The Market Might Be More Fragile Than It Looks ft. Cem Karsan

[00:00:02] Cem

We have a deal, two weeks, it’s going to be signed. Meanwhile, Iran, everybody else is like, what are these guys talking about?

It is all a charade, guys. It is all very orchestrated and the V bottom is a feature. It is not a bug. You guys are hedge fund managers. He’s literally saying, ha ha ha, I’m the House.

[00:00:25] Intro

Welcome to Top Traders Unplugged. In markets, success doesn’t come from predicting. It comes from being prepared for what you can’t predict.

In each episode we go deep with some of the world’s most thoughtful minds in investing, economics and beyond to understand how they think, how they prepare and how they decide and the experiences that shaped how they see the world. No noise, no shortcuts, just real conversations to help you think better and invest with confidence.

[00:00:58] Alan

Welcome back to Top Traders Unplugged where each week we take the pulse of the markets from the perspective of a rules-based investor. It’s Alan Dunne sitting here in for Niels again and allowed to be joined by Cem. Cem, how you doing? How’s all in Chicago?

[00:01:12] Cem

Great. Good to be here, Chicago in the fall. We just had a Monday Night Football Bears victory. The Cubs are in and the White Sox are in the playoffs. So, when sports are going well in Chicago, this is the Midwest, people are very happy. So, things are good here.

[00:01:31] Alan

Good stuff. Well, sounds like a good time to be in the Windy City. We have as usual loads to talk about. We’re recording a little bit earlier this week, we’re recording on Tuesday ahead of Saturday release. So, there could be plenty of market movement by the time this comes out. So, keep that in mind.

But as ever there is a lot to get through. We do like to start off by asking what’s been on your radar of late?

[00:02:00] Cem

Man, there are times when your radar, you look, and there’s nothing in the sky. And this is like, I feel like we’re air traffic control. It’s like every two seconds there’s a new military jet, new, freight… something new coming in, to monitor constantly.

But maybe the biggest new thing coming onto the radar, in my mind, is not just what the bond market’s doing but with what Bessent is starting to signal, I think there is a boiling of the frog situation happening where they’re really… The US$3, US$6, US$9 billion of buybacks really doesn’t move the needle, and he knows it.

It is a really important signal. They will do whatever it takes (in the words of Draghi) to hold down that long end of the curve, ultimately. And so, I think that’s the thing that people are whistling by the graveyard on.

Generally, it will take a tantrum right before the bazooka comes out. He doesn’t want that tantrum to happen yet. But I would prepare (and I think we’ll get into this more as we get back to the show) for a tantrum and a response.

[00:03:21] Alan

Okay, interesting, yeah. Well, for a long time we talked about the big bazooka in Europe. I think it was Mario Draghi who was rolled at the big bazooka first.

[00:03:29] Cem

But he didn’t say, I’m the House now. He didn’t say, I’m the House now, but similar energy.

[00:03:34] Alan

Whatever it takes were his immortal words. But good stuff.

Well, listen, we have a lot of macro themes to get through. So, I think maybe it naturally makes sense to just to give a quick update on performance in the trend following space before we get to that. As I say, we are recording a little bit earlier this week.

So, as of 25th September, which is still the end of last week, SocGen CTA Index is up 4.2%, and up 15.8% on the year. And SocGen Trend up 4.45%, and up 16% on the year.

So, obviously playing out to be a very good year in the trend space. And this month very much the story has been short positions across the fixed income space. It’s not just the long end and not just the US but very much across the whole universe and the short end, significant repricing there. So, that’s very much been the story of performance in the last couple of weeks.

So, not a whole lot to add there in terms of performance, but suffice to say, shaping up to be one of the stronger years for the index. In the last week I was chatting to Nick Baltas. I think he was making a point that it was maybe the third strongest in the last 10 years or so. So, all good from that perspective.

But you did mention the bond market, and obviously we’ve continued to hit new highs in terms of yield. Today, the trend is very much intact and, if anything, the momentum is increasing. I mean, I was saying to Nick last week, it’s been very interesting to me the amount of heated debate I’ve noticed around like what’s driving this? Is it a competition for capital? Is it growth, is it inflation? Previously it was the debasement concerns. Growth seems to be the primary driver. I mean, from your perspective, what’s your framework for viewing this rise in yields?

[00:05:28] Cem

I mean, what is not driving?

[00:05:31] Alan

Yeah, okay, maybe that’s a better way of phrasing it.

[00:05:36] Cem

Let’s make a… Let’s do a laundry list. Let’s go through it. Right?

First (and I think this is like 101), everybody refinanced in 2021. Go look at the numbers. And by the way, do you know anyone who didn’t refinance in 2020 or 2021 or take out as much debt as they could? Because if you don’t, you don’t have a lot of smart friends. The truth of the matter is, when interest rates are zero, people borrow. And the average duration of that debt is five to seven years. That’s sovereign, that’s corporate, that’s private in all kinds of ways, real estate, obviously.

Let’s do some simple math. 2021 plus five to seven years is when? It’s 2026 to 2028. Okay, so this is what happens, by the way, if you have something that has a 5% yield, business you invest in, and you borrow at 2.5%. That’s pretty good – pretty happy for the last five, six years. Now, borrowing is 7.5%. You have a decision to make.

Do you go borrow more and keep that as a negative yield now. Do you sell the 5% asset? By the way, those things are not doing well. This is how the world works. It’s not rocket science.

