up is just historically high and it’s possible that the underlying plumbing in the system is not wide enough. There’s not enough financing on the balance sheet to support that. So there could be some discontinuity there in going forward similar to what happened in the repo market a couple years ago. But that’s a decidedly a more minor issue compared to the bigger political themes.

[01:09:15] Niels

It’s great. It’s really important. Of course, everyone listening to our conversation today should go and get your book. Central Banking 101, is great one.

The final question, for me, at least. And that is, there are so many things that Cem and I could have asked you and we’d never have enough time with our guests. Of course. Is there anything that you feel that we missed that you really wanted to share with us today? Any final thoughts, Joseph?

[01:09:42] Joseph

No, I think we had a really good discussion. I really appreciate both of you taking the time to speak with me.

[01:09:48] Cem

Thanks for everything you’ve done. Thanks for joining us.

[01:09:50] Niels

Absolutely. Anytime.

Joseph, this has been a great conversation with so much knowledge shared from your experience inside the Federal Reserve. Thanks so much for doing that today.

And by the way, make sure you go follow and subscribe to Joseph’s work as well as getting his book “Central Banking 101”. You can of course find the links in the show notes of today’s episode. And as you can tell from our conversation, we’re living in a truly global macro driven world. And it is perhaps more important than ever before to stay well informed.

From Cem and me, thanks so much for listening, and we look forward to being back with you as we continue our global macro series. In the meantime, take care of yourself, and take care of each other.

[01:10:34] Ending

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