So, there’s a lot of malinvestment out there. There’s a lot of refinancing that’s happening. And so, outside of the AI complex, which we’ll get to, things are not so bueno. There’s a lot of just, malinvestment liquidation having to be rolled over. And guess what? There’s a lot of having to kind of refinance and come to the market at higher rates, which is a supply and demand imbalance.

All right, that’s 101. Let’s keep going. Is anything going on in the world, any reasons inflation might be coming down the pipe? Obviously, we’ve talked about this since 2020. 2021. When we get to populist environments, we go to protectionism. And then protectionism leads to what? Global conflict. Here we are, ’22 we had Russia/Ukraine.

Well, after we started talking about that, here we are in the Middle East, in Iran, Strait of Hormuz, is not opening. I’ve now talked about this for nine months. Everybody was like, but we’re going to get a deal. Look, we got a deal. There’s no deal.

Strait of Hormuz is not opening probably ever. At least for like years, and years, and years (ever is a long time). And by the way, Bessent told you it’s not opening. Go listen. We’re just going to reroute everything. And why? Because it’s all about control of trade for controlling the exorbitant privilege of the US dollar.

That’s what that word is about. It’s not about nuclear weapons, it’s not about Israel. It’s not about all the other things you hear about. It’s about the real most important thing in the world when it comes to power: the golden rule, he who has the gold makes the rules. US controls exorbitant privilege of the US dollar so it can print at scale and do (we will get to it later in the show) what it’s going to do.

But with that in mind, that the Strait of Hormuz is not opening for years (which I’ve been yelling from the mountaintops on every podcast that everybody listened to for now). Since the beginning of that war. That’s not good for inflation. And that’s not just bad for inflation. That has a lag which creates more and more problems. Energy is the root to pretty much everything, including, by the way, the AI trade.

Okay, so, two, structural inflationary forces; three, given the debt issues that the US has, it’s also trying to roll over its own debt. That’s part of that rollover that we’re talking about, right? How are we going to get out of this (again we’ll get to this later in the show). Debasement, everybody knows it. It’s not like surprising. And by the way, Bessent’s showing you and telling you (this is the great irony) by doing buybacks, by intervening in the end.

What’s actually happening? He’s telling you they’re going to print money. And yeah, that is good for like supply and demand if and when he does it by force. But that is a debasement. That’s debasement at its core. That doesn’t exactly engender confidence at the long end of the curve. So, counterintuitively, the realization that we’re going to debase money, which eventually will hold down the long end of the curve by force, drives a debasement fear.

Which leads to the third problem, which lessens international demand. Nobody wants to own US debt, internationally, because of the debasement trade, because of what the US is doing, and because of the general like way it’s doing it. So, we’re losing foreign buyers. That’s not good for supply and demand.

And then we happen to have another thing happening that’s demanding a lot of debt on its own which is the CapEx investment. So, all the private demand for all this yield, which interest rates are quite high, is softly backed by the US government, by the way. The US has basically got September 25th, what do we do? We got a bunch of guys around the table and said, dear leader, I’m going to do US$600 billion of CapEx. Dear Leader, I’m going to do US$400 billion of CapEx. Dear Leader, I’m going to do US$400 billion by 2028. (Why ‘28? Because that’s when they’re getting reelected.)

And very well documented, there’s a reason they’re flying on planes to China when we go to China together. There is a complex here where the AI businesses and the hyperscalers are working with the administration and really driving massive debt in order to drive this CapEx, which is driving earnings, which is driving the market, etc. But the cost of that is what? The cost of that is there’s competition for capital. And you could call it an earnings story but it’s really a competition for capital. And you’re seeing it, by the way, in credit default swaps, and you’re seeing there is massive risk coming, but there is a massive demand for debt.

Because the way we’re driving this concentrated CapEx story in the AI is debt, and more of it. So, debasement, crowding out from the CapEx story, less international demand, inflation coming from Strait of Hormuz and global conflict, and then just 101 the refinancing of all the debt that was taken five, six years ago. So, I don’t know, what’s not causing it to happen?

[00:12:53] Alan

The thing I found interesting, I mean, I agree with all of those kind of longer-term structural factors, it’s also interesting how much the market has shifted in terms of short-end pricing. I mean two-year yields have gone up I think about 90 basis points since the middle of August which seems a lot. I mean, if you consider going into the last FOMC meeting, until we had the CPI print, it was, oh, they might, they might not, then the core CPI came out, whatever, closer to 0.3 than 0.2.

Then it was a done deal. Now, they’re hiking four times in the next year. So, we’ve had this huge shift in expectations at the short-end as well. Maybe it’s somewhat justified, maybe it’s the realization that the Strait of Hormuz is going to stay shut or this CapEx expansion will continue. But I mean, what’s your perspective on that repricing?

[00:13:44] Cem

My perspective on all of the Fed kind of Kabuki theater is… First of all, let’s just step back for a second. Literally, the meeting before last Warsh came out and sided with the doves, and that projected that we were going to have no structural inflation and that we should be worried about. Then we got CPI, which showed, in their numbers, that inflation was slowing. And then he came back and projected into weakening dollar, and all the issues, a conservatism at Jackson Hole and then followed up with this very hawkish kind of projection. What changed? Why? What happened?

And, in my view, it is, first of all, we all know, and Bessent said as well that raising these interest rates in front of the curve has zero effect on inflation. This is a supply side inflationary story. This is not a growth inflationary story that we’re experiencing. And you are not going to slow inflation by raising rates.

So why do this? Well, what happened when the US did this, when they did this? Well, dollar strength, gold weakness, this is the whole game. If you want to be Japan, and you want currency strength and then you want to be able to print a gazillion dollars, you can’t look like a banana republic. So, you cannot have Warsh and Bessent, despite as much as they are 110% (you better believe) one and the same. There’s zero independence. They come from the same school of hedge fund managers. It’s not a coincidence. By the way, I want to be clear, Warsh’s father-in-law is literally, call it, best friends with Trump.

There is no light between the administration and Warsh. But the perception has to be. You need brakes on that race car if you are going to try and control. Imagine you are in control of trying to navigate what the US is going to try and navigate which is printing money at scale to drive money into its own economy, at scale. I’m not talking about like a trillion dollars, I’m talking about tens of trillions of dollars. You better project Kabuki theater like the that the Fed is independent. And when important, when needed, raise a quarter, do whatever you need to, to help manage the circumstances.

There’s a reason the two of them, Warsh and Bessent, are seen again and again flying on Airforce One together. This is not like a casual, like Powell, like we had our quarterly meeting, I went to the Oval Office for 45 minutes… This is like they’re continually…

And by the way, if the US is trying to pull off what it’s trying to pull off, this is not like business as usual. They’re both in it not for anyone else, they’re in for the US. If you think the Federal Reserve of the United States is in it for fairness, and that everybody is better off, I’ve got some beachfront property in Arizona to sell you. It’s not how it works.

So, for my mind, long-winded way of saying Kabuki theater. I would not put too much into it. It achieved its primary goal which is to create an appearance of independence of Warsh to strengthen the dollar in the short-term and to drive an ability to now navigate what’s coming. And again, we’ll get to that more and more at the end of the show.

[00:18:01] Alan

Going back to bonds and everybody’s been talking about the bond/equity relationship. I mean, obviously we’ve had that shift in correlation. That’s one dimension to it.

But I guess, more importantly, there’s a sense in markets. We have seen, historically, periods of time where we’ve had rising bond yields and equities have held up, and then you have, at some point, you reach a tipping point and equities can’t adjust. I mean, it’s not always the case but we’ve definitely seen that before; Q4, 2018, for example, 1987 is the classic example, although that’s extreme, yields at 10% in the stock market.

[00:18:48] Cem

Let me just jump in, Alan, that’s not where we are.

[00:18:51] Alan

Yeah.

[00:18:53] Cem

And let me tell you why that’s not where we are. We have the most concentrated earnings growth and economic, not to mention market, allocation in the history of markets. Not like 10, 20 years, literally like a 100 years of market history.

And Carlyle did a wonderful report, which I encourage everybody go read, that really dismisses this idea that the earnings growth that’s coming from all of the… By the way, where is it coming from? It’s coming from all the AI complex. There’s literally zero to negative earnings growth everywhere outside of the AI complex. Yet we’re seeing what looks like a tremendous burst of earnings growth year-over-year.

And people are justifying these record valuations, by the way. When I say record valuations, adjusted for the ten-year bond, which is how you need to look at valuation because that discount rate… valuations have never been higher, ever – tech bubble is lower and, depending on what metric you’re looking at, definitely close. So, there’s no debate there.

The way people are justifying that is saying look at this earnings growth, and projecting that earnings growth into the future. “We have an AI revolution, the earnings are going to sustain.” I hate to tell you that’s not how it works. And people have done the math and if you go read it, it’s very clear, all of it, a 100% of the earnings growth is not just coming from this complex. The reason it’s coming from this complex can be accounted for by two major forces. One, when Anthropic and all these companies go from US$380 billion to US$2 trillion, those gains get marked as earnings.

[00:20:50] Alan

Sure, it’s all revenue in day one.

[00:20:54] Cem

That’s not earnings, that’s not. I mean, they keep going to infinity but that’s literally the definition of a bowl, that number goes up. And it’s happening where? It’s happening all in that very concentrated space. And then when Anthropic all of a sudden has US$2 trillion sitting in its pocket, no earnings. But what does it do with it? Well, it’s got to go do CapEx. And by the way, dear leaders tap them on the shoulder, all the hyperscalers say, go spend that money. It’s, go spend that money or I’d hate to see what happens to that car outside.

So, that CapEx, and there are lots of charts which I could share (if we had the ability to here on the show) that cash, operating cash is doing one of these to those businesses. And income, non-cash accounting earnings is doing this. And so, it’s not just that, again, it’s a sugar boost, as well there, because that CapEx is earnings because you can now depreciate that CapEx. And so, they’re taking all this depreciation, they’re doing all of this accounting for all these gains. But I hate to tell you, if the market goes down, it’s not like we stop that earnings growth, it actually goes the exact opposite way. It’s not real sustainable earnings growth unless the market just keeps doing its thing. So, it’s not like the earnings is driving the market. The market is driving the earnings.

[00:22:31] Alan

But it’s spending that’s driving the earnings. Is that not fair? Which is now being financed.

[00:22:37] Cem

Which is coming from where? Where is that liquidity coming from?

[00:22:40] Alan

Yeah, it was operating cash flow.

[00:22:42] Cem

We just went to US$250 trillion dollars of equity valuation. In April and May of this year, in two months, it went to US$300 trillion. What is that? That US$50 trillion, I’m telling you, the majority of it is showing up as earnings. That’s going to drive some pretty good earnings growth, about 20%.

And so, again, this is not just me. You can go read the Carlyle report that breaks this down in intimate detail. But the fact that we paint this as somehow a sustainable level of growth that’s somehow connected to an AI revolution, it has nothing to do with the efficiency coming from AI. It literally has nothing to do with the efficiency coming from AI. It has everything to do with the CapEx spend that’s coming from the investment bubble that’s being inflated.

By the way, this financialization of the market. I mean, it’s hard to even compare this to the 2000 tech bubble because the market is way bigger relative to the economy. And so, the effect on the whole economy is literally a 5x relative to where we were in 2020… in 2000 (I said 2020), in 2000 though, similar effect, just to a much lesser extent.

What was earning growth in 1999? Any idea, Alan? It was 27% earnings growth. You think that’s a coincidence? Where was earnings growth in 2000, 2001? What was it? Was it the market driving the earnings or was it the economy driving the market?

This is what bubbles do. This is why bubbles exist. And by the way, there’s always, always a justification for the bubble which somehow points to earnings because those earnings are coming from the bubble. So, it’s always an argument that the valuations are justified because of the earnings growth. That is how a bubble literally, and structurally works. But we continue to do this very simple, stupid kind of human math that we project this earnings growth is real. It’s not real.

[00:24:59] Alan

The question is, how does it end? I mean…

[00:25:03] Cem

Just because there’s a bubble doesn’t mean it ends in a year or two, by the way. If we get to how…

[00:25:05] Alan

What are the catalysts? I suppose that comes to my point. I mean, I don’t think yields are going to dissuade 50 basis points, that CapEx spend. But what is the thing that, I suppose, slows the trajectory of growth of the CapEx?

[00:25:27] Cem

So, this is the critical thing for people to understand. People think calling it a bubble and not telling me when it’s going to pop is worthless. It’s not worthless. Because what’s important is to understand the fragility under a system. Because investing is not just about returns. It’s about risk relative to returns.

And the fragility of the system, by definition, because we are so concentrated, so focused on one thing, this is not broad-based economic growth. This is not diversified, like healthy growth. This is dependent on the equity market itself and the investment, that’s driving into this part of the complex, based on that growth. By definition, that creates fragility.

So, what I’m telling you is this is fragile. It does not mean that it’s not an inelastic situation where things can go up big before they go down. That can happen. But understanding that distribution allows you to bet on the outcomes that are not just up/down.

Everybody is still… not everybody, but the majority, let’s say 98% of the world is still playing in a 2D world. But Cem, is it going up or down? You know why they do that? Because it’s easy. Nobody wants to think. We have these incredible tools that are liquid. We can do much better. We’re literally on a podcast called Systematic Investor, which is, think about distributions, think about the risk and the different sets of outcomes that are out there, and let’s position accordingly based on that distribution.

[00:27:20] Alan

But I mean, I think it’s fair to say that for the majority of people, their portfolios are going to be impacted as to how long this is sustained. I mean, equity risk dominates most portfolios, as you say. The equity risk is primarily being driven by this one theme. Hyperscale spending is going to be US$800 billion this year. It’s supposed to rise to over US$1 trillion in the next few years.

Will that happen? Does that sustain us? Do we need to watch the second derivative, the third derivative? I suppose they’re the things that investors need to grapple with, to think about. What are the signposts for that this is starting to…

[00:27:56] Cem

So, let’s get to the signpost. That’s fine.

[00:27:58] Alan

Yeah.

[00:28:00] Cem

If fragility exists explicitly in this very narrow part of the market, like everything depends on this one part of the market which is driving this fragility. We should probably focus on that part of the market, because the rest of the market, it’s completely different characteristics. I think there was a recent piece, you mentioned it. I think before we talked about it, what percentage of the market was a negative beta?

The number was like 40%, 45%. Yeah, 45% of the S&P has a negative beta. Think about that. There’s no better sense of fragility. What’s driving the growth? It’s one thing, one very fragile thing.

And so, the question is, will there continue to be massive investment into this piece, and where is that going to come from? Who is going to support it? And if markets decline, how’s it going to happen?

And now there’s the good news. The government seems to be intent, and I think this is why the bubble ultimately exists, I think there’s a lot of, hey, we got your back, keep going. Hey, Larry Ellison (really close friends with the Trump administration) take as much debt as you need because the worst case, we will bail you out. We have your back.

So, that, in my opinion… And again, you saw it on September 25, when they sat around a table. You’ve seen kind of what’s happening here. In my opinion, that’s a big reason for why we are here and why they’re willing to take the level of debt they are to invest in this stuff. It’s not just the promises of AI, and being left behind. Yeah, there’s some of that. But to the scale at which this is happening is, in my opinion, very much driven by the administration forcing the issue, and it will more explicitly back it if and when it’s a problem.

And that’s the good news, assuming you think the administration has the ability and the power to control all of this. Which I know there’s a reason we say don’t fight the Fed, historically. The US is the biggest entity in the world and has the power, historically to, in the words of Bessent, I’m the House now – to be the House. And so, they are going to do everything they want to or need to as they feel. Now the question is, in a world with a China that is, nipping on their tails and really intent to disrupt what they want to do, which I think is very important, in a world where there’s internal political questions of whether Trump at all will remain in control and want the same things as the other politicians in the system, there are a lot of things that are uncertain. And basically, the linchpin, the cornerstone that supports all of this bubble, the continuation of this, the ability for it to not fall down, sits in Bessent’s and, increasingly, Trump’s hands. So, it is an incredibly fragile, yet currently managed, proactively managed situation.

And so, you asked me what’s going to happen. Imagine you have two tectonic plates, and the pressure is immense, and nothing’s moving. It doesn’t mean that the odds of an earthquake haven’t increased. I’m telling you the odds of an earthquake, of a tail event are increasing dramatically. But as long as that administration is proactive and wants to support that, they can in the short-term and will. But know that there are other entities that are also very powerful who would like to undermine that. And there are things that are fairly uncertain about the political control of the administration and its ability to support these things. And that is where the risk lies.

You want an early warning signal, watch the politics, watch the ability and control of the administration, if they can support it or not. Watch China, what China’s doing. And I hate to say, and this is not the same free market of 5, 10, 20, 30 years ago. It is a market of immense control and immense intentional proactivity to ruling its outcomes. That’s why they just brought on Zervos, by the way, into the Treasury. They’re looking. That’s why we have a hedge fund manager in each bucket on each side of the equation. But that does not mean they have infinite control.

[00:33:07] Alan

Well, you could say, I mean, look at this… I mean, Bessent’s intervention was what, mid August? Yields are probably, well, at least 50 basis points higher in the 10 years since then, if not more. Okay, he’s probably done an okay job. The yen has stabilized. The dollar has gone up against the euro, against European currencies, but has been stable against the yen. So maybe he has an okay there.

But I mean, to your point about control and the long end, what comes next? Clearly, we’ve had the initial announcement around buybacks, which the market has kind of quickly dismissed the problem hasn’t got any easier for the administration. So, what do they do now?

[00:33:54] Cem

So, let’s step back again, and let’s look at what they have done, and what can we learn about how they operate and how they maintain control when it seems like they can’t continue to get the control they want. And this has great effects and implications for trend following. This is no longer a free market, right? Which is they have learned, and this is not tinfoil hat stuff, it’s pretty obvious to me at this point. They have learned very well that there are lots of mechanically operated automated strategies that do certain things that they can use to their benefit. They can take markets down and turn trend following negative. They could turn vol, expand vol and create vol-targeting strategies to liquidate. They’re skewing the market and at the end of the day all the vanna and charm flows and things I talk about come back in the market if they can expand it and then compress it.

A V bottom exists for a reason. Covid was incredibly successful in terms of a V bottom. Everybody thought that was the end of the world. What did that do? That drove a massive new refresh and new bull market. This is well understood. The Senate will understand this incredibly well. I want to highlight, in early ‘25, as soon as they came in, what did they do? 150% tariffs, everywhere. It was new. Nobody knew what to expect. How much do we believe them? So, it’s easier to do, right?

27% decline very early on because guess what, if you’re going to take it down, when do you want to take it up? Early on because the midterms aren’t for another two years. They took it down 27% and then literally turned a switch on the market and said, all right, six months, nine months, we’re going to put these off for a while, 10% on some people, maybe 15% on others. We’ll see. V bottom, completely squeezed the market, incredibly successful operation. All right, you could call that one off. Maybe it wasn’t orchestrated. Blah, blah, blah, blah, blah, blah.

What happened this spring, exactly the same thing, same time, early in the year. What do they do? End of a civilization will be here tomorrow. Literally implying nuclear war. What does that do? Vol expansion, market down 10%. Next day, end of the quarter, day before the end of the quarter, bunch of short gamma in the market because of the JPMorgan trade, all the things, what they do?

We have a deal, two weeks, it’s going to be signed. Meanwhile, Iran, everybody else is like, what are these guys talking about? It’s all a charade, guys. It is all very orchestrated and the V bottom is a feature. It is not a bug. These guys are hedge fund managers. He’s literally saying, I’m the House.

[00:37:16] Alan

Well, where is the V bottom in bonds then?

[00:37:19] Cem

It’s coming.

[00:37:20] Alan

Okay, what’s that going to look like?

[00:37:22] Cem

It’s going to look like somewhere between 5.5% and 6% in the 10-year, and it’s going to be quick, and it’s going to happen sometime in the next three months, and then they’re going to come, and the market, by the way, is going to be allowed to also come down. Those two things will match at the same time. I think we’re getting 25%, similar to Liberation Day, 25% to 40% in the S&P in the first two quarters of this year could come in Q4, not likely, but it’s possible after the midterms. They don’t want it to happen before the midterms.

And when it happens, that will give them the excuse they need, much like Covid does, much like how these other crises have done, to deploy to bring the Fed and Warsh on. The Kabuki theater ends and Warsh comes on with massive facility at the long end of the curve. Like Hank Paulson literally came out five months ago and told you we have a coming treasury crisis. I told you five months ago. Everybody was like, talked about that for two seconds. I’m like, that’s important.

Do you think Hank Paulson comes out of nowhere and goes on to Bloomberg and says there’s a coming treasury crisis and we need to prepare a facility for it? Like literally five months before… does this look familiar, guys? We have a coming treasury crisis. Is that happening? Wake up.

Everybody’s like, no, this is a free market. This is a managed market by two hedge fund managers that have been placed there because they understand the things that I’m trying to communicate on here, that the earnings themselves are a function of the CapEx, and driving investment directly into this channel. And that can only happen if markets go up. And the only way we can do that at this point is because there’s not enough earnings coming to drive it itself, there’s not enough to do it itself. We have got to print the money.

[00:39:19] Alan

So, it is higher yields that breaks the equity market, is that what you’re saying?

[00:39:23] Cem

It is at least one of the reasons. It is the coming treasury crisis. That’s what drives the facility… Again, you need that to happen in order to have an excuse or reason to do QE to hold the long curve. But that also needs to be matched with the equity market decline. And that’s what allows you to roll out the sovereign wealth fund to buy all the equities and drive direct investment to compete with, by the way, what China has been doing for two decades.

How do we drive the scale of direct investment in the US that we need to compete with what China has done for the last decade plus? Do you think solar investment in the growth of the solar industry there had anything to do with profits? Do you think the electric car revolution that happened in China has anything to do with profits? Do you think the nuclear infrastructure buildout in China has anything to do with profits? How in the world can a free market compete with that? The answer is it can’t.

And so, if you want to, if you’re the treasury secretary and you need to compete with that, and you need to drive growth, and you need to compete with China, you have one thing that is dramatically a massive source of leverage against China and to grow out of this mess that you’re in, not to mention to monetize the debt. That is the exorbitant privilege of the US dollar.

And by the way, that’s why we’re in Iran. China knows this. China started to trade with Iran in yuan, they started to trade with Venezuela in yuan. Immediately after, what do we do? We go into Venezuela and Iran, close the Strait of Hormuz. Why? Because the Achilles heel of the US is the potential loss of the exorbitant privilege and it’s the greatest strength. And without it the empire falls.

[00:41:19] Alan

But we are a long way from QE at the moment.

[00:41:22] Cem

We are not. We are not. You quote me on this. We are within six months.

[00:41:26] Alan

Well, okay, I mean, okay, six months. But I mean you’re talking about a 40% sell-off in the equity market to facilitate that.

[00:41:33] Cem

We have QE happening right now, just nobody calls it QE. US$9 billion in treasury buybacks, which is small to start, but they’re boiling it down. And a US$60 billion facility to intervene in the Japanese yen. And the reason we haven’t done it yet is because Warsh should all… What would be the reaction now to this whole Kabuki theater if Warsh came out and just started printing money and putting a capital along on the curve, what would be the reaction? So, that’s why it’s not happening yet. And it feels like we’re a long way away. But when the administration is basically about post-midterms, is ready, and it will not be past June of next year because they have the ‘28 election happening. When they’re ready, they will step away.

They are the third leg of the stool. You have the macro, you have got the flows, and then you have the administration and what they are doing proactively to manage the situation. And that leg of the stool is currently keeping the plate spinning going into the midterms. But at this point, they need to take it down, to take it up, and they need bigger guns and they cannot deploy those guns without a crisis.

[00:42:50] Alan

You mentioned the midterms. I mean, how important are the midterms now, given Trump’s popularity level is so low? The general expectation, I think is fair to say, is a poor performance for the Republicans. More likely than not, the House and the Senate shift to the Democrats. That’s broadly what people are expecting. But does it matter for markets? How does that impact everything?

[00:43:18] Cem

Everybody’s still thinking about things from a prism of the last 40 years. That elections are still just like some type of thing that has ramifications. And these are free elections that happen in an XYZ way. I think, even though there is a level at which the will of the people goes far enough (and it’s hard to imagine that’s not already far enough, but it’s not) to force a change, we are not even close to that now.

And a loss in the Senate and the House on paper, in my opinion, given where we are now, regardless of these numbers, even if they’re worse than they actually look, within the realm of being able to control the outcome, the administration will (you have my word, hold me accountable if they don’t), will manage this election. And when I say they will, I mean the second…

When do all the Democratic votes come in? Late? That’s a nice little advantage, isn’t it? Because they come through what, mail-in ballots? Has there been any effort to kind of undermine the validity of mail-in ballots? Has that happened? Anybody paying attention to this? You think that’s a surprise?

The numbers are going to look better than expected or as good or whatever, not whatever. And then comes time for the mail-in ballots to come and all of a sudden some mail-in ballots are not going to appear. Some mail-in ballots are going to be deemed not fair or whatever, if needed. Now, they’re not going to do this unless they need to do it.

And I’m very much of the view that this is going to be a contested election. So, I don’t think people are whistling by the graveyard on that. I think this is just another midterm election. This is not your father’s election. By the way, this isn’t new. Anybody? This is Watergate 2.0 on steroids. They’ll do whatever they need to do.

By the way, did Trump do something else kind of similar at some point? I love that this already happened, and we’re like, no, no, he wouldn’t do that. So, we all like to believe that this feels safe to assume that things are fair now and things work like they used to work. It’s not how it works, and for reason.

This is not just about corruption. It’s not about the Trump administration. It’s about where we stand on the pressures in the system and the incentives that it’s driving. And so, my view on the midterm is, yeah, things are getting worse, which by the way, will lead to a much higher probability of a contested election here in the fourth quarter, which opens the window for whatever said decline happening sooner. And this period, which would normally not be as dangerous, which is the end of the year, becomes a lot more dangerous.

[00:46:43] Alan

What are you seeing in the options market from that perspective? Is that being priced or not or what? From a skew perspective…?

[00:46:50] Cem

It is starting to be priced a little bit, but it is way too cheap. Skew is definitely popping, but implied volatility for these events has not yet been priced. And then again, when I started talking about this a month ago, it was absolutely not priced at all. It has priced a bit more, but it is still incredibly cheap relative to the realities. In my opinion, March, January, February, March all the way to June, vol across the board in the markets is way too cheap, particularly equity vol.

And I do think that more times than not, people assume, because people are thinking that there’s risk there, that that’s less risky. And generally, that’s true. That’s very much my story, right, about flows. People are positioned for something that’s less likely to happen. And that is generally true.

I would really reiterate here, though, given the structural realities and given that administration would want something to happen there, again, trust me, Bessent et al turn from supportive and proactive to support the market, to let it go down, if not help it go down for a period. It’ll happen. You want to talk about don’t fight the Fed, don’t fight them on that side. And that’s what happened, by the way, in early ‘25.

[00:48:27] Alan

On the bond side, the move has been orderly, but what’s happened from an implied perspective? I mean, are you seeing a reaction there in response to the breakout above 5% in 10-years?

[00:48:46] Cem

Yeah, the MOVE index is starting to increase, like the implied vol, which I think is appropriate. I think this is like a rubber band. I was saying, the more those yields go higher, I think the potential energy of a bigger reaction, one way or another, gets bigger and bigger. And I do think, ultimately, this goes to maybe at 6% before it goes down to 4%. And then eventually comes back to 5%. But I do think that the markets are pricing in this risk on this end of the curve.

The realized move has not been that high. But this ‘Fed put’ is sitting out there and they’re projecting that that’s going to be at 6% or so. And I do think that’s the case. Now I want to be clear, I think inflation, not tomorrow, but like after this refresh is going to scream, in ’28. I think late ‘27, early ‘28, we’re going to get a real debasement trade like we haven’t seen before, inclusive of a Strait of Hormuz lag inflationary push. And I think that’s by design because the last thing this administration wants is deflation of any kind, at this point, to take hold. That’s the biggest risk because the debt is unsustainable and the US has to grow its way out and inflate its way out. That’s the only way. And it can drive that. All of that. This is where you don’t fight the Bessent. If they decide to turn the money printer on full force and buy stocks, at this point in history they can still do that.

[00:50:41] Alan

I’ve heard you talk about this before, this idea of effectively money printing to buy public ownership of stocks. How does that…? I mean, okay, I hear you. If we get the big equity sell off, that justifies QE money printing, etc., that’s plausible. Is that where this plays out or how can you justify that as an administration?

[00:51:11] Cem

Yeah, it’s actually going to be very popular when they do it because they’re not just going to buy. It’s not going to be like a ‘bailout’. It’s going to be sold as a sovereign wealth fund, which is similar to Norway’s sovereign wealth fund. Norway’s sovereign wealth fund is two and a half trillion, pays for all social services, it is stock ownership on behalf of the people. You’re going to reiterate that with actual ownership where people get to see their own accounts and see what they have in the form of Trump accounts. The infrastructure has already been laid for both of these.

I want to also be clear, Japan already owns 8% of the Nikkei. This is not new. People are like, oh, that can never happen. It literally happened for 20 years in Japan, and they printed money and they bought stocks. This will not be a new idea. And, by the way, it’s been incredibly successful in Japan. And how’s that sovereign wealth fund worked out for Norway? That’s worked out pretty well. So, it’s very easy to justify.

And in the process, it will not only allow the US to compete with China. And we’re going to do a… America first will be strategic investments? It’ll be very politically popular within the MAGA side of things, but it will also be very popular among the populace because it’s going to be right wing populism, at the end of the day. It’s going to be, instead of taxing the rich to give the poor, they’re going to take 10%, 20% ownership in these businesses, tax the rich, but they’re going to essentially buy in the public into stocks.

This prevents a too big to fail market going down. It drives economic growth, it allows competition with China, it short circuits the K-shaped economy by forcing everyone to be singularly invested into the equity market. And at the end of the day, it monetizes the debt. It’s the way out.

Now, the risk… not saying this is easy. This is what they want to do. I said this before, but everybody’s got a plan untill they get punched in the mouth (in the words of Mike Tyson). What’s the risk to this? Well, China doesn’t want this to happen. And, as we already highlighted, all the fragility in the system means this is very dependent on control, on the administration itself being able to deploy this without being legally or…

What happens if this world… there’s all kinds of fragility. This is like Minsky, right? It’s like built into the system. What drives the loss of control? It could be an assassination. It could be any number of things. It could be a cyber whatever. And I’m not going to point my finger at what that thing is because we don’t know. But to say, oh, it’s a black swan, is missing the point that the fragility is embedded in the system and they are trying to shoot the moon. And they have good cards, and they can drive it and they’re going to do whatever they can. But if you think it’s without risk, this is about as big a risk as there exists. This is risking the empire, this is risking the exorbitant privilege of the dollar. And this is the game we’re in right now.

[00:54:34] Alan

Curious. I mean, obviously you’re talking about control. I mean there is a natural timeline on this. We’re kind of halfway through this administration. So, if this is the actual end game, then presumably we’re seeing this playing out, starting to play out next year. If things chug along, if the equity market stays at these levels, we don’t see that big correction, then what?

[00:54:57] Cem

Then they’re going to try and deploy this at all-time highs, and they are going to have to manage and control the unpopularity of that. And what you can expect, regardless by the way, is a trend towards greater and greater control and authoritarianism because they don’t have a choice but to try to deploy it. They prefer to do it in a way, through free markets, where they don’t need as much control, where it’s broadly more popular. But you’re getting this one way or another because they have no choice. Which, by the way, would not mean we have a crisis. That would mean like a blow-off inflationary loop that starts crisis.

[00:55:44] Alan

It’s an inflationary boom. I mean does that change your…? It sounds like a change of view. I mean for a long time we’ve been talking about the inflationary period, the 1966-‘82 period. Equities traded sideways, up and down.

[00:55:58] Cem

That is not a change of view. It’s not a change at all. I mean, I’m telling you inflation’s coming. I’ve been telling you inflation’s coming for a long, long time. When interest rates were at zero.

[00:56:08] Alan

It has been five years. So that’s hitting you.

[00:56:10] Cem

We’ve been talking about this for six years. When interest rates were zero. We were pounding the table on this.

[00:56:14] Alan

But you got two very distinct scenarios there. One is the prolonged bear market punctuated by bull markets, bear market rallies effectively, and you look back after 15 years and nothing’s happened. Or are you talking about an inflationary money printed equity boom which presumably would look at Japan? You give the example of public ownership of Japan. It’s fueled a massive equity rally there. So which scenario is more likely?

[00:56:44] Cem

I want to be clear. You’re focused on the equity outcome in nominal terms. I’m really focused on the equity outcome in real terms, and I have been from the very beginning. I’ve said very much from 1968 to 1982 that markets lost 40% of their value in real terms.

Again, we all live in a world of nominal illusion. 1962 to ’82 – 20 years, 60/40 went nowhere. And by the way, that 20 year period matches 1929 to 1949 in real terms. But psychologically, and this is why we do this now, as opposed to opposite. Psychologically, everybody thinks of ‘29 to ‘49 as the Great Depression, which is a reason why we went off the gold standard, went to fiat and instead drove it through the inflationary realm. The two are the same. It’s just a matter of doing it in a fiat world where you exert it through inflation as opposed to a nominal outcome. So, I think the flaw or the mistake in that question is assuming that the inflation is any better than…

[00:58:11] Alan

Are you saying we’re going to see double digit inflation, then, for a period of time? Okay, well that would resolve this. Yeah, fair enough.

[00:58:19] Cem

Yes. I think you’re going to see inflation as bad, if not worse, probably worse than the ‘60s and ‘70s. Yeah.

Now I’ll add one little caveat to that. I didn’t mean to completely dismiss that out of hand, Alan. I think it’s fair, to some extent, which is we didn’t buy equities in the ‘60s and ‘70s. We did through Arthur Burns, drive real interest rates negative and drive an inflationary loop, which I think was very much on purpose. And we will do that again, but at greater scale.

The difference is we are going to, instead of tax the rich give to the poor, Great Society program, yada, yada, which we did in the ‘60s, ‘70s, because we’ve learned from that mistake. Instead, try and drive not taxing the rich and giving to the poor. Instead tax the rich, give to the poor, not allow the poor to spend that money because we’re going to do it through the equity market channel. We’re going to hold the sovereign wealth fund on your behalf. We’re going to deploy Trump accounts, where you can’t sell, this is for your children for 20 years.

Now, whether that flies, whether after two and a half years of this, whether the next administration says… whether the people are okay with this, what China does in response. My point is we’re going down the same alley. We’re trying to, historically… It rhymes, everything’s very similar. But this administration is trying to now react to the ‘what happened last time’ and say, okay, we had a better solution. I’m skeptical that it really works as smoothly as they’re hoping and my best guess is that we end up in real terms, which is really how you have to look at this, in a very similar outcome.

[00:59:59] Alan

Good stuff. I’m just conscious we’re up at the hour. Was there anything else? I’m just looking at my notes. We covered many themes. Was there anything we missed or was any particular points you wanted to make that we hadn’t got to?

[01:00:13] Cem

Well, I think anybody listening to this just feels probably like, powerless. Like, what do I do? And I think I’ll end with, 60/40, at its core, its success of the last 40 years is a function of interest rates going top left to bottom right.

And the reason we haven’t seen a reset. We saw a reset on the bond side, we’re seeing that. We keep talking about the bond side, but the reason we haven’t seen the equity side, because of what we started the whole conversation with, which is this lag to the refinancing of the debt. And a concerted effort by the administration proactively to try and drive CapEx to keep things going in the equity market.

But know that, at its core, interest rates and inflation are keeping the long end of the curve at higher and higher inflation, ultimately the only way out of this is either equity markets lower because of multiples or massive inflationary outcome. And in this inflationary outcome, your greatest risk to your wealth is equities may not be the answer for you, bonds definitely won’t be the answer for you, is to hedge that structural inflation.

So please, by all means, do everything you can to manage that debasement and, importantly, make sure you’re diversifying. Make sure that you can benefit from different outcomes of different things that are unrelated to equities and bonds. And I think that’s something that most people aren’t used to and most people are recency bias machines. We just look at the patterns of our lives and say, well, this has worked, so this has got to work. But I really encourage people not to wait a year or two at this point because I think we’re up against those changes as we speak from the equity side of things as well.

[01:02:13] Alan

Good stuff. Well, diversification and looking at alternative sources of return is definitely on message from all of us here at Top Traders.

So, thanks very much, Cem, for joining us again. Niels will be back next week, so if you’ve got questions, it’ll be Niels in the chair, but thanks for tuning in. We’ll be back again soon. So, from all of us here at Top Traders Unplugged. Talk to you soon.

[01:02:40] Ending

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